Understanding the GSEs’ Role in the Mixed Economy

I’m not sure why Matthew Yglesias chose to adopt the unpleasant leftist tactic of beginning an argument with insult (“conservatives don’t know anything about anything”) in response to a recent Corner post of mine. Yglesias also engages in shifting the goalposts, because my “enthusiastic recommendation” of a Wall Street Journal leader column was not enthusiastic for the argument he chooses to highlight, but for its expose of the tactics Sen. Dodd and co are employing in the current debate.

Let’s leave all that irrelevance aside, however, and concentrate on Yglesias’ supposed killer point, which is his characterization of the “conservative position” on Fannie and Freddie:

[T]he implied government guarantee to Fannie and Freddie might cause them to take unduly large risks, and … the very scale of those risks would mean that in the event of a crash we actually would need to bail them out despite the lack of explicit guarantee. Thus, the idea of limiting the size of the Fannie/Freddie portfolios. The point was that if the Fannie/Freddie portfolios could be kept small, then perhaps the GSEs wouldn’t be “too big to fail” and we could afford to avoid bailing them out. And if we did wind up needing to bail them out, we wouldn’t be on the hook for such an enormous amount of money.

Yglesias concedes that this concern was valid, but further argues that:

[T]his has nothing to do with the current crisis in the financial system. In case you, Murray, John McCain, or the WSJ opinion section hasn’t noticed, it’s not as if we’ve managed to get away with not bailing out non-GSE firms. Instead, the magnitude of the crash has been so giant that we’re now partially nationalizing the entire banking system. Fannie and Freddie being somewhat smaller wouldn’t have changed anything…It’s a red herring.

As it happens, I had noticed (although I neither claim nor wish to speak for Senator McCain). And I can also notice that Yglesias is the one introducing the red herring (to add to the straw man I mentioned above). You see, that valid concern was not the only one conservatives had about GSEs and indeed it isn’t the most important one in our current critique of Fannie, Freddie and the politicians who supported them (especially those who took large campaign contributions from them). For evidence, here is Fred Smith’s testimony on the GSEs from June 2000:

We should realize that the capital that is attracted to the housing markets by Fannie and Freddie doesn’t come out of thin air: it is diverted from other possible end uses in the market. These uses include the financing of small businesses, technological startups, municipal and state programs, and foreign investments. Artificial shifts of capital into the housing market, of course, benefit somewhat those now purchasing homes, yet it disadvantages all of the above groups. Whether, on net, these loses are offset by the potential gains of additional home ownership is unclear. Would America be better with a marginally smaller home ownership ratio but a somewhat higher marginal rate of successful small business start ups?…

Moreover, while home ownership is a “good thing,” so also are other values that may well be harmed by the Fannie/Freddie distortions. Luring undercapitalized individuals into debts beyond their ability to repay does them no favor. Society must tread a very narrow path between pricing the poor out of the market, and exposing them to excessive financial risk. Moreover, the major problems with affordable housing are not borrowing costs, but rather regulatory costs, which fall outside the purview of Fannie and Freddie.

Our central critique of Fannie and Freddie is that they were the main vehicles of a government policy that severely distorted market allocations and perhaps even caused the resulting housing price bubble. Their size was a factor in this – if they had been smaller, perhaps the distortion would have been smaller – but it was their very existence that was most important. Coupled with the loose monetary policy of the Fed going back to 1995 (which is probably even more important), government signals that the market picked up on were the main reasons behind this massive misallocation problem. Peter Wallison and Charles Colomaris spell out the results (emphasis added):

Although a large share of the subprime loans now causing a crisis in the international financial markets are so-called private label securities–issued by banks and securitizers other than Fannie Mae and Freddie Mac–the two GSEs became the biggest buyers of the AAA tranches of these subprime pools in 2005—07. Without their commitment to purchase the AAA tranches of these securitizations, it is unlikely that the pools could have been formed and marketed around the world. Accordingly, not only did the GSEs destroy their own financial condition with their excessive purchases of subprime loans in the three-year period from 2005 to 2007, but they also played a major role in weakening or destroying the solvency and stability of other financial institutions and investors in the United States and abroad.

Moreover, it is simplistic to suggest – and for Yglesias to insinuate conservatives (or even libertarians) believe – that there is just one cause for such a complex problem. My current list of government-related causes stretches to 43 separate, identifiable factors, of which only a handful are Fannie/Freddie-related (five relate to British government actions). Their size isn’t one of them.

This was a failure not of just Wall Street, not of just the Fed, not of just Fannie/Freddie, but of the whole Mixed Economy that we have erected over the past few decades. Fannie and Freddie, however, were pillars of that Mixed Economy, like Wall Street and the Fed. All must bear their share of the blame, and attempts to cover up that blame must be exposed, whatever Matthew Yglesias thinks.