Hardly Unfettered!

Former Senior Fellow and Vice Chair, Board of Trustees

Despite the need of a government rescue of our shambolic financial markets, reports of the death of the free market system have been greatly exaggerated.

Quite the contrary, the lessons of the past week--or rather the past year--confirm that markets work all too well. Sooner or later, markets punish voracious and imprudent risk taking, loose money, misdirected or inadequate regulation and lax oversight, all of which played a role in the current debacle.

The foundations of a free market system are discipline, restraint, rationality, delayed gratification, enterprise, rule of law and accountability. More or less every 10 years, these conditions are tested only to discover that "markets can stay irrational longer than you can stay solvent"--as Keynes put it. Irrational perhaps, but not "unfettered"--as sloppy commentators and conflicted politicians want us to believe. Unfettered free markets have not existed in this country for the better part of a century.

The subprime binge began more than a decade ago on a road paved with good intentions (those of increasing home ownership and revitalizing and stabilizing communities). Instead of designing policies to provide equity and down-payment assistance, however, Congress crafted measures that increased maximum allowable mortgage debt and reduced minimum thresholds of creditworthiness.

Congress also expanded the powers of Fannie Mae and Freddie Mac without concomitant controls to ensure disciplined market practices. As government-sponsored enterprises (GSEs) with low "core capital" requirements, Fannie and Freddie bought bundles of subprime mortgages which they swapped for mortgage-backed securities. Fannie and Freddie set the tone and a panoply of players relaxed underwriting, lending and rating standards whilst Federal Home Loan Bank subsidies financed the likes of Countrywide and IndyMac.

The large Office of Federal Housing Enterprise Oversight bureaucracy was incapable of reining in Fannie and Freddie, and Congress ignored warning calls from the then secretary of the Treasury and Fed chairman. In September 2003, John Snow proposed legislation to tighten oversight of Fannie and Freddie, but he was rebuked by Barney Frank for conjuring frightful scenarios about GSEs that were "fundamentally and financially sound." In 2005, Alan Greenspan warned that Freddie and Fannie could put the "total financial system of the future at risk" but Chuck Schumer insisted that "Fannie and Freddie have done an incredible job."

Congress seemed more focused on Fannie's and Freddie's political donations and preferential mortgages than on the damage that was being inflicted on financial markets. This week, ironically, it made oversight a cornerstone of the debate on the rescue package.

What about other sectors of the financial industry? History will judge whether or not the Gramm-Leach-Bliley Bill, supported by the entire Clinton Administration and a 90-8 vote in Congress, was the catalyst for an apparent free-for-all among banks, securities firms, mortgage lenders and insurance companies. Did the SEC act brazenly in allowing investment banks to become more leveraged? Did the SEC fail to monitor rating agencies properly?

Yet opponents of deregulation conveniently overlook the bevy of new regulations that were enacted roughly at the same time. The adoption of Basel I and II rules, for example, granted excessive power to the oligopoly of rating agencies who, in turn, were paid generously for underestimating risk. No competitive free market there. The adoption of market-value accounting exacerbated the credit crunch and blurred the real value of performing, albeit illiquid, loans. Compensation rules that require asset managers to be paid according to the size of their portfolios probably caused them to take excessive investment risks rather than return funds to their investors. Finally, loose monetary policy exaggerated a global savings glut.

Irrespective of one's position on these issues, it is impossible to describe this maze of policy interventions and regulations as an "unfettered" free market. What was unbound were the ambitions and greed of many market participants willing to sacrifice prudence for higher returns.

Borrowers lied about their ability to repay loans, and lenders allowed them to do so. Asset managers bought and demanded high-risk, high-return products. Entire firms borrowed short and lent long and mismanaged and mis-priced risk. They tested the limits of the markets and the market response was stentorian.

With so much blame to be apportioned among all the players, private and public, the danger is that, even with a rescue package, the management of this crisis and the stabilization of financial markets will be interrupted by ideological shibboleths, petty posturing and misguided policies to avert or assuage recessionary forces. Recent experience suggests that markets will punish such behavior severely.

Newly released data on jobs, durable goods and business spending confirm that the economy is slowing down markedly. Pressures will mount to save fledgling industrial firms, erect trade barriers and enact another stimulus package. Congress would be well advised to judge every proposal according to its likely impact on investment and growth.

There will also be time to review issues such as executive compensation, improved home ownership measures, corporate governance, SEC regulation and many more. The urgent matter is to unclog credit markets, restore confidence and encourage institutions to raise capital and resume responsible lending--as well as reasonable risk taking to support growth. Markets work, and they will not forgive politically inspired tinkering.