Tuesday, December 11, 2007

Paulson's Folly

Nicole Gelinas puts a finger on the problems raised by the government's proposed solutions to our mortgage/credit crisis in this article at City Journal.

Although the economy seems to be chugging along, most of us are aware of an underlying discomfort. The housing market is in turmoil, some of us either are in mortgage payment trouble or know someone who is, and we've all heard about recent banking troubles.

The government thinks it can solve these market problems by waving a magic wand, even though they are contributors to it in the first place. (See this post for details about that.) They would like to force those who control mortgage payments to change the terms of certain of the loans, supposedly to keep many people out of foreclosure.

Talk about confusing.

ReadScratchHead
[Thanks to class.uidaho.edu for this image.]

In this country where we talk the free market talk, we walk like a drunken sailor.

As Gelinas puts it:

"Paulson’s program is somewhat analogous to the price fixing that economically illiterate governments do to stop inflation—only in this case, the government is fixing rates rather than prices." Precisely. Price fixing never works; even the public has learned that one from the gasoline sector, but for some reason the government thinks we'll buy it this time.

I think the public is wiser than the government seems to believe, even though we may play along, having other things to think about in our daily life. (See this post for an example of how wise we are.)

Here are the six major reasons why Paulson's and the government's idea is counterproductive, according to the article:

1. "First, it will reward and encourage irrational behavior by future home buyers. It wasn’t logical for people to take on mortgage obligations that they couldn’t afford, but it will become logical in the future if they can reasonably expect that the government and their lenders will bail them out when the going gets tough." This is called moral hazard, i.e. the government has set up a program that encourages improper behavior through the incentive it provides.

2. "Second, the deal will thwart the market by keeping home prices artificially high." Correct. Remember, this was a housing boom. Housing booms imply inflated prices. Inflation always deflates, and if it doesn't happen through a diminution of house prices, it will happen through the diminution of the money that buys them. The dollar has already lost half of its value compared to the euro (Source). I don't think it's over yet. ... "Hope Now [Gelinas's name for the government's new plan], by placing an artificial floor under home prices, will penalize first-time buyers who did the right thing: not taking out mortgages that they knew they couldn’t afford...." Yeah. Who's thinking about them? That's socialism: Favoritism towards one group over another, mostly to procure votes and remain in power.

3. "Third, the deal may hurt some borrowers it was meant to help, by encouraging homeowners who can barely afford their teaser rates to continue making those monthly payments in the hope that the property market will recover quickly and allow them to sell their homes. If that doesn’t happen, they’ll be right back where they started in a few years." True. This is not a solution to their problem. It just prolongs the agony.

4. "Fourth, the deal will allow investors in these mortgage securities and participants in the housing market to delay new pain, beyond what they’ve already experienced...." Likewise. These people also will have to deal with this now or later.

5. "Fifth, the deal essentially calls for banks and mortgage investors to rewrite billions of dollars in private-investment contracts under government pressure. It’s likely, for example, that banks that have actively approved or underwritten subprime mortgages feel an implicit threat from the government." Since when is a contract subject to government review? This is an extremely important point. It is to contracts what the Kelo case was with regard to property rights. I can see it all going to the Supreme Court--or at least it should.

6. "Sixth—and most important—Paulson’s mortgage mulligan will permanently alter investors’ perception of the risk of government interference in the American credit markets." Another great point. People invested in America because of our free markets. As of the implementation of this new program, our free markets are no longer free. Or more accurately, it's just one more leather strap around freedom's ankles in America, and it's a signal to investors that this is not the fiscal paradise it used to be.

Excellent points, all.

And when I think that Paulson himself was CEO of one of those huge financial houses that contributed to this mess in the first place.

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