How to avoid the next housing bubble

Today’s question: How do we avoid another disastrous housing bubble? Increased regulation, or trust the market to price risk better next time? Previously, Mitchell and Abromowitz discussed what Washington should do about Fannie Mae and Freddie Mac, John McCain’s proposal for the government to buy bad mortgages, the biggest players in the mortgage meltdown and whether Washington should give tax breaks to homeowners.

Act more like Hong Kong, not France
Point: Daniel J. Mitchell

At the risk of putting a smile on your face, David, I must admit that the last month has been a miserable time for people like me who support economic liberty. The politicians in Washington approved a massively expensive $700-billion bailout. The Treasury Department, after first proposing a goofy plan to buy bad assets for either too much (to line the pockets of financial institutions) or too little (to supposedly make a profit for taxpayers), has now decided to coerce banks into accepting partial government ownership. Combined with a similarly inept $300-billion housing bailout earlier this year, politicians are displaying their typical ability to make a bad situation even worse.

But the ultimate insult to injury is that the financial crisis is largely a result of other government mistakes. As I explained in my counterpoint column on Tuesday, the current turmoil is the result of the housing bubble, and the housing bubble can be traced to three misguided policies.

* Easy money from the Federal Reserve: Egged on by politicians who think artificially low interest rates somehow are good for growth, the Federal Reserve flooded the economy with excess liquidity earlier this decade. That extra money had to go someplace, either by bidding up consumer prices or bidding up asset prices. For reasons I’ll explain soon, the funds got channeled into the housing market.

* A corrupt system of subsidies from Fannie Mae and Freddie Mac: As I explained in my Thursday counterpoint, these two infamous government-sponsored enterprises used their favored status to dramatically expand the size and scope of their activities, making the bubble even bigger and increasing systemic risk.

* Government-mandated lending to borrowers with bad credit: A number of policies, ranging from the Community Reinvestment Act to so-called affordable-housing quotas imposed on Fannie and Freddie, either extorted or lured lenders into giving mortgages to people who were ill-prepared for the responsibilities of homeownership.

The only piece of good news in the “perfect storm” of bad policy is that policymakers now have a road map to avoid disastrous housing bubbles in the future. If politicians want a stronger economy (or, to be more accurate, if they want a stronger economy more than they want to curry favor with special-interest groups), they should get rid of the policies that caused today’s mess.

That means abolishing Fannie and Freddie, which hopefully should be easy now that they’ve gone bankrupt and have stopped giving campaign contributions. It also means repealing the Community Reinvestment Act and other “affordable-housing” mandates. Luring people into homes they cannot afford is bad for banks and bad for poor people.

But why stop there? To protect taxpayers as well as the economy, the entire Department of Housing and Urban Development should be shut down. And, just to be on the safe side, the building should be razed and the ground covered with a foot of salt to prevent it from springing back to life and haunting future taxpayers. As I explained in my Monday post, housing is not a legitimate role for the federal government.

Fixing monetary policy is a more challenging task, particularly since a stable, zero-inflation policy requires the Federal Reserve to accurately gauge both the supply of money and the demand for money. But one no-brainer step would be to repeal the Humphrey-Hawkins Act, which saddles the Fed with an impossible dual mandate of price stability and macroeconomic fine-tuning. Europeans generally are not role models for economic policy, but we could learn at least one lesson from them, because the European Central Bank is responsible for price stability and nothing else.

The key goal, in all cases, is to reduce the amount of damage that government imposes on the economy. There is a reason the United States is more prosperous than France, and that is because the burden of government is smaller. But this is also a reason Hong Kong grows so much faster than America. It has a limited government, similar to what our founding fathers envisioned. Rather than become more like France, maybe it’s time for the United States to become more like Hong Kong.

Daniel J. Mitchell is a senior fellow at the Cato Institute, where he is an expert on tax reform and supply-side tax policy.

Government must keep an eye on the ‘free market’
Counterpoint: David M. Abromowitz

Dan,

If consistently repeating “poor people ruined our housing market” in various ways made it so, conservatives would win the argument. But I’ve see no data that agree with you, nor does your point agree with basic common sense. Lump together all the families assisted by the Community Reinvestment Act, Fannie and Freddie affordability efforts, the Federal Housing Administration or any other dreaded government housing help for schoolteachers, secretaries and police officers, and they would still make up a fraction of borrowers during the frenzied bubble period of 2000-06. And as I’ve pointed out all week, these responsible lending programs verify income and use fixed-rate loans -- meaning that the families making, say, $40,000 or less who were helped by these programs were not the ones bidding $250,000 houses up to $400,000. That behavior, Dan, was brought to us by the excesses of unleashed market “innovation.”

But back to topic: Going forward, what would help the housing market restabilize and thrive? A few thoughts:

* First, given the real causes of the bubble (pdf); perhaps you and I agree that a Fed that ignores an inflating asset bubble does so at everyone’s peril.

* Mortgage brokers and originators play a critical role in launching either responsible or shoddy loans into the commerce stream. To strengthen the market, we need baseline national standards of responsibility (without pre-empting states that want to more carefully oversee mortgage companies). Although I am sure you would want a caveat-emptor approach -- assuming the average American can ferret out hidden fees, prepayment penalties, interest rate trends and the like -- the experience of the last few years demonstrates why that wouldn’t work. Thoughtful proposals exist on how to do this better.

* Now is an opportunity to expand housing affordability for moderate-income families, not retreat from it. Prices have dropped, and as I noted earlier this week, many safe and sound lending models with proven, low-default rates exist for first-time buyers. Particularly interesting is a recent University of North Carolina study highlighting that it is not the low-income borrower profile but rather the risky mortgages themselves that cause defaults (pdf). We must also, however, attend to the rental side of the equation. With nearly one-third of Americans in households that overspend on housing, the market is apparently underproducing on rental options for working families.

* Finally, whatever mortgages are originated, be they fair or predatory, they will be bundled and sold into investor pools in today’s global capital era. Reforms are needed to prevent abuses, manage dispersed risk, minimize more “too big to fail” situations and deny incentives to peddle bad products that present little risk to mortgage brokers. Some of these reforms have emerged; others still need to be crafted.

Dan, in sum, all week you have consistently painted government as the problem and the unfettered markets as naturally good. To many of us who do believe in market economies, this is faith-based economics -- which recent experience (not to mention the savings and loan meltdown that occurred after massive deregulation) proves false. As I have written at greater length elsewhere, markets are a human invention harnessed to achieve human goals, not a divine set of commandments to which we must submit. Moreover, for markets to function, we need market referees. Those features that many assume are a natural part of a “free market” -- such as relatively even bargaining power, effective alternatives, perfect information and the like -- do not automatically happen in the real world. Government has a vital role in keeping markets fair and intervening for the public welfare where markets fail or fall short.

David M. Abromowitz is a lawyer and a senior fellow at the Center for American Progress Action Fund.