The new New Deal

Cross Posted at Heritage

Could the current crisis usher in a new “New Deal”, with a new brand of corporatism to replace the free market system? Certainly European leaders are arguing that case. The current economic “crisis,” may itself have been caused by bad policy. Yet, is provides a great pretext for an expansion of government.

During the 1930s, as part of the New Deal, Franklin D. Roosevelt nationalized banks, set prices, wages and work hours, and promoted public works programs to employ the unemployed. The New Deal, or the National Industrial Recovery Act (NIRA) to be precise, was supported by many industrial leaders, some of whom had helped draft the legislation. Cartels, inflated prices and subsidies were great perks for established business, especially those that would have trouble staying ahead in a free market.

Businesses then, as now, cried to Congress about their need for a bailout, and the disaster which would be wrought by their bankruptcy. NIRA was eventually declared unconstitutional. The decision made the important point that “extraordinary conditions do not create or enlarge constitutional powers.”

Until then these laws were widely supported and considered critical to recovery from the economic crisis of the time. Yet intervention did more to cause and prolong the crisis than to aid recovery.

Although these measures were defended as being necessary during an emergency, and only temporary, many still exist today. For example the emergency farm supports created with the Agricultural Adjustment Act (AAA) have morphed into the current Farm Bill, which still pays farmers not grow food.

Like the New Deal period, we are seeing waves of nationalization, bailouts of unrelated industry, and expansion of central bank power. The nationalization of banks during the New Deal was actually smaller than what we are doing today – as a percentage of GDP it was the equivalent to about $500 billion. Today the state took shares in the largest nine banks and bailouts total well over a trillion dollars.

As John Goldberg points out, the stake that government now holds in these banks is actually greater than the stake it held in Fannie Mae and Freddie Mac, and it is quite likely that this temporary measure might too become the regular state of affairs.

If Obama is the next president, he would like to see a return to union domination and government mediation in wages and hours. Obama also favors public works programs to employ those out of work. He has already proposed at least two kinds of programs like this: his “transitional jobs” program which hires the unemployed, and his National Infrastructure Reinvestment Bank. With the excuse of an ongoing recession, he could easily roll these into New Deal sized public works projects.

But, prior to the New Deal we had small government. Prior to this new “New Deal” we already have enormous government and massive debt. The Deal we sign today would be for European style socialism, with European style unemployment and stagnation.

Causes and Cure for the Credit Crunch

This crisis is often complicated way out of proportion to what is necessary. It is really quite simple. This article makes a nice rundown, and I will give you some basic bullet points. Then I will attempt to convince you that the best medicine is to let the market detox.

Causes

The crisis was triggered by a collapse in housing. There was first a bubble - with housing prices rising and rising and rising and everybody knew it couldn't last - and then it popped. Crash. And then - oops - it took down all related lending, since so many firms had a major portion of their lending wrapped up with mortgages. Hence, credit crisis.

Now, what could have caused the bubble and the pop? Well, before jumping right to culprits, lets remind ourselves what drives prices up and down: supply and demand. So, for prices to rise, there must be greater demand than supply (lots of bids on few houses) and for prices to crash, there must suddenly be greater supply than demand.

OK. So what could have gotten supply and demand out of whack? In normal times, if demand is high and prices rise, more suppliers will come in, prices fall again; but here the supply never caught up with demand. Why?

Supply and Demand

Several policies and programs have been put into place to encourage home ownership, but which drove a wedge between supply and demand. These include:

(1) Fannie and Freddie which ensure cheap mortgages as they buy bad loans back from places like AIG and which dominate at least half of the housing market, drove reasonable lenders out of business, and made poor lending and bad loan packaging possible by being a massive customer (read: subsidy) to places like AIG.

Demand: Much more demand by the lower income buyers, demand for bad loans by gov.
Supply: Private market crowded out by Fannie/Freddie except those making loans that gov. buys

(2) The Community Reinvestment Act which forces lenders to offer cheap loans (with quotas) and which, together with Fannie and Freddie, led government to create the securitized secondary mortgage market, and which also drove potentially profitable lenders out of business, expanding Fannie and Freddie's dominance.

Demand: Much more demand by the lower income buyers, demand for bad loans by gov.
Supply: Private market crowded out again, only the few big ones can meet gov. quotas

(3) Fed-induced low interest rates which made mortgages more affordable, tax write offs and personal tax credits for mortgages, etc.

Demand: Much more demand by all buyers
Supply: Supply contingent on interest rates staying low, otherwise defaults


Now, what was the point of Fannie and Freddie? Their charter states that it is to ensure loans to those who cannot normally afford them by buying low-income private loans up on a secondary market. This is not a recipe for profit maximization, it is a recipe for excessive risk. Now, it is non-profit insurance - risk sharing - in theory. If that could work.

But it can't for several reasons. Moral hazard and plain old demand will go up, when rates are this low, so losses grow. Government has actually fed the demand of low income buyers, not only by offering them cheap housing but also by driving interest rates down, offering tax credits, etc. In fact, they kept expanding and expanding further into low-income and sub-prime lending, in the dream of reaching 70% home ownership.

Meanwhile those who would offer low-income loans at rates which would allow profit are all crowded out of the market. The only ones left who can make a profit are those who depend on Fannie and Freddie to buy their risky loan packages. So long as Fannie and Freddie stay in business, they are OK. But Fannie and Freddie can only appear as if they are above water so long as housing prices keep rising, so long as fuel keeps going on the fire of demand.

But they are going deeper and deeper and crowding out everything around them. They are swollen with risk and poised right in the center of the credit market, waiting to explode.

Why did it all come a head now? Because:

Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined, according to company filings and industry data.

Boom.


Cure

I keep stressing that we understand what caused the problem. The reason for this is that (as the first link above mentions) the cure that we are putting in place is actually more of the same-- more of what caused the crisis. If the crisis was caused and fueled by these policies, why do we expect them now to save us?

Fannie and Freddie caused the crisis by not pursuing profitable business strategies - by risky lending and loss-making pricing - and yet, Paulson promises that to cure our ails he will make sure that Fannie and Freddie stop worrying about being profitable. Put the homeowner first.

Fannie and Freddie caused the crisis by expanding into the sub-prime market, the answer to foreclosures a year ago? Expand Fannie and Freddie's mandate for low-income lending. Today? More of the same.

Fannie and Freddie caused the crisis by subsidizing a risky secondary market for mortgage-back securities. Our initial response a year ago? Buy more bad loans. Our current plan? Buy more mortgage backed securities (bad loans).

The fed fueled the fire with easy money. Answer? Easy money.

This is classing government intervention feeding on itself.

What is the right cure? Leave it be. Let the market restructure. Don't feed the crisis. If you think it will hurt, you may be right. But won't $700 billion in transfer from taxpayer to government also hurt? Won't feeding the loss-making machinery of socialized companies, which will need to be bailed out again and again hurt? Won't subsidizing failing companies which drive out regular business hurt too?

There is no pain-free answer. But there are cures that hurt because they detoxify, and there are cures that feel good right now, like a mamosa over breakfast after a drinking binge, but fail to actually solve the problem. In fact, they make it worse. And the final detox hurts more.

This crisis, the more I learn of it, the more it reminds me of the transition in Russia. We have to cut the strings. We are being made a muppet.

What I wrote to my Congressman

Mr. Congressman,

I urge you with all my heart to vote NO on the bailout bill. I was very pleased when the bill first failed in the House - finally Congress had heard the American people, and refrained from rushing blindly to enact desperate and far-reaching legislation that would only exacerbate economic troubles.

The new bill is hardly any better than the old bill. Passing the bill would be foolish, short-sighted and a slap in the face of the American taxpayer, and voter.

I urge you to stop, consider carefully other options, and consider what the market can do on its own. The people are even ready to accept a short term economic hit, if it will lead to a necessary shakeup, so that this won't happen again.

Government has stepped outside of its constitutional role - as Senator Coburn pointed out - for too long. Government and the Federal Reserve is to blame for this mess, and a government bailout will only make it worse, as it will prevent the adjustments that need to be made, and allow companies to keep making bad decisions.

Several letters have been written and signed by economists which object to the bailout and which offer alternative policy proposals. The American public deserves serious consideration of alternatives.

Please, I urge you, VOTE NO on the bailout.

Your concerned constituent,

Guinevere Nell