Government Regulation to Blame

Government regulation, not free-market greed, caused this crisis

When government distorts incentives, the invisible hand can become a fist. Many observers, including most politicians, have blamed the ongoing financial crisis on the "free-market greed" supposedly unleashed by the "reckless deregulation" of the financial system. Such arguments are rhetorically powerful, but they don't stand up to scrutiny. If they go unchallenged, however, they could hasten a "solution" that's worse than the problem. That's why it's so important to examine the record. What it shows is that government regulations and other interventions – not greed – are the major cause of our current problems...

Firms are profit seekers, but they will seek it where the institutional incentives signal profit is available. In a free market, firms profit by satisfying their customers, investing wisely, and making prudent loans. Regulations, policies, and political rhetoric can change those incentives...

To call the housing and credit crisis a failure of the free market or the product of unregulated greed is to overlook the myriad government regulations, policies, and political pronouncements that have both reduced the freedom of this market and led self-interested actors to produce disastrous consequences, often unintentionally...

Fueling this speculative fire was the Federal Reserve, also a government-sponsored organization. The Fed moved interest rates to extraordinarily low levels beginning in 2001. The additional credit it provided artificially lowered the cost of mortgages and dramatically accelerated the housing boom begun in the 1990s. Did people suddenly get greedy in their pursuit of McMansions, second homes, and flipping homes for easy profit? Yes, but only because abnormally low interest rates made it foolish not to be. This was hardly a failure of free markets or greed. It was the predictable consequence of government distorting the interest rate...

Good intentions are not enough in designing public policy. Regulations designed with the best of intentions are likely to lead to more crises if they distort incentives and thereby cause individual "greed" to undermine economic growth and harm millions. History is full of examples of politicians adopting short-run solutions without seeing the harmful long-run consequences. Today, the calls to "do something" are loud. Yet amid the cacophony, there are a few voices urging not more, but less; not faster, but slower; not short term, but long term; not intent, but outcomes. Those are the voices we should heed, because if we had listened to them 15 or 20 years ago, we might not be where we are today.

Steven Horwitz is a professor of economics at St. Lawrence University.

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Open Letter from Steven Horwitz

In the last week or two, I have heard frequently from you that the current financial mess has been caused by the failures of free markets and deregulation. I have heard from you that the lust after profits, any profits, that is central to free markets is at the core of our problems. And I have heard from you that only significant government intervention into financial markets can cure these problems, perhaps once and for all. I ask of you for the next few minutes to, in the words of Oliver Cromwell, consider that you may be mistaken. Consider that both the diagnosis and the cure might be equally mistaken...

To call the housing and credit crisis a failure of the free market or the product of unregulated greed is to overlook the myriad government regulations, policies, and political pronouncements that have both reduced the "freedom" of this market and channeled self-interest in ways that have produced disastrous consequences, both intended and unintended. Let me briefly recap goverment's starring role in our little drama...

Complicating matters further was the 1994 renewal/revision of the Community Reinvestment Act of 1977. The CRA requires banks to to make a certain percentage of their loans within their local communities, especially when those communities are economically disadvantaged. In addition, Congress explicitly directed Fannie and Freddie to expand their lending to borrowers with marginal credit as a way of expanding homeownership. What all of these did together was to create an enormous profit and political incentives for banks and Fannie and Freddie to lend more to riskier low-income borrowers. However well-intentioned the attempts were to extend homeownership to more Americans, forcing banks to do so and artificially lowering the costs of doing so are a huge part of the problem we now find ourselves in...

The current mess is thus clearly shot through and through with government meddling with free markets, from the Fed-provided fuel to the CRA and land-use regulations to Fannie and Freddie creating an artificial market for risky mortgages in order to meet Congress's demands for more home-ownership opportunities for low-income families. Thanks to that intervention, many of those families have not only lost their homes, but also the savings they could have held onto for a few more years and perhaps used to acquire a less risky mortgage on a cheaper house. All of these interventions into the market created the incentive and the means for banks to profit by originating loans that never would have taken place in a genuinely free market...

Those of us who support free markets are not your enemies right now. The real problem here is the marriage of corporate and state power. That is the corporatism we both oppose. I ask of you only that you consider whether such corporatism isn't the real cause of this mess and that therefore you reconsider whether free markets are the cause and whether increased regulation is the solution.

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