It’s the (mixed) economy, Stupid. Berlau in debate

Ain’t it something!

Congress just got through with passing a multi-billion dollar bailout to the government-sponsored housing enterprises Fannie Mae and Freddie Mac, which own half of America’s mortgage debt. Fannie was created as a government agency in 1937 as part of the New Deal, and despite it and Freddie’s restructuring some 40 years ago, it still maintained government privileges and other implicit subsidies (which have now been made explicit.)

Yet amazingly, despite these two government-created behemoths at the center of the housing storm, many are gaining traction arguing that the housing mess somehow shows the failure of the “free market.” What “free market?” The fact is that despite the partial deregulation of past decades, financial services remained one of the sectors most controlled by the state. The politicians now pointing their fingers at lenders making high-risk loans are the same ones who just a few years ago were chiding banks for not making enough loans to poorer borrowers who carried higher risks, and passing laws like the Community Reinvestment Act to pressure banks to chuck underwriting standards.

I delved into these issues a few months ago in an international online debate hosted by the Economist magazine. Against the backdrop of the Bear Stearns collapse in March, I had the task of arguing in favor of the proposition, “By intervening to regulate business and financial risks, goverments have made things worse.” I ended up getting 49 percent of reader’s votes, losing to my opponent’s 51 percent by a wafer-thin margin. These are the closest results so far in the Economist’s series of policy debates, and in the words of Economist Executive Editor Daniel Franklin, “there is no doubt that the clash of values and philosophies on view granted many of us a broader understanding of the issues at hand.”

Here is my closing statement in the debate. I started by saying that I shared the antipathy toward bailouts and corporate welfare, which my boss, CEI President Fred Smith often calls the “privatization of profits and socialization of losses.” I then pointed out that fiancial innovation the housing boom did indeed produce tangible benefits that will outlast the bubble’s bursting. Homeownership increased in all sectors, and it is still the case that “the vast majority of borrowers in all demographic categories do not face foreclosure.” The foreclosure rate and number of foreclosures have certainly been on the upswing, as we all know, but the overall rate of U.S. mortgages in foreclosure is still around 2 percent.

In the three-part debate, I brought up government regulation that hindered private risk management, including the Community Revinvestment Act and the blocking of competitors to the two dominant credit rating agencies. The rating agencies had turned out to be spectacularly wrong about the soundness of many mortgage-backed securities, yet there was an overreliance on these ratings in substantial part because the federal government would not accredit rival firms that may have had differing assessments.

Another big factor in the mortgage mess was the limits on short-selling imposed on ordinary investment vehicles such as mutual funds. Hedge funds, by contrast, had this ability and many weathered the subprime storm and even prospered by shorting banks’ mortgage securities. But regulators, ironically, considered this useful risk-management technique too “risky” for retail investment vehicles. So ordinary mutual fund and 401(k) investors lost out. That’s why, in the essay, I call for “a second stage of deregulation” that would let mutual and exchange-traded funds engage in some of the same financial management techniques for ordinary folks that hedge funds do for their super-wealthy investors.

Feel free to look at my other essays now — as well as the arguments of my opponents and a supportive essay by Tom Firey, managing editor of the Cato Institute’s Regulation magazine — at

We don’t want a world without risk, for that is also a world without opportunity. But eliminating market-distorting corporate subsidies and regulation — not to mention preventing new ones being touted as “cures” — could greatly reduce financial volatility.