Fixing What Ain't Broke, Hiding What Is

The financial-regulatory reform bill currently under consideration in Congress highlights a recurrent theme among the left. Whenever liberals want to pass legislation intended to solve a particular problem that increases the size and scope of the federal government, they revise history and create imaginary villains which their bill is intended to combat. They never admit that it is they and their previous polices who are at fault.

The recession is a lesson in unintended consequences. In the government's attempt to increase homeownership, it created an enormous housing bubble. The bubble inevitably burst, leading to the largest financial crisis since the Great Depression.

In 1993, President Clinton significantly broadened the Community Reinvestment Act, originally signed in 1977, which required all FDIC-insured banks to give more loans to lower-income households (or less creditworthy borrowers). This move received broad political support. As a result of these changes, homeownership and inflation soared.

Furthermore, the government-sponsored enterprises Fannie Mae and Freddie Mac enthusiastically purchased high-risk mortgages from lenders on the secondary mortgage market. Encouraged by the knowledge that high-risk mortgages would be swallowed up by Fannie and Freddie, lenders had incentive to extend as many mortgages as possible, regardless of the creditworthiness of borrowers.

Finally, in 2006, the Fed raised interest rates from 1% to 5.25% to avoid high inflation. Suddenly mortgage payments shot up, the demand for housing dried up, foreclosures multiplied, the credit crunch ensued, and heavily leveraged firms collapsed.

According to the left, none of the above matters. Instead, the cause of the recession was deregulation, which allowed for the creation of huge systemic risk throughout the entire financial system. When this risk was coupled with unbridled greed, it created a housing bubble. When the housing bubble inevitably burst, it took down the entire American economy.

What exactly was deregulated? According to Veronique De Rugy, "the great villain in the deregulation myth is the Gramm-Leach-Bliley Act, signed into law by Bill Clinton in 1999, which repealed some restrictions of the Depression-era Glass-Steagall Act, namely those preventing bank holding companies from owning other kinds of financial firms."

The left claims that this act broke down walls between banks and other kinds of financial institutions, thereby allowing enormous systemic risk to filter through the financial world. However, investment banks such as Lehman Brothers, who were at the center of the crisis, would have been able to make the same bad investments if Gramm-Leach-Bliley had never been passed.

Other often-cited causes of the crisis are derivatives such as mortgage-backed securities that were left unregulated by the Commodity Futures Modernization Act of 2000. However, tighter regulation of these agents would not have made the actual bad loans and mortgage-backed securities any less likely to go bad when the bubble finally burst.

The left's response to all of this is quite predictable and the administration is calling for limits on the size of financial institutions and wants to prohibit commercial banks from carrying out some kinds of "high risk" trades.

Essentially, the left's argument boils down to this: The government needs to regulate bad investment and decrease systemic risk. But hindsight is twenty-twenty, and in this case, the bad investment was in the government-fueled housing market. The investment vehicles were only outgrowths of the housing bubble, and had the housing market continued its upward trajectory, these derivatives and mortgage-backed securities would have turned out to be great investments.

Perhaps the worst part of the left's regulatory-reform plan is that it conceals the main cause of the crisis, for it does nothing to address the Fed's cheap-money policy or the unsustainable subsidies that the government is still providing to homeowners and mortgage-purchasers like Fanny and Freddy. It also doesn't guarantee that taxpayers won't have to pay for more bailouts in the future.

Further, it is an oxymoron to think the government would be capable of decreasing risk when they were incapable of foreseeing the inevitable bursting of the huge bubble their policies created in the first place. In a House Financial Services Committee hearing, Sept. 10, 2003, Rep. Barney Frank (D-MA) declared the following regarding the soundness of the government sponsored enterprises Fannie Mae and Freddy Mac:

I worry, frankly, that there's a tension here. The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios.

Then in another hearing on Sept. 25, 2003, he said the following:

I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing... I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.

But Frank was not alone in missing the boat on the upcoming housing crisis. In the Senate Banking Committee, Feb. 24-25, 2004, Sen. Christopher Dodd (D-CT) said the following (emphasis added):

I just briefly will say, Mr. Chairman, obviously, like most of us here, this is one of the great success stories of all time. And we don't want to lose sight of that and [what] has been pointed out by all of our witnesses here, obviously, the 70% of Americans who own their own homes today, in no small measure, due because of the work that's been done here.

What excellent work indeed.

To make a crude analogy, the left's response to the recession is similar to a parent blaming an auto manufacturer for making an engine too fast when his or her child was drunk and speeding and got into a wreck.

Like an auto-manufacturer is expected to make capable engines, the job of markets is to create investment opportunities. Blame should be placed on the driver for being irresponsible and creating conditions conducive for disaster. In this case, the conditions of the housing market were driven irresponsibly by government policies. The market, like the engine in the car, simply did its job and responded to the input it was getting.

Instead of increasing the power of the government and expanding its regulatory control, we should regulate liberal members of Congress who foolishly believe the government (i.e., they themselves) can steer results and outcomes by taking away their licenses in November.

Most of the energy of political work is devoted to correcting the effects of mismanagement of government.
- Milton Friedman
Andrew Foy, M.D. is co-author of The Young Conservative's Field Guide and can be contacted through his website at
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