A Conservative Economic Narrative

At City Journal, The Free Marketeers Strike Back. It is a long and probing look from the perspective of conservative economists at free markets, regulation, and the origins of our current fiscal crisis. I highly recommend the entire article. To summarize the conclusions:

- Keynes was demonstrably wrong.

- Rising costs of energy were implicated in our economic meltdown and are the looming challenge for our future economy. Our government is not moving to meet this challenge, it is moving in the opposite direction.

- Don't underestimate the importance of monetary policy. Keep interests rates high enough so that prices remain stable but sufficient currency and credit are available to finance steady growth. Interest rates set too low for too long are a major factor in causing spectacular bubbles. That is what happened with Greenspan and the housing bubble.

- Market bubbles are an inevitable part of capitalism. You can't kill bubbles without killing capitalism. It is only when bubbles are combined with a very cheap money supply that they become truly dangerous in size.

- Recessions, as a part of the business cycle, are an intregal part of capitalism. Recessions are necessary for our system to correct market imbalances. You can't stop recessions without killing capitalism.

- The much maligned derivative market brought tremendous financial benefit, particularly to the world's poor. They allow for the efficient allocation of risk, thus increasing the availability of cheap credit. Some have recommended greater transparency for the market by funneling them through a clearing house that would create a record of the swaps.

- Big banks do not bring any economy of scale and, therefore, we should consider limiting the ability of banks becoming "too big to fail."

- Big banks should not enjoy taxpayer protection because that harms free competition, putting smaller banks at a disadvantage

- Reasonable regulations are necessary to efficient markets, and that includes requiring sufficient reserves. Banks become far too overleveraged, leaving them vulnerable during the economic downturn.

- Republicans need to stand up more forcefully for markets.

- Ballooning American and European debt poses a huge threat to long-term prosperity.

- By increasing taxes and imposing the wrong regulations, Western governments are hindering entrepreneurship and hence growth, that is the path to long-term prosperity.

The one thing Guy Sorman touches upon in his article does not go into any great detail about is the dismantleing of traditional lending standards. It is critical to note that Democrats dismantled our lending standards in the 1990's on a now discredited assertion that racism was endemic in the mortgage and loan industries. Even though now fully discredited, the race based standards remain in our laws and have actually been strengthened by Obama as part of the financial regulatory overhall recently passed into law.

Sorman does make one interesting point in addressing this issue. That is that, in comparing U.S. to Canadian home ownership, the Canadians fared better because of higher down payment requirements, yet the overall home ownership percentage between the U.S. and Canada are the same, suggesting the final irony, that Democrats destroyed our credit system for nothing. Here is how Sorman addressed the issue:

. . . [E]asy money helped expand a massive credit bubble. And that credit helped fund a wild proliferation of risky subprime mortgages, often issued with little or no money down, thanks to relaxed mortgage-lending laws and to Fannie Mae and Freddie Mac, the now-infamous “government-sponsored enterprises” that busily bought mortgages from lenders to keep homeownership expanding. The bursting of the bubble in 2008 brought the U.S. banking system, which had invested extensively in the subprime mortgages, to its knees. Given the enormous scale of the crisis, Taylor says, it’s clear that the private sector could not have caused it on its own. “Distorted incentives encouraged private speculation,” he says. “Central banks should return to their former global targets against inflation and be less erratic and more predictable.”

Taylor’s analysis draws support from a comparison of the financial crisis in the U.S. and Canada. Canadian banks, it turns out, weathered the financial storm much more effectively than American banks did. The reason: Canadian mortgages, unlike American ones, legally required robust guarantees, usually a 20 percent down payment. That helped keep homeowners from running away from their mortgage payments when things turned south, as happened in the United States. Canada and the U.S., it’s worth noting, still have the same percentage of homeowners—roughly 67 percent—meaning that the American incentives that favored risky bank behavior failed to increase ownership levels.

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Our Post Racial President, The Recession & The Financial Sector

So what caused our financial crisis?

According to Obama, it was Wall Street greed and the lack of financial regulation. Indeed, to prove the point, he had DOJ and SEC initiate criminal investigations of one of the biggest of derivatives traders, AIG's Joseph Cassano. Further, Obama established a commission under Phil Angelides to lay blame - then promptly pushed for vast new financial regulations several months prior to the completion of the commission's report. No need to worry about that though, as the Commission's scope of investigation does not include Fannie Mae and Freddie Mac. This would be the same as commissioning an investigation into the causes of the civil war, yet excluding slavery from the scope of the investigation. The bottom line, even if the useless commission report were of any value, even if its recommendations were valid, and assuming all recommendations were followed completely, given the limited investigatory scope, the reality is that, the chances of the recommendations actually and effectively sorting out our financial sector would be minimal.

Further, it would seem today that the claim that derivatives were at the heart of our financial mess took a major knock over the past month. The WSJ reports that "both SEC and Justice Department investigations, which many had expected to expose the ultimate subprime malefactor, recently evaporated overnight, apparently clearing (AIG's derivatives trader) Mr. Cassano of wrongdoing." Color me not surprised. Derivatives played an important role in spreading risk. They fell apart not because of "Wall St. greed," (nor "white folk's greed," for that matter) but largely because of mark to market accounting rules and an incredibly anomalous turn of events where the market for mortgage backed securities dropped to zero for a period of time.

At any rate, the proximate cause of the sub-prime meltdown, and thus our current fiscal crisis, was the left's social engineering to force erosion of lending standards and downpayment minimums based on what amounts to racial quotas - no finding of any actual racism need be identified. Fannie Mae and Freddie Mac were then used to create massive demand in this degraded market.

The single most important correction Obama could make to insure a financial melt-down of this ilk never again occurs would be to reinstitute reasonable, colorblind lending standards by simpling striking the provisions of the Community Reinvestment Act that, today, punish lending institutions for failing to meet racial quotas without respect to whether any single act of racial discrimination every occurred. Obama would of course retain authority to punish severely any cases of actual racial discrimination in lending. Obama has chosen the opposite tack. He is significantly expanding government enforcement of current CRA provisions as part of his financial "reform."

And now we learn today that Obama, as part of his financial regulations, plans to introduce race and gender quotas into our financial sector itself. This from Real Clear Politics:

. . . Section 342 [of the Senate & House financial regulation bill] declares that race and gender employment ratios, if not quotas, must be observed by private financial institutions that do business with the government. In a major power grab, the new law inserts race and gender quotas into America's financial industry.

In addition to this bill's well-publicized plans to establish over a dozen new financial regulatory offices, Section 342 sets up at least 20 Offices of Minority and Women Inclusion. This has had no coverage by the news media and has large implications.

The Treasury, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the 12 Federal Reserve regional banks, the Board of Governors of the Fed, the National Credit Union Administration, the Comptroller of the Currency, the Securities and Exchange Commission, the new Consumer Financial Protection Bureau...all would get their own Office of Minority and Women Inclusion.

Each office would have its own director and staff to develop policies promoting equal employment opportunities and racial, ethnic, and gender diversity of not just the agency's workforce, but also the workforces of its contractors and sub-contractors.

Is it just me who is getting the old Soviet political officer vibe?

What would be the mission of this new corps of Federal monitors? The Dodd-Frank bill sets it forth succinctly and simply - all too simply. The mission, it says, is to assure "to the maximum extent possible the fair inclusion" of women and minorities, individually and through businesses they own, in the activities of the agencies, including contracting.

How to define "fair" has bedeviled government administrators, university admissions officers, private employers, union shop stewards and all other supervisors since time immemorial - or at least since Congress first undertook to prohibit discrimination in employment.

Sometimes, "fair" has been defined in relation to population numbers, . . .

Lest there be any narrow interpretation of Congress's intent, either by agencies or eventually by the courts, the bill specifies that the "fair" employment test shall apply to "financial institutions, investment banking firms, mortgage banking firms, asset management firms, brokers, dealers, financial services entities, underwriters, accountants, investment consultants and providers of legal services." That last would appear to rope in law firms working for financial entities.

Contracts are defined expansively as "all contracts for business and activities of an agency, at all levels, including contracts for the issuance or guarantee of any debt, equity, or security, the sale of assets, the management of the assets of the agency, the making of equity investments by the agency, and the implementation by the agency of programs to address economic recovery."

This latest attempt by Congress to dictate what "fair" employment means is likely to encourage administrators and managers, in government and in the private sector, to hire women and minorities for the sake of appearances, even if some new hires are less qualified than other applicants. The result is likely to be redundant hiring and a wasteful expansion of payroll overhead.

If the director decides that a contractor has not made a good-faith effort to include women and minorities in its workforce, he is required to contact the agency administrator and recommend that the contractor be terminated.

Section 342's provisions are broad and vague, and are certain to increase inefficiency in federal agencies. To comply, federal agencies are likely to find it easier to employ and contract with less-qualified women and minorities, merely in order to avoid regulatory trouble. This would in turn decrease the agencies' efficiency, productivity and output, while increasing their costs.

Setting up these Offices of Minority and Women Inclusion is a troubling indictment of current law. Women and minorities have an ample range of legal avenues already to ensure that businesses engage in nondiscriminatory practices. By creating these new offices, Congress does not believe that existing law is sufficient.

Cabinet-level departments already have individual Offices of Civil Rights and Diversity. In addition, the Equal Employment Opportunity Commission and the Labor Department's Office of Federal Contract Compliance are charged with enforcing racial and gender discrimination laws.

With the new financial regulation law, the federal government is moving from outlawing discrimination to setting up a system of quotas. Ultimately, the only way that financial firms doing business with the government would be able to comply with the law is by showing that a certain percentage of their workforce is female or minority.

The new Offices of Women and Minorities represent a major change in employment law by imposing gender and racial quotas on the financial industry. The issue deserves careful debate - rather than a few pages slipped into the financial regulation bill.

And Obama campaigned on a promise of healing America's racial divide? Between this and the reverse racism pervading the DOJ, it would seem that, like seemingly all of Obama's promises, the gulf between what he promised and the reality he has brought are night and day.

Update: It would appear that Obama is not merely going to force race front and center of our lending industry, but that his administration has actually resuscitated the very riskiest of loans - no doc's. This from Hot Air (links omitted):

Remember how angry America got in the wake of the housing market collapse about the no-document mortgages bought by Fannie Mae and Freddie Mac? The so-called “liar loans,” also known as “NINJAs” (no income, no job or assets) frequently allowed people who shouldn’t have qualified for mortgages to get loans by simply not disclosing their financial position, and then speculate that the equity would increase fast enough to either flip the house on a resale or refinance under better terms. ABC News and Forbes reports that just two years after the collapse, “liar loans” are making a comeback. . . .

In the height of the housing boom in 2006 and 2007, low-doc loans accounted for roughly 40% of newly issued mortgages in the U.S., according to mortgage-data firm FirstAmerican CoreLogic. University of Chicago assistant professor Amit Seru says that for subprime loans, the portion exceeded 50%.

Then came the housing collapse, with subprime loan defaults playing a leading role, particularly the low-doc “liar” variety. The delinquency rate for subprime loans reached 39% in early 2009, seven times the rate in 2005, according to LPS Applied Analytics.

. . . [T]he federal government has jumped feet first back into risky lending, this time through FHA . . .:

. . . the Federal Housing Administration is making 95% LTV [Loan To Value] loans to low-income borrowers with poor credit and little savings, he argues.

Say what?

Well, the fact that the federal government has shifted its social engineering to FHA after all but destroying Freddie and Fannie should come as no surprise. Nor should it come as a surprise that they’re using the same mortgage-backed securities mechanism that created the global financial collapse to shed the cost of guaranteeing those loans. But one might have thought that the collapse of the housing bubble from overspeculation and irrational supply of credit would have taught Washington a lesson about interfering with the lending markets.

If FHA is guaranteeing loans for 5% down to people with bad credit and no liquidity, then be prepared for the next collapse and bailout, this time at FHA. . . .

The only way that Obama and the far left can lead us down this road to hell again is because they have successfully hidden the actual causes of our current economic crisis. When Obama was elected, the chance that Congress would actually investigate the causes of the crisis dropped to zero. And indeed, it would seem that our Post Racial President is actually going to increase the degree of racial / social engineering in our financial sector. God help us but we are in a race - will Obama destroy our country before we can throw he and the far left out of office?

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Demonizing Credit Default Swaps

If you listen to Obama and the left tell the story, the cause of our economic meltdown had nothing to do with Fannie, Freddie, fraudulent bond ratings, or - at the heart of all of these - race based market distortions introduced by Democrats and protected with the race card right up until Fannie and Freddie failed. The left's boogyman is Wall St. greed as expressed through transferring risk to Fannie and Freddie and the use of Credit Default Swaps. And this meme has been picked up in Europe as regards Greece's fiscal meltdown.

I blogged on Credit Default Swaps in a long post on the origins of our economic meltdown here. Credit Default Swaps are basically insurance - a way of managing risk. There is nothing untoward about them - though they failed during the mortgage meltdown because of mark to market accounting rules along with a big assist from fraudulent bond ratings.

Now, the left, and the Europeans, want to place substantial restrictions on Credit Default Swaps. It is suffice, it to say, an unwise idea. This from Prof. Bainbridge:

. . . This is just absurd.

Let's review what credit default swaps are and how they work:

Credit default swaps (CDS) are a form of insurance. Let's say you borrow money from me. I'm worried that you might default. So I hedge that risk by purchasing a CDS. If you end up unable to pay me back, the seller of the CDS will cover my losses. (The insurance analogy admittedly is not exact, but it suffices for present purposes.

As the Journal explained, banning the use of CDSs as a hedging device would have adverse consequences, just as banning insurance would:

Any attempt to restrict CDS trades could result in unintended consequences such as more risk for the financial system and higher borrowing costs for a range of nations and companies, some analysts and investors warn.

Restricting credit-default swap trading could push up borrowing costs for various nations if investors feel they have fewer ways to protect themselves if the bonds' prices decline. . . .

. . . As the Journal explained:

[A] study released Monday by Germany's financial regulator, BaFin, found no evidence that credit-default swaps have been used to speculate against Greek national debt. The study showed the net volume of outstanding credit-default contracts on Greek national debt has remained unchanged since January at about $9 billion. This compares to total Greek government debt of about $400 billion. "The market data do not show massive speculation in CDSs," the regulator concluded. . . .

There is much more. Do read the entire post. The bottom line is that CDS perform an important function, and to regulate them out of existence or to severely circumscribe their use is very likely to have unwanted consequences. And the last thing the world economy needs now is more volatility.

Of course, that is the rational way of looking at it all. For Obama, who has shown that he is quite willing to demonize anyone (Chysler secured debt holders) or anything (insurance companies) for political ends, rationality would seem to be of little consequence.

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