Should Feds Fix the Housing Market 'Failure'?

Do the housing meltdown and the credit crunch it has spawned provide an example of a "market failure" that requires a big government bailout? Former Fed Vice Chairman Alan Blinder, for instance, proposes creating a $300 billion 21st-century version of the New Deal-era Home Owners Loan Corp. to help struggling homeowners refinance their mortgages. To get a better handle on this issue, I asked a variety of folks for their two cents on this multibillion-dollar issue.

Russell Roberts, economics professor at George Mason University and Café Hayek blogger:

The political calculus of a bailout is straightforward—there are a lot more taxpayers than people whose houses have negative equity. Those who are bailed out jump for joy while the taxpayers may not notice the loss or may not feel it deeply, especially when it's financed by borrowing.

Yet many taxpayers recognize the fundamental unfairness of such bailouts—the prudent homeowner who bought a smaller house and the prudent renter who waited to accumulate more savings are punished for their prudence rather than being rewarded. So the politicians must beautify their schemes with talk of "market failure" or how a bailout will preserve the financial system or prevent a crisis. This gives the illusion that all of us have a stake in avoiding the consequences of individual mistakes.

But the real cost of a bailout isn't the cost to taxpayers but the incentives that are created in the future for carelessness and irresponsibility. Letting people enjoy the profits when things go well, but insulating them from the costs when things don't go well, erodes the incentives for informed risk-taking and productive transactions in the future. This is true for borrowers, lenders, builders of homes in flood plains, and steel companies looking for tariffs.

Dean Baker, codirector of the Center for Economic and Policy Research and Beat the Press blogger:

There was a massive market failure during the bubble in that lenders were allowed to issue mortgages to borrowers who frequently did not understand the terms. There was also a market failure in that the safeguards that should have prevented these bad loans from passing through the system were obviously lacking. Most importantly, the bond-rating agencies and the various oversight agencies (especially the Fed) were completely out to lunch.

The two sides of this failure are that the banks and investors are losing hundreds of billions of dollars on bad loans and millions of homeowners are facing foreclosure. Absolutely nothing should be done to protect the former. The incompetent managers should lose their jobs, and the investors should lose their shirts, teaching them to hire competent people next time.

We can help moderate-income homeowners by temporarily changing the foreclosure laws to give people facing foreclosure the option to stay in their home as renters paying the fair-market rent [http://www.cepr.net/content/view/1274/45/]. In addition to providing security, this change is likely to discourage foreclosures and cause most mortgage holders to negotiate terms that keep people in their houses as homeowners. This policy would not bail out the banks and doesn't cost the taxpayer a penny.

Donald Luskin, chief investment strategist at Trend Macrolytics and writer of The Conspiracy to Keep You Poor and Stupid blog:

Unprofitable decisions by home buyers, developers, borrowers, and lenders do not constitute a "market failure." There is nothing in the specification of a well-functioning market that says losses must be ruled out. Indeed, quite the opposite. The possibility of gains and the threat of losses are the carrot and stick that form the incentive system that motivates market transactions in the first place and put a necessary discipline on the price discovery process. If participants were guarded against losses, there would be no reason not to pay infinity for all goods and services, knowing that your money will be refunded if, in hindsight, infinity turns out to have been too high a price.

John Tamny, editor of RealClearMarkets:

The present crisis doesn't call for a government response because it is the government that caused it to begin with. Housing ultimately is commodity-like when it comes to price movements, so when the Treasury and Fed oversaw a decline in the dollar beginning in 2001, commodities and housing began their long boom.

Banks correctly deduced that home loans were safe investments because with the dollar weakening alongside rising home prices, those loans were safe for their customers, plus this was a way for banks to hedge against the falling greenback. In the end, though, markets eventually caught up to the weak-dollar money illusion, and housing's rally faded. The natural response from banks was to reduce exposure to the property sector, and the credit crisis was the result.

Governments can't solve anything, and it's surely true that behind every "market failure" there is economy-retarding government activity. The one thing the government should do now and from now on is stabilize the value of the currency it issues. Markets don't need a bailout, but market systems are surely reliant on a stable dollar. If the government provided this, the investment distortions that invariably lead to "credit crises" would become much less frequent.

Daniel Mitchell, senior fellow at the Cato Institute:

The current turmoil in credit markets, particularly housing, is not a sign of market failure. Instead, it is a sign that markets work. Innovators in the financial services industry developed a new product line—subprime mortgages—that has been very beneficial for people who traditionally had trouble achieving the dream of home ownership. But unveiling a new product line usually involves a learning process. Some people make mistakes, and those mistakes are a necessary and valuable form of feedback, ensuring an even more efficient allocation of capital in the future. But there has been a systematic failure—on the part of government. The Federal Reserve kept interest rates artificially low for an extended period, luring people into decisions that were not warranted by underlying economic conditions. Let's hope that politicians don't compound one government mistake with another by interfering with private mortgage contracts. That would create considerable uncertainty and drive up the cost of future home ownership by making investors more cautious about putting money at risk.

Craig Newmark, associate professor of economics at North Carolina State University and author of the blog Newmark's Door:

We should evaluate proposals to deal with the subprime problem in two ways: how much they reduce the chance of the problem repeating and how much they decrease the economic damage from the current problem. On the first criterion, a massive bailout of borrowers or lenders simply fails. And on the second criterion, with one qualification discussed below, a bailout is also unhelpful.

To reduce the chance of the problem repeating, I prefer other policies. One purported cause of the problem is that some subprime borrowers were poorly informed or simply lied to. If they were lied to, they—or public-interest lawyers acting on their behalf—should pursue the same remedies that anybody who is defrauded can pursue. If they were poorly informed, I urge that public schools and colleges offer more opportunities for individuals to learn some basic facts of personal finance.

I also think the role that poorly designed government policies may have played should be further studied and, if necessary, those policies should be modified. I refer to two policies: restrictive zoning and policies intended to promote mortgage lending to less creditworthy borrowers.

As for limiting the economic damage, I believe that those individuals who willingly assumed the risk of subprime mortgages—speculators, banks, and other mortgage originators, and investors in the subprime-based securities—should bear the cost of their poor choices, with no aid from the government. But the government may have a role to play in helping those individuals and firms who did not assume the risk, but who have been, or could be, damaged by the fear and uncertainty the problem has created in the credit markets. I have in mind something like federal deposit insurance and the role it plays in protecting innocent parties from bank runs. Even a conservative, market-oriented economist such as Milton Friedman approved of federal deposit insurance. How such an insurance policy should be designed and implemented is beyond the scope of this comment.

Josh Hendrickson, economics instructor at Wayne State University and author of the Everyday Economist blog:

Many politicians and some economists seem to believe that the credit crisis is a market failure and therefore necessitates intervention. There are two fundamental problems with this analysis. First, the idea of market failure is somewhat lacking. Markets are not desirable because they are perfect or because they are free of mistakes; rather they are desirable because they are the best way to correct for mistakes. Second, government intervention will not cure the disease; it will only treat the symptom.

A New Deal-style bailout would be a disaster. The United States is already spending beyond its means in addition to facing the future unfunded liabilities of Medicare and Social Security. Also, a bailout will create moral hazard by signaling that the government will come to the rescue in the event of bad decision-making on the part of borrowers and lenders in the future. Most importantly, however, a bailout ignores the cause of the problem. The current economic discoordination is not the result of predatory lenders and ignorant borrowers, but rather the recent leniency of lending standards and the loose monetary policy of the Federal Reserve. Therefore, the problem can only be solved as a market correction (as well as an accommodating—but not inflationary—Fed), not through the benevolent hand of Congress.