Michael Novak’s Shoddy Economic Analysis Part II

Michael Novak’s Shoddy Economic Analysis Part II July 1, 2009

Almost exactly two years ago, when this blog was first launched, and we were all more naive and innocent (!), I wrote a post entitled “Michael Novak’s Shoddy Economic Analysis“. I took him to task for misreading the economic data to prove his point, which was that inequality did not increase under the Bush administration. Well, folks, everybody’s favorite Catholic laissez-faire liberal has struck again, and this time he muses on the global financial crisis. In a nutshell, he blames it on the government and on poor people. This is what he says:

“government action was the principal villain in the 2009 debacle. It was the federal government that forced banks to make sub-prime loans to poor families (who were known to be unable to pay their mortgages on a regular basis)….The federal government even guaranteed the work of two huge quasigovernment mortgage companies—Fanny Mae and Freddy Mac—that wrote more than half of all mortgages during the fateful years.”

This is so wrong I don’t even know where to start. Let me talk about the global financial crisis, which started in the US subprime mortgage market and spread across the world. The explanation I will give is conventional wisdom, on which nearly everybody agrees. Some might emphasize some points over others, but there is nothing controversial here.

Let me start with the global savings glut, something Ben Bernanke has been talking about for a long time. Basically, the huge increase in global savings driven by China and the oil exporters pushed long-term interest rates to all-time lows. These savers wanted to recycle their funds into US securities, which fed a credit boom. What is bound to happen? Well, cheap money led to mounting debt, and the result was an asset price boom, particularly notable in the housing market. It fueled an environment in which people thought prices would rise forever, and people could make capital gains forever, and debt went through the roof.  Now — and this happens time and time again — when you get a credit boom, underwriting standards tend to slip. After all, nobody can lose, so while rain on the parade? This was all aided and abetted by a loose monetary policy, which kept rates low at the short end, and encouraged financial institutions to take on greater amounts of risk.

The second angle is the lax regulatory environment. There were many failures here. Mortgage originators could simply wash their hands of risk by selling it on, thus limiting their incentive to actually monitor it. At the same time, CDOs were created by packaging assets of various quality in one jumbo instrument, and this gave the illusion of safety. Nobody really knew where the bodies were buried and the ratings agencies gave their seal of approval, relying on highly dubious statistical models. Regulators were asleep at the wheel, and did not fully understand the complex interconnections among systemically-important financial firms that proved too big to fail (at least without taking the whole financial system down with them). They stood by when leverage went through the roof, and when firms clearly did not have enough capital or liquidity to support their underlying assets. Market discipline simply did not work.

Were Fannie and Freddie responsible? No. The GSEs might have invented securitization, but this was a private sector affair. More than 84 percent of the subprime mortgages in 2006 (the peak year) were issued by private lending institutions. During 2004-06, the subpime years, the share of subprime loans held by the GSEs fell from 48 perecent to 24 percent. A key reason is that the GSEs were subject to tougher regulation than the private sector. This is not to say that the GSEs were entirely blameless — they did ride the surprime wave to a limited extent, but only out of concern that their market share was dropping fast. Like many other institutional investors, they did so by buying securities that they thought were totally safe.

The next point relates to blaming the subprime crisis on lending to the poor. Again, this is totally off. I’ve addressed this before, and will recap briefly. During the peak of the boom, the private sector made 83 percent of the subprime loans to low- and moderate-income borrowers. Many people on the right are blaming the Community Reinvestment Act of 1977, which required banks to lend in the communities they serve. But top economists like Robert Gorden and Janet Yellen have debunked this myth completely. For a start, the timing is off — the CRA comes from 1977, and was actually weakened by the Bush administration during the subprime boom. Also note that the CRA is restricted to banks and thrifts that are federally insured. In fact, only 20-25 percent of subprime loans came from institutions fully under the CRA. And they were well-known for their good behavior– Janet Yellen (president of the San Francisco Federal Reserve) showed that independent mortgage companies made subprime loans at twice the rate of banks and thrifts. The CRA has actually been a force of moderation.

To get back to the start — if anything is to blame for this crisis, it is the culture of greed, the notion that you can make lots of money by taking financial gambles, by creating something out of nothing. As Pope Benedict noted, “We see it now in the collapse of the great banks that money disappears, it’s nothing…Whoever builds his life on this reality, on material things, on success … builds (his house) on sand.” And speaking of “these fundamental errors that have been revealed in the failure of the large American banks” he noted that  “the error at the basis of it is human greed.” Indeed. Too bad Michael Novak refuses to acknowledge such an obvious point.


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