Montreal, August 15, 2009 • No 269


Vincent Bénard works in France as a territorial issues specialist. He is President of the Hayek Institute in Brussels.




The Seven State Regulations of Markets That Made the Crisis Possible—And What Should Be Done about Them


by Vincent Bénard


          Human enterprises sometimes fail. Bad judgement, excessive greed, bad luck, poor risk management—all of these things are common human foibles, the necessary counterparts of all the qualities that make human beings so unique. The ability to succeed is consubstantial with the ability to fail.

          So when analysts put the blame for the present financial turmoil on bad judgement, excessive greed, poor risk management, and black swans, they bring nothing new to what we know of mankind. The right question to ask is: why, this time around, has this well-known ability of some people to fail been so economically destructive?


          Since the beginning of time, societies have been confronted with the risk of failure of some of their members. Naturally, human imagination under free-market incentives brought into being the necessary mechanisms for preventing individual failures from evolving into global nightmares. These mechanisms are: full individual responsibility, proper management of bankruptcies, fair courtroom litigation, diverse kinds of insurance, risk-based interest rates, and so on.

          Most of these mechanisms evolved naturally from social needs and were enforced by authorities as “natural” laws. Authorities that were successful in applying these principles performed better than others, economically and socially. In modern terms, we would say that their development was more “sustainable.”

          The evil of the current crisis is often attributed to a lack of supervision and intervention by the authorities. But a closer look at the state regulations that were in effect before the crisis shows no lack of regulations, but rather counterproductive ones, which have broken down the “natural mechanisms of defense” against the multiplication of failing entities that free markets provided to society time and again.

          Below are the top seven state interventions and regulations that broke our market-based defences against failures and thus brought us the worst economic crisis since the Great Depression. The first three interventions can be branded as elements of a “system of subsidies” to banks and financial institutions, aimed at artificially lowering the cost of financial resources to banks. They exist worldwide. The four others are specific to the real estate and mortgage markets, and some are specific to the USA.

Subsidies to the Banking System

Federal Reserve manipulation of interest rates

          Much has been written about Alan Greenspan and the Fed’s interest rates being kept too low between 2001 and 2004. Some would like to put the whole current mess on his shoulders alone. This is clearly excessive, just as articles like “Reagan did it” by Paul Krugman(1) are excessive. As we’ll see, there is not one single explanation to the crisis, but rather a combination of several bad state regulations and interventions that led to it.

          But, obviously, the way money is managed by central banks, and especially the Fed, contributed enormously to the current mess.

          Some defenders of the Fed’s actions argue that the real estate bubble began to take shape in 1999, when interest rates were still high, and continued to grow after 2004, when rates increased again. This argument is flawed. The money supply curves(2) show that monetary creation, especially M2 and M3 aggregates, began to grow out of control after 1997, and that 1999 showed an astounding 12% year over year change in the aggregate money supply. This means that the so called “high” interest rates observed between 1999 and 2001 weren’t nearly high enough, fuelling the dot com bubble and the beginning of the real estate bubble.

          Greenspan didn’t follow the requirements of the “Taylor formula” between 2001 and 2005.(3) This formula is aimed at emulating what the interest rate would be if it was set by market forces. Even if the accuracy of the formula can be disputed, holding interest rates under its recommended level for a long period of time could only lead to an excess supply of money, which would necessarily result either in general inflation, or in the formation of asset bubbles.

          For three years, the Fed rate was maintained as much as 4 percentage points below what it should have been in order to keep the inflation rate under a reasonable 3%, according to this formula. Some Fed defenders point out that the official CPI was around this value at the time. But others, like Nobel Prize laureate Vernon Smith,(4) estimate that real estate prices have been poorly accounted for by the consumer price index. Smith and others point out that if the CPI had been accurate, the real growth figures would have approached zero during these years, with a real inflation rate of around 6%. In fact, the excess money supplied to the economy only fuelled an artificial rise in home prices, and excessive consumption through the widespread practice of “borrowing against equity,” but no real wealth creation.

          All of this shows that an arbitrary fixing of the price of money by so-called “experts” doesn’t work. If the price of money was determined by free market forces, without any doubt, the rush of borrowers clamouring for mortgages would have increased the interest rate over its greenspanian value between 1999 and 2004, and the bubble would have burst before getting out of control.

          But Greenspan and his colleagues at the Fed board couldn’t determine the “right” interest rate, simply because they were confronted with contradictory signals and poor statistical indicators, and because no expert can handle the thousands of variables that contribute to the prices of goods in a free market, which result from millions of individual decisions. They saw real estate prices bubbling in some places and not in others; they saw the stock market stagnating; they saw the poorly calculated CPI remaining low…

          As Hayek stated, no expert, even the most skilled one, can emulate the full range of signals coming from the market and determine the right price arbitrarily. Only gold- and silver-based currencies display the natural disciplining mechanisms that a centrally-planned monetary system lacks for avoiding the formation of too-big credit bubbles.

Tax codes that favour over-leveraged companies (especially financial institutions)

          Most countries include dividends to stockholders in the tax base of their corporate taxes, but exclude interest paid to debt holders. This results in a well-described distortion(5) in the choices companies make, leading them to leverage their balance sheets above suitable levels just to enhance their rate of return on equity. This trend is especially noticeable for big financial institutions, whose balance sheets frequently total more than one trillion dollars. One percent more or less in capital requirements may represent hundreds of millions of dollars of profits—or losses—all because of this one fiscal distortion.

          The very low level of equity in financial institutions’ balance sheets has been the biggest factor in the expansion of the crisis, revealing how phony the capital structures of these financial companies really are. Tax distortions leading to such situations should be removed.

          As Alvin Rabushka and Steve Forbes have argued in their flat tax proposals, fiscal laws around the world should treat interest paid to lenders and dividends paid to stockholders on a par, and thus interest should be reintegrated into the corporate tax base. As a positive side effect, this could permit corporate tax rates to be lowered.

Basel I and II inflexible capital requirements

          Along with the fiscal distortion explained above, the way Basel I and Basel II requirements forced banks to compute their equity levels induced dramatic threshold effects. This pushed financial engineers to devise financial products that combined higher yields (generally associated with higher risk) with good notation from rating agencies, previously reserved for “blue chips” investments.(6)

          These products, mostly referred to as collateralized debt obligations, used techniques like “slicing and dicing.” This was supposed to provide a high level of protection to “senior bonds” with a higher remuneration than traditional AAA products, but a lower remuneration than the risky loans providing the collateral, through a higher interest “junior tranche” that was supposed to bear the entire risk of any eventual losses.

          These financial engineering techniques were costly, and have proven inefficient in preventing a bigger than usual economic downturn from translating into big losses for senior bondholders. The AAA rating of these bonds was nothing more than wishful thinking. Slicing and dicing didn’t make senior bonds secure, but simply disguised unsecured bonds as secured ones.

"If the price of money was determined by free market forces, without any doubt, the rush of borrowers clamouring for mortgages would have increased the interest rate over its greenspanian value between 1999 and 2004, and the bubble would have burst before getting out of control."

          If the Basel requirements hadn’t been promulgated as local law in most countries, banks would have had very little incentive to use these techniques to such an extent, reserving them only for “niche” purposes. Instead, they would have kept more direct investments in their assets portfolios. In that case, the first signs of weakness from some type of assets, like real estate mortgages, would have provided an early signal to financial institutions that it was time to reshuffle their portfolios, and the potential losses of the financial system would have been much lower.

          Good regulation should compel banks to disclose fully the primary investment vehicles in their asset portfolios and the exact levels of their liabilities, but leave them free to choose the right level of equity and the types of investments they put in their assets. Combined with the elimination of the tax distortion mentioned above, this should lead to much better market information about the financial health of banks, forcing the weakest among them to borrow at higher interest rates and to reinforce their equity level against the risk they assume in their portfolios.

Distortions in Mortgage and Real Estate Markets

Special advantages granted to Fannie Mae and Freddie Mac

          As Congressman Ron Paul and others noted from the very beginning of the new century, the special credit line and other fiscal privileges granted by the federal government to government-sponsored entities (falsely seen as private companies) like Fannie Mae and Freddie Mac amplified the risk of the creation of a real estate bubble that could heavily damage the US financial system when it burst.

          These guaranties provided by Washington to GSEs allowed them to borrow money at rates close to those obtained by the federal government itself for its own bonds, giving Fannie and Freddie an unfair advantage over purely private banks. Worse, special accounting rules granted them by their supervising authority (the HUD), allowed them not to fully disclose their off-balance operations and to over-leverage their balance and off-balance liabilities 80 times more than their equity.

          Had Fannie and Freddie been under the common law of private institutions, they couldn’t have borrowed so much money at such low rates to finance such risky operations. No financial institution should be granted special rights. Fannie and Freddie must be liquidated and abolished. Loan refinancing must be turned into a purely private business, as it is in many countries.

Special constraints placed on Fannie Mae and Freddie Mac

          All these advantages provided to Fannie and Freddie were not granted with no strings attached. Fannie and Freddie, since 1992, were forced to contribute to the refinancing of loans attributed to low-revenue families. The percentage of these loans was gradually increased, by law, from 40% in 1992 to 56% in 2008.(7)

          Since an internal scandal put pressure on the two GSEs, threatening their existence through congressional action, they tried
(successfully) to justify their privileges with a huge increase in the refinancing of loans for low-income families from 2004 to 2007. A press investigation showed that they didn’t do it directly, but mostly indirectly, through the purchase of large amounts of bonds collateralized by risky loans made by other institutions. Congressional testimony showed that Fannie’s and Freddie’s managers, though aware of the unorthodox nature of their actions with regard to the risk level their companies were bearing, couldn’t resist the political pressure to “take more loans.” These “juggernaut policies” contributed to the over-leveraging of GSE balance sheets mentioned above.

          This shows how harmful it can be to maintain so-called private companies under political pressure because of the privileges they are granted: politicians tend to subordinate economic imperatives to their political agenda. No company should be forced by the state to engage in dangerous behaviours.

Community Reinvestment Act

          The CRA was a law aimed at preventing “discrimination” against visible minorities by lending institutions. CRA provisions forced banks to lower their lending standards toward these minorities. CRA loan delinquency rates have not been much higher than the rates for other loans, and this gives momentum to CRA defenders. But the drawbacks of the CRA were hidden elsewhere. The law submitted bank mergers and acquisitions to the oversight of several agencies with the power to block the deals if they were not “CRA compliant.”

          This forced small banks that kept their good habits of “serious lending” (there were many of them) to remain small. It also forced bigger banks that wanted to benefit from the 1994 and 1999 deregulation laws (Riegle-Neale and Gramm-leach-Bliley) to build great nationwide networks, in order to lower their loans’ underwriting standards.

          These deregulations should have been economically positive, since they repealed older texts from the 1920s and 30s that prevented banks from practicing accurate risk diversification. However, the reinforcement of CRA regulations in 1995 turned them into risky moves, because banks that wanted to take advantage of them could only do so by adopting riskier lending behaviours.

          Since the purportedly large differences in lending approval rates between communities have been proven less significant by several studies, debunking the myth of “racist banks.” these CRA provisions should be repealed. Banks should be free to select mortgage applicants according to their own rating standards.

Smart Growth Policies and similar land-use regulatory restrictions

          Although very few observers have noted this, the real estate bubble was highly uneven geographically throughout the USA (and Canada, too). In fact, price escalation was huge in about a dozen states, but nearly nonexistent in others, even if there was a huge demand in those states too. The three fastest-growing areas of the USA—Atlanta, Dallas, and Houston—didn’t experience the same real estate bubble as big cities like Los Angeles, or midsized ones like Portland. If demand had been the sole factor behind real estate price hikes, Houston and Atlanta should have been the most expensive metro areas in the country. They remained among the cheapest. So the bubble should also be explained from the supply side of the equation.

          The different behaviours between these two kinds of markets arise from land-use regulations. The Brookings Institute has classified metro area regulations into two categories: prescriptive regulations, which make it difficult for land owners to turn non-constructible land into land that can be developed; and conversely, responsive regulations, which are aimed at keeping enough land available to meet demand for new housing units.

          The housing bubble basically only occurred in areas with prescriptive regulations,(8) generally referred to as “smart growth policies,” or, in two cases (Arizona and Nevada), in areas where local power actually owns the land and decided to reduce land sales to developers in order to raise their financial revenues through higher land prices.

          The total value of originated mortgages increased from $5,200 billion in 2000 to $12,000 billion at the peak of the bubble. More than 80% of the mortgage escalation occurred in areas with “smart growth” and equivalent policies. This means that if the whole country had enacted the same land-use regulations as Atlanta or Houston, the total exposure of the financial system to mortgage risk would have been reduced by about $4,000 billion.(9) This would certainly have made the current crisis much less severe.

          But there is more. If the whole country had been a “no bubble can even get started” area, as Nobel Prize-winner Paul Krugman formulated it, the behaviour of lenders and borrowers would have been completely different. It would have been much more difficult to persuade borrowers to jump recklessly onto the easy credit bandwagon, and lenders would have found it much less interesting to take homes as guarantees for high-risk loans.

          This would have avoided many “borrow against equity” mortgages aimed, not at purchasing a home, but at using continually growing home prices to finance flat screens, SUVs, and other goodies. Growth rates in the USA would thus have been less spectacular, but also less artificial.

          When studied in detail, environmental and agricultural concerns against urban surface expansion, a.k.a. “sprawl,” appear to be widely exaggerated. Smart growth policies, aimed at providing a government response to these exaggerated fears, have produced extremely harmful unintended consequences, and imperceptible benefits. Smart growth policies must be repealed. This can be easily justified by the fact that most are clearly violating property rights, whatever the Supreme Court has said in recent rulings.

Conclusion: Restore Markets!

          Markets are imperfect because human beings are. All the state interventions in free market mechanisms described above were supposed to bring corrections to unavoidable market imperfections. They were supposed to provide us with safer banks, better access to consumer goods for the poor, better-performing companies and economies, better use of space, and better social side effects. None of the intended goals of these interventions have been achieved. But by destroying the “natural” defences of markets against failure, they wrought havoc on the world economy.

          It’s time for politicians to ask themselves why state regulations of land, finance and money failed so miserably, and if we should not replace them with a few market-based mechanisms that would be more efficient in achieving their stated goals.


1. Paul Krugman, “Reagan did it," The New York Times, May 31, 2009.
2. Wikipedia, “Money supply."
3. Lawrence White, “How did we get into this financial mess?," Cato Institute, Cato Briefing Paper no. 110, November 18, 2008.
4. Vernon Smith, "From bubble to depression?," Wall Street Journal, April 6, 2009.
5. Ruben D. Cohen: “An Implication of the Modigliani-Miller Capital Structuring Theorems on the Relation between Equity and Debt."
6. Vincent Bénard, "Comment les accords de Bâle ont favorisé la crise qu'ils devaient prévenir," Institut Hayek, 12 mars 2009.
7. Russell Roberts, “How government stoked the mania," Wall Street Journal, October 3, 2008.
8. Wendell Cox, “5th Annual Demographia International Housing Affordability Survey," 2009.
9. Wendell Cox, “How Smart Growth Exacerbated the International Financial Crisis," The Heritage Foundation, WebMemo #1906 , April 29, 2008.