What Caused tlie Eoenomic Events of the Past Five Years?

Policymakers, pundits, and academics bave blamed tbe financial
crisis on various factors, sucb as excessive risk-taking by tbe private
sector, inadequate or inappropriate regulation, deficient rating agencies,
and so on. My assessment is tbat all tbese factors played a role,
but tbe crucial, underlying problem was misguided federal policies.”
The first misgi.iided policy was the attempt to increiuse bomeownersliip,
a goal the federal government b;is pursued for decades. A
(partial) list of policies designed to increase bomeownersbip includes
the Federal Housing Administration, tbe Federal Home Lx)an
Bimks, Fannie Mae, Freddie Mac, the Community Reinvestment
Act, tbe deductibility of mortgage interest, die homestead exclusion
in tbe personal bankruptcy code, tlie tax-favored treatment of capital
gains on bousing, tbe HOPE for Homeowners Act, and, most recently,
the Emergency Economic Stabilization Act (tbe bailout bill).”
Government efForts to increase homeownership are problematic.
Private entrepreneurs have adetjuate incentives to build and sell
houses, just as individuals and families have adequate incentives to
purchase them. Thus, government intervention to expand homeownership
has no justification from an efficiency perspective and is
instead an indirect method of redistributing income. If government
redistributes by intervening in the mortgage market, however, it creates
the potential for large distortions of private behavior.
The U.S. government’s pro-housing policies did not have noticeable
negative effects for decades. The reason is likely that the interventions
mainly substituted for activities the private sector would have undertaken
anyway, such as providing a secondary market in mortgages.
Over time, however, these mild interventions began to focus on
increased homeownership for low-income households. In the
1990s, the Department of Housing and Urban Development
ramped up pressure on lenders to support affordable housing. In
2003, accounting scandals at Fannie and Freddie allowed key
members of Congress to pressure these institutions into substantial
risky mortgage lending.^ By 2003-04, therefore, federal policies
were generating strong incentives to extend mortgages to
borrowers with poor crecht characteristics. Financial institutions
responded and created huge quantities of assets based on risky
mortgage debt.
This expansion of risty credit was especially problematic because
of the second misguided federal policy, the long-standing practice of
bailing out failures from private risk-taking. As documented by
Laeven and Valencia (2008), bailouts have occurred often and widely,
especially in the banking sector. In the context of the recent financial
crisis, a crucial example is the now infamous “Greenspan put,”
the Feds practice under Greenspan of lowering interest rates in
response to financial disruptions in the hope that expanded liquidity
would prevent or moderate a crash in asset prices. In tlie early 2000s,
in particular, the Fed appeared to have made a conscious decision
not to burst the housing bubble and instead to “fix things” if a crash
occurred.
The banking sectors history of receiving bailouts meiuit that financial
markets could reasonably have expected the government to
cushion any losses from a crash in risky mortgage debt.’” Since government
was also exerting pressure to exj^and this debt, and since it
was profita!>k’ to do so, the financial sector had every reason to play
along.” It was inevitable, however, tliat at some point a crash would
ensue. As explained in Cortón (2007), the expansion of mortgage
credit made sense only so long as housing prices kept increasing, but
this ci)nltl not last forever Once housing prices began to decline, the
market had no option but to suffer the unwinding of the positions
built ou untenable assumptions about housing prices.
This intcipretation ofthe ihiancial crisis therefore puts primar\’
blame on federal policy rather than on Wall Street greed, inadequate
regulation, failures i)f rating agencies, or .securitiz;ition. These other
forces pla\x’d important roles, but it is implausible that any or all
would have produced anytliiug like the recent linancial crisis had it
not been for tlie two misguided federal polices.’- Wall Street greed,
for exauiple, certainly contributed tí) the sitiiation if, by greed, one
means p rot it-seeking behavior. Many on Wall Street knew or suspected
that their risk exposure was not sustainable, but tlieir positions
were protitalile at tlie time. Further, markets work well when
private actors respond to profit opportunities, unless these reflect
perverse incentives created by go\enuncut. Tlie way to avoid future
crises, therefore, is for governments to abandon policies tliat generate
such incentives.