11

Where Do We Go from Here?

An unpleasant but unavoidable conclusion is that Wall Street was (and remains) a giant government-sanctioned Ponzi scheme. Homebuyers borrowed money from lenders who got their money from Fannie Mae, Freddie Mac, and banks that borrowed money from investors who expected to be reimbursed by the politicians who took that money from taxpayers. Almost everyone made money from this deal except the group left holding the bag—the taxpayers. There is an old saying in poker: If you don’t know who the sucker is at the table, it’s probably you. We are the suckers. And most of us didn’t even know we were sitting at the table.

Many people have placed the current mess at the doorstep of capitalism. But Milton Friedman liked to point out that capitalism is a profit and loss system.1 The profits encourage risk-taking. The losses encourage prudence. Government policies have made too many markets one-sided. Because of implicit government guarantees, the gains were private and the losses were public. The policies allowed people to gamble with other people’s money, and by rescuing the creditors of Fannie Mae, Freddie Mac, Bear Stearns, AIG, Merrill Lynch, and others, policy makers have further weakened the natural restraints of the profit and loss system. This isn’t capitalism—it is crony capitalism.

Even those who are skeptical of the role of creditor rescue in creating this crisis understand that it has raised the chance of the next one. The standard policy response is to reduce the size of financial institutions to make them small enough to be able to fail, restrict executive pay to reduce the potential for looting, and increase capital requirements to reduce the fragility of the system induced by leverage.

But the symbiotic dance between politicians and Wall Street is why so many proposed reforms are unlikely to be successful for very long.2 Fannie and Freddie had their own regulator. We’ve had capital requirements. Yet these attempts at oversight failed. The firms and the executives with the biggest stake in the outcomes made sure that the system served them rather than the taxpayer.

Part of the reason reform is so difficult is that the interaction between politicians, regulators, and investors is a complex system that we don’t fully understand. F. A. Hayek understood the challenges of engineering a complex system from the top down when he wrote, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Economists and regulators imagine we can design a better financial system. Hayek would argue that such efforts are inherently flawed. That’s why the next time is never different.

Instead of trying to improve a system we only imperfectly understand, we would have better luck letting the natural restraints of capitalism reemerge. Rather than trying to turn this dial or push that lever the optimal amount (holding everything else constant, somehow), we should let natural feedback loops reemerge that encourage prudence as well as risk-taking.

Here are some changes that would move us away from crony capitalism and toward the real thing:

• Don’t try to re-create the old system while trying to make it “better.” There is a natural wariness about securitization right now. That is good. Let it blossom. There is a natural wariness about zero-down mortgages. That is good. Let it blossom.
• Recognize that having every American own a home is not the American Dream, but the dream of the National Association of Home Builders and the National Association of Realtors. The government should fund any government programs to increase homeownership out of current tax dollars where the costs are visible. Don’t reform Fannie and Freddie. Don’t resurrect them. Get the government out of the business of hidden subsidies to mortgage interest rates.
• Be aware that the Fed is certainly part of the problem and may not be part of the solution. The Fed created the artificially low interest rates that helped inflate the housing bubble. The Fed then raised interest rates too quickly, with disastrous effects for the adjustable rate mortgages encouraged by their low interest rate policy. Monetary policy should not be left to any self-proclaimed or publicly anointed maestro. Following an automatic money growth rule or the Taylor rule would have avoided much of the pain. Somebody needs to hold the Fed accountable for funding exuberance.
• Restrain rather than empower the Fed. It has played a major role in exacerbating the moral hazard problem. It is not good for a democracy to have an agency as unaccountable as the Fed acquire even more power and use it in ad hoc ways.
• Take the “crony” out of “crony capitalism.” Rescues have distorted the natural feedback loops of capitalism. Removing the cronies will not be easy, and economists should not make it more difficult. The near universal praise by economists for the actions of Bernanke, Paulson, and Geithner and the near universal condemnation by economists of the decision to let Lehman Brothers enter bankruptcy greatly reduce the credibility of any promise by policy makers to act differently in the future.
• Stop enabling obscene transfers of wealth. In this crisis, average Americans have sent hundreds of billions of dollars to some of the richest people in human history. This has been done over and over again in the name of avoiding a crisis, akin to putting out every forest fire. But this only postpones the day of reckoning. Eventually a conflagration comes along that consumes everything. The better the citizenry understands this reality, the better the chance that political incentives will change. If people don’t understand it, the political incentives will stay in place. Economists play an important role in how people perceive what has happened. We should stop being the enablers of such obscene transfers of wealth by claiming they are necessary for stability.
• Excoriate, condemn, and call to account rather than praise and honor policy makers who make creditors and lenders whole. Zero cents on the dollar for bankrupt bets made by lenders and creditors would be ideal, but it is unlikely to be a credible promise. So let’s start more modestly. A ceiling of 50 cents on the dollar for creditors and lenders when the institutions they fund become insolvent is a natural place to start. Even this may be too difficult for politicians to stomach. But economists should be able to support such a move and preach its virtues.

Rescuing rich people from the consequences of their decisions with money coming from average Americans is bad for democracy. It is bad for democracy because the Fed and the Treasury are spending trillions of dollars of taxpayer money with very little accountability or transparency. It’s bad for democracy because it means that some people have to live with the consequences of their decisions while others get rescued. That in turn creates a very destructive feedback loop of rent-seeking, where losers seek government help after the fact rather than make careful decisions before the fact.

Rescuing people from the consequences of their decisions is bad for capitalism. It means that a distorted calculus of risk and reward allocates trillions of dollars of capital. The biggest mistake of the last decade of distorted incentives is that trillions of dollars poured into more and bigger houses instead of into better medical devices or new forms of entertainment or more efficient cars. It was a bad deal private decision makers would never have made on their own. It was a bad deal that only took place because public policy distorted the incentives.

Is it really imaginable that we can regain a profit and loss system, a true capitalism where people take responsibility for their actions instead of relying on being bailed out by those more prudent than themselves? It’s up to us. All we have to do is demand politicians who feel the same way. We need to look in the mirror. Too many of us applauded when Presidents Clinton and Bush pushed for higher and higher homeownership rates. Too many of us applauded when Fannie and Freddie were asked to “give something back” and become more “flexible.” Too many of us applauded when Wall Street was rescued. If we as voters more fully understood the consequences of those decisions, we might get different politicians and policy makers, or at least politicians and policy makers who will make different decisions the next time around.

Milton Friedman once observed that people mistakenly believe that electing the right people is the key to better public policy. “It’s nice to elect the right people,” he said, “but that isn’t the way you solve things. The way you solve things is to make it politically profitable for the wrong people to do the right things.”3 To do that, we, the people, have to favor a different philosophy for the relationship between Washington and Wall Street than the one we have now. We have to favor a relationship where there is both profit and loss.

NOTES

  1.  Milton Friedman and Rose Friedman, Free to Choose (Orlando, FL: Harcourt Books, 1980), p. 45.

  2.  I discuss this in more detail in “How Little We Know,” Economists’ Voice (November 2009), http://www.invisibleheart.com/How%20Little%20We%20Know.pdf.

  3.  Milton Friedman, “Why It Isn’t Necessary to ‘Throw the Bums Out,’ ” video file from a speech circa 1977, http://www.youtube.com/watch?v=ac9j15eig_w&feature=related.