Monday, December 08, 2008

David Henderson busts deregulation mythology

Excerpts below from here:
Many journalists claim that the U.S. economy since the late 1970s has been very free, with little regulation; that this absence of regulation has caused markets to fail; that there was a consensus in favor of little regulation; and that, now, this consensus is fading. On all these counts, the reports are false.
Free markets have done much better than governments at providing safety, fairness, economic security, and environmental sustainability. The reason, for three out of the four, is simple. Economic freedom tends to lead to economic growth, as Pearlstein himself admits in the above quote, and economic growth leads to more safety, more economic security, and more demand for environmental quality. Safety and environmental quality are what economists call "normal goods." As our real incomes rise, we want more of them. Over the 20th century, as our real incomes rose, we workers demanded more safety. And we got it. As economist W. Kip Viscusi notes in "Job Safety," published in The Concise Encyclopedia of Economics, as U.S. per capita disposable income per year rose from $1,085 in 1933 to $3,376 in 1970 (all in 1970 prices), death rates on the job fell from 37 per 100,000 workers to 18 per 100,000. Note that all of this preceded the Occupational Safety and Health Administration, which began in 1970. This shouldn't be surprising. As workers, we show our demand for safety by the wage premium we insist on to take a given risk. As real incomes rose, this wage premium rose. Employers found it cheaper to avoid some of the risk premium by reducing risk—that is, by increasing safety. In short, there is and has been a "market for safety."

The case with environmental quality is similar. Past some income level, environmental quality is almost certainly a normal good, that is, a good that people demand more of as their income increases. But demand does not guarantee supply. Why not? One major factor is that so much of the environment is a "commons," a resource that everyone can use but no one owns. As Garrett Hardin pointed out in his classic 1968 article "The Tragedy of the Commons," when no one owns a resource, it will be overused because no one has much incentive not to overuse it. One obvious solution is to transform, to the extent possible, the commons into private property. This has been done with rivers, lakes, and land, but is hard to do with air and oceans. But certainly we could go much further toward private ownership than we have until now, turning rivers, for example, into private property, as is done in Scotland. Scotland, not coincidentally, has pristine rivers. So note the irony. Contra Pearlstein, one reason that we haven't had the environmental quality we have demanded is that overregulation has prevented private ownership.

On the issue of economic security, the wealthier we are, the more secure we are. And because, as Pearlstein himself admits, economic freedom creates wealth, it necessarily creates security.


On housing prices, Gosselin claims that "the rise in house prices and the recent plunge grew out of an almost unregulated corner of the mortgage market—the one for riskier loans." But in fact much of this problem arose from regulation. Jeffrey Hummel and I detailed how in Investors' Business Daily ("Blame the Feds, Not the Fed, For Subprime Mortgages," March 23, 2008). Federal government regulation contributed in three ways. First, the federal government helped cause the boom in housing prices by helping cause moral hazard: people taking risks because they know that if things turn out badly, someone else will bear some of the cost. The federal government's semiautonomous mortgage agencies—Fannie Mae, Freddie Mac, and Ginnie Mae—all buy and resell mortgages. Of the more than $15 trillion in mortgages in existence in early 2008, about one third were owned by, or were securitized by, Fannie Mae, Freddie Mac, Ginnie Mae, the Federal Housing and Veterans Administration and other government agencies that subsidize mortgages.

Although Fannie Mae and Freddie Mac were no longer government agencies during the time period at issue, they were government- sponsored enterprises. Many buyers of their repackaged loans, therefore, assumed an implicit federal-government guarantee. That assumption, as we now know, was all too true. This implicit guarantee caused less scrutiny by lenders than otherwise, which helped drive up housing prices.

The federal government's second contribution to the increase in housing prices was the Community Reinvestment Act. This act, first passed in 1977 and beefed up in 1995, requires banks to lend in high-risk areas that they otherwise would avoid. Banks that fail to comply pay fines and have more difficulty getting approval for mergers and branch expansions. As Stan Liebowitz, a University of Texas economist, has pointed out, a Fannie Mae Foundation report enthusiastically singled out one mortgage lender that followed "the most flexible underwriting criteria permitted." That lender's loans to low-income people had grown to $600 billion by 2003. Its name? Countrywide, the largest U.S. mortgage lender and one of the lenders in the most trouble for its lax lending practices.

Finally, a little-noted change in regulations by the comptroller of the currency in December 2005 acted as the trigger. The comptroller made it mandatory for banks to require minimum payments on credit card balances, causing increases of at least 50 percent for most cards and as much as 100 percent on others. Many people who hold subprime mortgages are people for whom a higher monthly payment on a credit card would be a problem. Whereas before this regulation, many people's priorities would have been mortgage first, credit card second, the new regulation caused many borrowers to reverse the order. Thus the comptroller's seemingly small increase in regulation had the unintended effect of causing some mortgage borrowers to default.


Moreover, notably absent from all four earlier-mentioned articles is an argument for why regulation would work or how deregulation fails. I have already provided evidence of how badly regulation has worked in oil and in the housing market. But there's more to say. There are two main reasons that regulation generally works out badly. One is that the regulators have little incentive to get things right. Indeed, when their regulations fail, they often use this fact to argue for more power and more regulation. Astonishingly, the argument often works. The second reason is that regulatory agencies are often captured by the politically powerful and used to stomp out competition. The recent regulations on housing finance, for example, require mortgage brokers to be licensed. That will reduce competition in mortgage brokering and enhance the incomes of existing mortgage brokers.


But shouldn't economic journalists, whatever else they do, get the facts right? And the three overriding facts are:

(1) we have not had a period of light regulation,

(2) deregulation didn't fail, and

(3) regulation makes things worse.

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