Saturday, October 4, 2008

The Free Market can save the U.S.

By Sean Radomski

It is impossible today to pick up a newspaper without reading about the apocalyptic financial crisis and the bailout bill that will supposedly prevent a second Great Depression. Not surprisingly, the media has been quick to assign blame to President George W. Bush’s economic policies. While attacking Bush’s policies may be a good way to score votes this November, it does not address the fundamental cause of this financial crisis. The current economic slowdown has been fundamentally caused by excessive government intervention into the economy, dating back to the Carter Administration.

That fact that the origin of the problem is the Carter Administration, which is notoriously known for long gas station lines, high inflation, and even higher interest rates, should not come as a surprise to free-market advocates. In an effort to further so called “economic justice,” Carter signed into law the 1977 Community Reinvestment Act (CRA) in an attempt to promote “affordable housing.” The CRA forced banks to make loans to minorities and consumers with poor credit and allowed regulators to impose fines on the banks if they did not meet these standards.

Fast-forward 26 years to 2003, the year when mortgage giants Fannie Mae and Freddie Mac were found to have committed accounting fraud. In an attempt to sidestep Congressional criticism, Fannie and Freddie offered to increase loans to low income, poor credit consumers in accordance with the CRA. This move was political music to Rep. Barney Frank’s ears who believed that Fannie and Freddie were “not facing any kind of financial crisis,” and that “the more pressure there is on these companies, the less we will see in terms of affordable housing.”

His Senate counterpart, Sen. Christopher Dodd also praised the mortgage giants for “riding to the rescue” and believed that they “need[ed] to do more” in terms of “affordable housing.” Conversely, while Democrats in Congress were praising the call for more “affordable housing,” Treasury Secretary John Snow was urging for the creation of a new agency to monitor the mortgage giants. In fact President Bush publicly called for reform of Fannie and Freddie 17 times before this year, but his call fell on the deaf ear of the Democrats in Congress. It should be noted that Sen. Dodd, Rep. Frank, and current Presidential candidate Sen. Barack Obama have received $133,900; $40,100, and $105,849 in campaign contributions, respectively, from Fannie and Freddie since 1989.

To add fuel to the fire, from 2003-2005 the Federal Reserve kept the federal funds rate at 1%. The Fed kept the rate low in an attempt to stimulate economic growth after the “dot com” bubble had burst. Low income consumers with bad credit (yes, the same ones targeted by the CRA, Fannie, and Freddie) saw this as an opportunity to take out a subprime mortgage and buy a house. The rapid increase in home ownership fostered by the 1% interest rate drove up home prices and created a housing bubble. However, once the Fed raised interest rates and those with subprime mortgages could not keep up, the bubble burst.

The bursting of the housing bubble has led to the failure of many financial firms, such as Bear-Stearns and Lehman Brother, that had mortgage-backed securities on their balance sheets. Their failure has led to the call for a massive $700 billion bailout bill that will enable the Secretary of the Treasury to buy these securities, thus removing them from the firms’ balance sheets. The theory is that with now clean balance sheets, the firms will draw capital, thus unfreezing the credit market which will allow Main Street consumers to receive much needed loans.

This bailout bill is flawed and is bad for the American economy because it fails to remember the key principle of capitalism: reward those who perform well. Instead, the bill does the complete opposite and rewards the companies that made poor investments.

If passed this bill will set a frightening precedent that encourages bad investing with the knowledge that if you fail, the government will save you at the expense of the American tax payer. The bill’s logic is also flawed in assuming that once these toxic assets are off balance sheets, capital will flow to the firms. Why would anyone risk investing his hard earned money in a company that has so recently shown poor judgment?

Excessive government intervention into our countries financial system in the triple threat of the CSA, Fannie Mae and Freddie Mac, and the Federal Reserve has led to this crisis. The last thing we need is $700 billion of more government. The fastest way to fix this mess is eliminate the mark-to-market accounting rule that has artificially lowered firms’ asset values.

Mark-to market accounting requires firms to value their assets at the price they could fetch on the open mark right now. If this rule is eliminated, firms will be able to value the assets at an estimated future market price; thus increasing the value of the balance sheets. If mark-to-market were eliminated earlier this year, Washington Mutual and Wachovia would not have been sold and Lehman Brothers would not have failed. As for the firms that still cannot make it: let them fail. This will weed out the poorly managed companies, making sure they are not around in the future to make the same mistakes. This will allow stronger, well run firms to gain market share and protect the future of the American economy.

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