Montreal, October 15, 2008 • No 260



Jean-Hugho Lapointe is a lawyer. He holds a certificate in business administration from Université Laval.




by Jean-Hugho Lapointe


          History has a tendency to repeat itself. Governments have always been quick to claim credit during good economic times, and even quicker to blame the market during downturns.

          The current financial crisis is the latest evidence of this timeless habit, and Congressman Barney Frank (D), chairman of the House Financial Services Committee, is its perfect personification.


          Frank made his opinion about what caused the crisis crystal-clear: "bad decisions that were made by people in the private sector" sending the country into dire straits "thanks to a conservative philosophy that says the market knows best." Which is just about exactly what progressives said after the October 1929 crash, setting the stage for the welfare state and Keynesian economics in America.

          No direct causal relationship can be established, but it is once again taken for granted by many that the free market led us here and that the current crisis proves the failure of capitalism. Editorials around the world have endorsed this view, fuelled by populists like the French president who appeared before world representatives to call for a "new" or a "moral" capitalism, whatever that might be.

          At the core of the attack that is being mounted against capitalism, prosperity and freedom is a denial of the American government's responsibility in this mess. The very same government that is usually blamed first for every problem occurring in the world is suddenly enjoying a free ride, now that blaming it would hinder the progressive agenda.

The roots of the problem

          In fact, beyond the gaffes that obviously did occur in private decisions made in the ordinary course of business, there exist direct causal relationships between specific actions of the American government and the current crisis.

          The Federal Reserve has in recent years dropped interest rates to record lows in a bid to avoid a recession, a move that was bound to create an inflationary bubble and which cannot be blamed on the free market or deregulation. This bubble arose primarily in real estate and mortgage credit, as other public decisions moved enormous capital into those sectors.

          Fannie Mae and Freddie Mac, two government-sponsored entities (GSEs) involved in creating affordable housing, were used to provide liquidities to financial institutions so that they could keep lending. These GSEs bought loans made by lenders, pooled them, and then securitized them by issuing mortgage-backed securities (MBSs). It was also implied and expected that Washington would bail out Fannie Mae and Freddie Mac should problems arise, thus creating a moral hazard and pushing the limits of the housing bubble.

          Playing the role of catalyst in the crisis was the Community Reinvestment Act, a so-called progressive housing law that dates back to the Carter era but that was revised by the Clinton administration in the late 1990s, making it more aggressive. On the basis of a lousy study that found that banks were discriminating against minorities because of their lower ratio of credit acceptance, some institutions were forced by the CRA to lend to people with poor or non-existent credit histories (“subprime loans”). Since these subprime loans were bought by the GSEs anyway, all banks were pressured to follow suit in order to protect their market shares. Underwriting standards were lowered throughout the world’s largest economy. Coupled with low interest rates, this caused both the demand for and supply of houses and mortgage credit to explode artificially in the early 2000s.

          It worked as long as the real estate market was not losing steam. Once it did, as it was meant to, housing values could no longer fully support the mortgages or refinancing requests, defaults soared, and the MBSs underlying pools of assets became suspect. The MBSs lost their exchangeability, mark-to-market accounting rules started to hit, and the whole house of cards came tumbling down.

          Market participants, whose investment and risk management decisions are usually guided by information and rules such as credit ratings or the international Basel Accords, obviously could not be saved from the problems inherent in this government housing scheme, nor from the effects of questionable accounting rules forced on the markets(1), and here we are.

"Beyond the gaffes that obviously did occur in private decisions made in the ordinary course of business, there exist direct causal relationships between specific actions of the American government and the current crisis."


Barney Frank revisited

          So, in retrospect, were these really just bad decisions made by people in the private sector? Certainly there were some, as there are every day. But using this sophistry to explain the crisis is an oversimplification used as cover for the progressives’ mistakes. Ask the 44 leading economists who signed the FreedomWorks Foundation petition to Congress to oppose the Paulson bailout: "Many of the troubles in today's market are the result of past government policies (especially in the housing sector) exacerbated by loose monetary policy. Congress has been reluctant to reform the government sponsored enterprises that lie at the heart of today's troubled markets, and there is little to suggest the necessary reforms will be implemented in the wake of a bailout. Taxpayers should be wary of such an approach."(2)

          And Barney Frank’s bluff goes further. Writing in the Boston Globe in September 2007 about the subprime crisis, Mr. Frank had this story for Americans: "Beyond that, a second major aspect of the subprime crisis demands attention: the unanticipated impact it had on financial markets in general. Indeed, that lack of anticipation is a danger sign: None of the entities charged with supervision of the economy predicted that the crisis would have broader negative effects."

          Lack of anticipation? Not according to a September 30, 1999, New York Times article: “Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people (...) But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.”

          Unpredicted broader negative effects? Barney Frank was there in 2003 when Dr. Greg Mankiw, then chairman of the President’s Council of Economic Advisors, warned that “[t]he enormous size of the mortgage-backed securities market means that any problems at the GSEs matter for the financial system as a whole. This risk is a systemic issue also because the debt obligations of the housing GSEs are widely held by other financial institutions. The importance of GSE debt in the portfolios of other financial entities means that even a small mistake in GSE risk management could have ripple effects throughout the financial system.”

          Barney Frank opposed the White House attempts, in 2003, to overhaul the giant GSEs, arguing that the administration was more concerned with financial soundness and safety than with housing, and claiming that "these two entities, Fannie Mae and Freddie Mac, are not facing any kind of financial crisis."

          Bill Clinton himself identified this part of the problem during an interview on ABC's "Good Morning America” on September 25, 2008: "I think the responsibility that the Democrats have may rest more in resisting any efforts by Republicans in the Congress, or by me when I was president, to put some standards and tighten up a little on Fannie Mae and Freddie Mac."

          And now, teaming up with the Bush administration against Republicans in Congress, Barney Frank, Nancy Pelosi and the progressives were fully involved in the American government’s attempt to “save us” from the collapse that they hypocritically blame on deregulation and the market—an attempt which might later be seen by historians as the final proof that the government had to intervene to save the world from the failure of capitalism.

          History really does have a tendency to repeat itself.


1. Some argue that mark-to-market accounting rules might have played a large part by themselves in the fallout on Wall Street. See Zachary Karabell, "Bad Accounting Rules Helped Sink AIG," The Wall Street Journal, September 18, 2008, or Terence Corcoran, "The Mark To Market Fiasco," Financial Post, March 18, 2008, for instance.
2. Wayne Brough, "Economists Send Open Letter to the United States Congress on the Wall Street Bailout," FreedomWorks, September 25, 2008. See also Harvard economist Jeffrey Miron’s "Bankrputcy, Not Bailout, Is The Right Answer,", September 29, 2008.