Published: October 02, 2008 11:59 pm            

ARTHUR FOULKES: Good reason to be skeptical of government fix for economic woes

TERRE HAUTE — The subprime mortgage crisis came about for two primary reasons. First, the government created a lot of new money for years after 9/11 to prevent a big recession. Second, Congress wanted to encourage home ownership and so allowed two major players in the mortgage market, Fannie Mae and Freddie Mac, to avoid strict oversight if they just helped people who normally could not afford a home buy one.

Now we are being told the solution to the current problem is printing new money and allowing Congress to pass another law. We have good reason to be skeptical.

The U.S. government creates new money through the Federal Reserve Bank. Since its creation in the early 1900s, the Fed has almost exclusively caused the money supply to rise. This is why the dollar is worth less each year.

The Fed and most people in Washington think creating new money is a smart way to avoid economic slowdowns. After 9/11, people worried about a big recession, so the Fed worked to create lots of new money. This new money meant banks had more money to lend at lower and lower interest rates. This new money found its way to the housing market where prices of homes started to rise dramatically in many parts of the country. Lenders lowered their standards and home ownership rates in America started to climb for the first time in decades.

Fannie Mae and Freddie Mac are two government-created institutions that were designed to make housing more affordable for Americans. As the Reason Foundation’s Michael Flynn writes in an essay on the root causes of the crisis, around 2003, these institutions were found to have been engaging in misleading accounting. When Congress prepared to lower the regulatory boom on them, however, Fannie and Freddie struck a deal with Congress, avoiding tighter regulation by promising to make home ownership possible for yet even more Americans.

Suddenly, Americans could buy a home with virtually no proven ability to pay. High risk or “subprime” mortgages, normally around 8 percent of the mortgage market, suddenly rose to around 20 percent. And lenders didn’t worry about making these risky loans because they knew Fannie Mae and Freddie Mac, with their quasi-government backing, would buy the loans from them, essentially transferring the risk of default to faceless taxpayers.

Finally, around 2004, the Fed started to slow down the creation of new money and interest rates started to rise. This quickly affected sub-prime mortgage holders with adjustable-rate mortgages. Defaults on homes started to rise and investments that were made up of mortgages packaged together started to become investments few people wanted.

Earlier this year, panic began to set in. The Fed began pumping new money into the economy once again. The government took over Fannie and Freddie, financed the purchase of Bear Stearns, a big investment firm, and bailed-out AIG, a big insurance company with lots of money in mortgage-backed investments. As a next step, Congress wants to buy billions of dollars worth of “toxic” mortgage-backed securities from private companies and restore “confidence” in the system.

In other words, the very people who got us into this mess, in the Fed and Congress, promise to get us out.

American taxpayers and voters are right to smell a rat. The real culprit here is the government itself, and the desire of politicians to tamper with the free market by creating false “wealth” by printing new money and subsidizing home purchases for people without adequate credit.

Every element of the proposed government rescue is bad. Creating new money always leads to new “bubbles” and a false prosperity that always ends in a crash. And rescuing people from bad investments creates a “moral hazard” and slows the market’s ability to adjust to genuine consumer demands. Even supporters of the rescue package admit it is designed for the short-term alone.

Many people worry that America’s credit markets will freeze up if the government does nothing. If they mean subsidized credit markets, or credit markets encouraged by easy money policies at the Fed, this is a good thing. If they worry investors will not discover new (or rediscover traditional) ways to find good borrowers, they are worrying for no reason.

Markets are incredibly resilient because they are merely the combined and cooperative efforts of human beings to improve their lives. For this reason, they are creative, dynamic and strong. They require no government “rescue.”

Arthur Foulkes writes a column on business and economics. He can be reached at (812) 231-4232 or arthur.foulkes@tribstar.com

        

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