April 19, 2010
George Soros's New EconomyBy Andrew Foy and Brenton Stransky
There has been much talk of the opaqueness of the recent financial crisis. How could such a crisis come to fruition without forewarning from the multitude of economists, Wall Street advisors, and media soothsayers?
To address this troublesome question, the socially, politically, and economically liberal billionaire investment guru George Soros congregated some of the world's most prominent economic minds this past weekend for the inaugural meeting of The Institute for New Economic Thinking (INET). Soros is the largest financier of the group, donating $50M and using his influence to acquire the financial backing of others.
Meeting at King's College in Cambridge, England, the intellectual members of this new group grappled with the causes of the recent financial crisis. One of the keynote speakers of the event was University of California at Berkley professor of economics and 2001 Nobel Economic Laureate George Akerlof. In his address, Akerlof describes one of the core contributors of the financial crisis as the failure of capitalism:
On the Institute's website, several of the leading advisory board members of the group share their interpretations of the mission of INET via video. Anatole Kalesky, Principal Economic Commentator for the Times of London and one of these board members, said,
It is interesting that Kalesky chose to reference Adam Smith. Smith is considered the founder of political economics, and his seminal work Wealth of Nations' most oft-quoted passage refers to the "invisible hand" by which the free movement of the market can more efficiently promote economic growth than can a government regulated economy. This important idea is in direct contrast with Kalesky's statement.
Regarding economic theory and policy, there are really only two directions to chart: The first is toward less regulation and less government interference in the market, and the second is toward more regulation and more government intervention. Through Akerlof's and Kalesky's comments, we should understand that INET's mission is to influence world economic policy by suggesting means for more regulation and government involvement in the economy.
In reality, INET's "new" thinking is just promoting more of the same old type of Keynesian ideology that calls for greater regulation and government oversight of the free markets. For some reason, these highly regarded thinkers have failed to observe (or at least acknowledge) that it was this type of government regulation and intervention that helped cause the financial crisis in the first place.
As it happens, the financial crisis wasn't as opaque as George Soros, INET, or most financial news outlets would have you believe. The Austrian School of Economics and two of its greatest adherents (Ludwig Mises and Friedrich Hayek) postulated in the first half of the 20th century that large economies cannot be rationally planned because market prices (a function of supply and demand) cannot be perfectly known.
The recent financial crisis was to a large degree the result of the housing crisis, which in turn was the result of a reduction in the value of homes from over inflated values. Very basically, mortgages were given to borrowers, and then these mortgages were bundled into "mortgage backed securities," leveraged sometimes more than thirty times, and presented to investors as relatively safe investments.
When more homeowners than usual couldn't pay their mortgages to the investors because they overpurchased, the effect was significantly multiplied by the leverage. If only two percent of the mortgages went to foreclosure, but the portfolio of mortgage backed securities was leveraged at thirty times, then the effect would be a 60% loss. These foreclosures became known as toxic mortgages and were the contagion by which the financial crisis spread.
The above explanation is dangerously simple but important to touch on because to a large extent, the government intervention in the market directly caused this financial crisis through at least three interventions.
The first interference of the supply-and-demand dynamics of the housing market by the government came through the 1977 Community Reinvestment Act that was broadly expanded in 1993 by the Clinton administration. In his memoir My Life, Clinton says,
This regulation artificially increased the demand for houses by adding more purchasers to the market. The increase in demand was artificial but temporarily increased the value of homes because more consumers were buying the same supply of houses, therefore bidding up the prices. When these buyers tried to sell their homes because they couldn't pay for them, a glut of houses (supply) hit a decreased market (demand). As a result, home prices today are regressing toward their more historical rate of growth.
The housing bubble partly created by a forced easing of lending standards was exacerbated by the Federal Reserve, who dropped interest rates to very low levels for an extended period. This second example of intervention allowed borrowers to get mortgages at historically low costs, but when the Fed increased rates, the cost of getting a traditional mortgage or keeping an adjustable rate mortgage increased greatly, further contracting demand.
The final and perhaps most important government influence in the housing market that led to the financial crisis was the creation of Fannie Mae and Freddie Mac in 1968 and 1970, respectively. These quasi-government agencies provided the means for primary lending institutions (like your corner bank) to sell their mortgages, and with them, their risk. The idea was that if the bank didn't have the mortgage on its books, then it could make another mortgage, thereby increasing the money supply.
This practice reduced the corner bank's concern over the creditworthiness of the borrower, because the bank knew that it would be able to sell the mortgage to either Fannie Mae or Freddie Mac. Because so many bad mortgages were sold to Fannie and Freddie, their balance sheets were crippled, and the Federal Housing Finance Agency took control of them in 2008. This takeover pushed the burden of the bad loans to the taxpayer and assured that future mortgages could continue to be sold to the government.
These three important interventions into the free market by well-meaning government policies led to the financial crisis from which we are recovering today -- the law of unintended consequences fully shown.
The Institute for New Economic Thinking will certainly soon propose new ways by which to guarantee future success through regulation or government planning. But as has been the case in the past, these regulations will lead only to future crises. The danger we face is that well-meaning but ill-informed regulators will follow the advice of these thinkers and ignore the lessons of the past.
George Soros's $50M investments would have been better spent by sending a copy of Adam Smith's Wealth of Nations and F.A. Hayek's Constitution of Liberty to everyone in his rolodex.