Did Free Market Ideology Cause the Housing Bubble?

by William L. Anderson
by William L. Anderson

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Detective Paul Krugman is on the case once again, this time in taking apart the causes for the destructive boom-and-bust Housing Bubble that is threatening to spill into financial markets in general. After analyzing just what happened, Professor Krugman says that he has found the real culprit: free market ideology. He declares:

So where were the regulators as one of the greatest financial disasters since the Great Depression unfolded? They were blinded by ideology.

This is most interesting, and Krugman goes on to explain his point:

"Fed shrugged as subprime crisis spread," was the headline on a New York Times report on the failure of regulators to regulate. This may have been a discreet dig at Mr. Greenspan’s history as a disciple of Ayn Rand, the high priestess of unfettered capitalism known for her novel "Atlas Shrugged."

In a 1963 essay for Ms. Rand’s newsletter, Mr. Greenspan dismissed as a "collectivist" myth the idea that businessmen, left to their own devices, "would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings." On the contrary, he declared, "it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product."

It’s no wonder, then, that he brushed off warnings about deceptive lending practices, including those of Edward M. Gramlich, a member of the Federal Reserve board. In Mr. Greenspan’s world, predatory lending – like attempts to sell consumers poison toys and tainted seafood – just doesn’t happen.

But Mr. Greenspan wasn’t the only top official who put ideology above public protection. Consider the press conference held on June 3, 2003 – just about the time subprime lending was starting to go wild – to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.

Also in attendance were representatives of financial industry trade associations, which had been lobbying for deregulation. As far as I can tell from press reports, there were no representatives of consumer interests on the scene.

One hardly knows where to begin, but, as the late-night ad for Ginsu Knives declares, "Wait! There’s more!"

Of course, now that it has all gone bad, people with ties to the financial industry are rethinking their belief in the perfection of free markets. Mr. Greenspan has come out in favor of, yes, a government bailout. "Cash is available," he says – meaning taxpayer money – "and we should use that in larger amounts, as is necessary, to solve the problems of the stress of this."

Given the role of conservative ideology in the mortgage disaster, it’s puzzling that Democrats haven’t been more aggressive about making the disaster an issue for the 2008 election. They should be: It’s hard to imagine a more graphic demonstration of what’s wrong with their opponents’ economic beliefs.

Now, it is one thing for a political operative to make statements like that, but quite another for someone who is nominated every year for the Nobel Prize in Economics. Of course, in this situation, I have pointed out before, Krugman long ago abandoned economics for politics, or at least "progressive" politics. Moreover, other than Ron Paul, I really do not see any free market "ideologues" running on the Republican side.

Nonetheless, because so many people are anxious to parrot whatever this "prophet" is declaring, we need to examine his claims closely. So, we ask the simple question: Did ideology create the housing bubble?

Krugman offers the following comments as "proof" of his claim:

Apologists for the mortgage industry claim, as Mr. Greenspan does in his new book, that "the benefits of broadened home ownership" justified the risks of unregulated lending.

But homeownership didn’t broaden. The great bulk of dubious subprime lending took place from 2004 to 2006 – yet homeownership rates are already back down to mid-2003 levels. With millions more foreclosures likely, it’s a good bet that homeownership will be lower at the Bush administration’s end than it was at the start.

Meanwhile, during the bubble years, the mortgage industry lured millions of people into borrowing more than they could afford, and simultaneously duped investors into investing vast sums in risky assets wrongly labeled families will end up owing more than their homes are worth, and investors will suffer $400 billion or more in losses.

The keyword here is "unregulated," as in "the risks of unregulated lending." Now, I am no player on Wall Street, but I can assure readers that financial markets in the United States do not fall into the "unregulated" category. Furthermore, with mortgage lending being backed up by government-created corporations nicknamed Fannie Mae and Freddie Mac, as well as a host of regulations and policies, this hardly falls into the category of "unregulated lending."

Nonetheless, Krugman has made his claim. To debunk it, however, we first must examine the background of mortgage lending. Contrary to Krugman’s assertions that the mortgage industry suddenly sprang up in a whirl of free market ideology, the modern industry actually has its roots from policies coming from the administration Krugman believes to be the Standard of Presidential Excellence: Franklin D. Roosevelt and his New Deal.

Official government policy was that of promoting home ownership as being "good for society." To generate money for lending and to set up a net of protection from mortgage failures, the federal government not only de facto created the savings and loan industry (or at least the industry that existed from the 1930s to the early 1980s) and regulated it heavily, but also created corporations that would purchase mortgages in the secondary markets and bundle them into mortgage securities that could be sold in the financial markets in order to raise more cash for more mortgage lending.

This system clearly was not of free market origins, although it did attempt to engage some aspects of market mechanisms. However, market mechanisms are not the same as free markets, since in the mortgage market, government has been manipulating the strings at every turn.

Furthermore, the current crisis was born out of the policies of the Federal Reserve System, which hardly is a free market entity. In the wake of the bursting of the previous stock bubble (which resulted in the recession of 2001, which Krugman claims was caused by cuts in income tax and capital gains rates) as well as the aftermath of the 9/11 attacks, the Fed cut its own interest rates to about one percent, which clearly was not a "free market rate." It was artificial – and unsustainable.

With interest rates being extremely low and other government agencies aggressively pushing for mortgage lending and refinancing of existing mortgages as being a means to place money in the hands of consumers (and push up consumer spending to give the illusion of prosperity), this was a train wreck waiting to happen, and it did. However, none of this came about because of "free market ideology," contra Krugman.

In answer to Krugman’s claim that the subprime lending orgy came about because of "unregulated free markets," I only can scratch my head. Krugman subscribes to a "populist, progressive" public agenda, and at the very heart of that agenda is the belief that consumption should not be based upon individual productivity. To put it another way, individual consumption of goods should not be related to one’s income or one’s ability to create goods in the marketplace. What happened during the Housing Bubble was completely consistent with Krugman’s "populist" beliefs.

Thus, it completely is inconsistent for Krugman to claim that there was "predatory lending" because individuals who wish to purchase houses or anything else should not be limited by their incomes, in the Progressive viewpoint. Krugman, who constantly is railing against any income "inequality," cannot turn around and say that regulators should have been keeping people from purchasing houses they could not afford because to do so would have been anathema to so-called Progressives.

Even now, Krugman and his fellow New York Times editorialists are calling for huge bailouts of homeowners who either are facing foreclosures or who are struggling to pay their mortgages. Thus, they believe that consumers should not have to face any consequences for their choices, since they hold that government should be in the business of eradicating any consequences due to the law of scarcity. This is tantamount to believing that government itself can eliminate scarcity, which is utterly foolish.

If free market ideology actually were the order of the day, there would have been no mortgage crisis and no housing bubble. That is because in a free market system, there would have been no central bank "creating" new bank reserves out of thin air and shoving them into the credit markets. A free market would not have created entities like Freddie Mac and Fannie Mae which at best only hide the risks, as opposed to mitigating them. The Law of Scarcity still holds, no matter what people like Krugman want us to believe.

Those "unregulated lenders" against whom Krugman and other "Progressives" rail actually were operating in an arena of government-created "moral hazard." Lenders did what lenders always do when they know that government is covering their rears: they lend without regard for the real risks they face.

You see, Paul Krugman demands that we believe the following fairy tale: Once upon a time when the financial markets were completely regulated by Wise Men operating in an arena in which they believed in the Great Powers of Government, all was well. However, when that racist Ronald Reagan managed to seize power in 1981, he cast a magic spell upon everyone in the markets in which they no longer came to believe in the Magic of Regulation, but, instead, came to believe that free markets were perfect and government always did wrong, a spell that existed for 25 years.

But now, to quote Al Hunt after the 9/11 attacks, it is "government to the rescue." Yes, all it takes is the belief – the belief – that government can eliminate the Law of Scarcity, and that wise regulators who believe in government once again can create prosperity and eliminate all poverty.

This is not a caricature of what Krugman has written. Read his columns. He constantly insists that all that is needed for government to work wonders is for people in government to believe, yes, be True Believers in the State. I am not making up these claims. They are there in black and white.

As for the rest of us, I guess that we simply have become blinded by our own free-market ideologies. Yes, although the Great Depression was given that name for a very good reason, we are to believe that it really was a Golden Age because "income inequality" lessened during that time. We are to believe that Franklin Roosevelt’s New Deal ended the depression, and that all it took was for people to Believe in Government.

The collapse of the housing bubble was inevitable, but it was not the result of free market ideology. Instead, the housing bubble was nurtured and pushed by those entities that Progressives have created for more than a century. From the Federal Reserve to Deposit Insurance to government-formed financial entities to expand individual home ownership to the vast sums of money taken in taxes – that will be spent to bail out those who engaged in bad lending practices, lenders and borrowers – we see the fingerprints of the hoary Progressive Agenda at every turn.

Krugman simply is wrong when he claims that everyone in the markets was "blinded by free market ideology." Instead, people have been blinded by "Progressivism" in which they have been told time and again by people who should know better that government can magically eliminate the Law of Scarcity.

William L. Anderson, Ph.D. [send him mail], teaches economics at Frostburg State University in Maryland, and is an adjunct scholar of the Ludwig von Mises Institute. He also is a consultant with American Economic Services.

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