Econ 101: The Financial Crisis and Danger of Government Intervention

     Ludwig von Mises in a classic 1927 book, Liberalism, wrote that government intervention in markets would lead inevitably to unintended consequences that resulted in further government intervention.

     The current financial difficulties are the result of a series of government actions that has culminated in vastly expanded government intervention in the credit markets, which may provide short-term relief but is dangerous in the long run.

     It is difficult to correct a problem when the cause of the problem is misunderstood. The presidential and vice-presidential candidates have all said that “Wall Street greed” has led to the financial mess we are in. On the very face of it, this does not seem likely. Even if greed leads to problems, is it possible that greed has suddenly become much greater than before?

     One beauty of the market system is that individual self-interest (which is not greed but that is the subject of another commentary) is satisfied only by pleasing other people, and the structure of the market leads individual interest “as if by an invisible hand” to support the public interest. No such mechanism exists in the institutions of government.

     Our current financial crisis is the result of several government interventions in the market – Fannie Mae's government sponsorship, the Community Reinvestment Act of 1977, the creation of the secondary mortgage market and imposition of government accounting rules.

     One underlying cause of the current crisis is the expanded housing market where loans were made that could not be paid off by the borrower. A quick summary analysis is that that the government attempted to increase home ownership beyond what the market would or could sustain.

     First, we can look at the creation of Fannie Mae in 1938 as part of the New Deal. It was a government entity that dominated the secondary mortgage market in the United States. In 1968, in order to remove its balance sheet from that of the government’s, Fannie Mae was turned into a stock holder-owned entity, but not quite a private corporation, called a government sponsored enterprise.

     In a series of regulatory changes, Fannie Mae was granted certain privileges in order to expand credit into the subprime market. In 1999 The New York Times reported on the expansion of credit to minority borrowers through easing credit restrictions.

     “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. 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 1980s,” the Times warned.

     In 2004, the government changed regulations and further encouraged high risk mortgages. The result of all this was the creation of a secondary mortgage market that would not have existed in such size and scope had the government not attempted to increase the home ownership rate.

     This distortion of the housing market was further aggravated by the Community Reinvestment Act in 1977 and its subsequent amendments. This federal legislation basically required banks to expand their mortgages into areas where the economic fundamentals indicated borrowers would not be likely to make mortgage payments.

     Another major government intervention has been the expansion of credit pursued by the Federal Reserve through its policy of targeting a federal funds rate below the rate of inflation. This artificially low rate of interest led to what Nobel Laureate Friedrich Hayek termed “malinvestment.” Austrian business cycle theory predicts that artificial credit expansion leads to investment in assets that will not be sustainable (in this case housing stock). This is a reasonable explanation for the housing bubble.

     Yet another interference, the mandatory use of government accounting rules requiring banks to mark their assets to the market price, which in thinly traded assets may be the last sale, led to lending institutions having to write down their capital when the mortgage-backed securities began to sell at fire-sale prices.

     As a result, banks as a group had to seek additional capital, with few banks willing to lend precious capital to rival institutions. The lack of certainty in the value of mortgage-based securities meant that few banks wanted to hold them. This further froze the market in these assets, reducing their value and creating a crisis in capital. Economist Brian Wesbury has said that the majority of the credit crisis has been caused “by mark-to-market accounting in an illiquid market.”

     The President and Secretary of the Treasury came before a national audience on Sept. 20 and announced that if the Treasury Secretary was not given $700 billion to purchase securities and take equity positions in the banking sector by Sept. 22, we risked a major financial collapse. This, of course, did little to calm the markets since the President didn’t already have the votes for passage. This created further uncertainties that lead to more market disruption.

     Unfortunately, as Mises predicted, the response to the financial meltdown has not been that the government should cease attempting to increase home ownership beyond what can be sustained in the market and should refrain from excessive increases in the credit markets. Instead, the attitude of many in the media and government has been that a crisis has occurred due to unfettered market capitalism and that government must be expanded in order to solve the crisis. 

     Mises defined socialism as state ownership of property. Under the bailout plan, taxpayers will be “protected” by taking equity interest in the financial institutions that take advantage of the Treasury offer. Will you receive shares of AIG stock in the mail? No. What this really means is that the government will own shares of the company – i.e., the socialization of the financial industry.

     What is likely to happen is that markets will once again reach equilibrium after adjusting to the malinvestment in housing and mortgage-backed securities. The federal government will have increased its intervention in the marketplace, which is really the long run threat to the nation and the economy. The security of our economic system lies in an understanding of the efficiency of the market system and its ability to provide wealth for the masses and realization of the failures of central planning and the process by which we end up there.


Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College.