Over the course of several decades politicians—both Democrat and Republican—encouraged banks and mortgage companies to ease lending standards in hopes of making housing more affordable for the poor. They also urged the government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae (the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association) to purchase the resulting low-quality loans from lending institutions. This freed up money, enabling banks to make more loans than would have otherwise been possible. These actions, along with low short-term interest rates set by the Federal Reserve and tax advantages for home buyers, sparked a housing boom. Home prices soared and investors flocked to purchase mortgage-backed derivatives. Speculation became rampant, and houses were bought simply to resell, or “flip,” when prices rose.

Eventually, the bubble burst. Housing prices collapsed and thousands of home buyers defaulted on their mortgages, sending derivative prices into a death spiral and sparking a Wall Street sell-off. The rest is history: a history that the government is apparently anxious to repeat. The Fed is still pushing its easy-money policies with a vengeance, down-payment subsidies for low-income home buyers are still available for the taking, and lenders are still being pressured to ease standards for minorities and for low-income home buyers. The thinking appears to be that if housing prices can be driven back up to their pre-bust levels, everything will be fine. Homeowners who are currently “underwater” (meaning they owe more on their homes than the homes are now worth) and all those banking and investment houses that saw the value of their mortgage-based securities plummet will supposedly be back in the black.

There is only one problem with this scenario: The pre-bust price levels are not sustainable. We have the bust to prove it.

In the midst of the attempt to reinflate the bubble, politicians, needing to deflect blame for the collapse, have settled on Wall Street and the mortgage lenders as the most plausible villains. (Which is not to say they are blameless; the State-banking partnership is as old as the republic.) Last September the Federal Housing Finance Agency, which oversees Fannie and Freddie, announced it was suing the nation’s 17 largest banks—some of which the government had recently bailed out—for selling risky mortgages to the two GSEs. Yet just two months before, the Department of Justice “requested” that a number of banks lower lending standards for minorities with poor credit ratings, threatening them with discrimination charges if they failed to comply.

How did banks get into this damned-if-you-do-damned-if-you-don’t nightmare? It started in 1977 with the Community Reinvestment Act (CRA). The act requires “each appropriate Federal financial supervisory agency to use its authority when examining financial institutions, to encourage such institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions.” As Thomas Sowell wrote in his book The Housing Boom and Bust, the act, though seemingly innocuous, was based on the “implicit assumption that government officials are qualified to tell lenders to whom they should lend money entrusted to them by depositors or investors.” Sowell notes that lawmakers never seriously questioned this assumption.

The CRA Gets Teeth

At first the CRA had little impact but it was given teeth by subsequent legislation. The main impetus for additional regulation came from Federal Reserve studies run in the early 1990s showing differing home loan approval rates for black and white applicants. Largely ignored were the findings by these same studies of no racial differences in default rates among approved borrowers. As Sowell explained in Economic Facts and Fallacies, had minorities been unfairly denied loans, their default rates should have been significantly lower than the rate for whites. Instead, the equal default rates indicate the various groups were being held to the same standards.

Imagine a thoroughly racist loan officer looking for the slightest excuse to deny a loan to a minority home buyer. Minor flaws that he would ignore if the applicant were white are eagerly used as justifications for rejecting a mortgage to a minority applicant. Only black and Hispanic borrowers with stellar credit ratings would have their loans approved. The few loans the officer did make to minority borrowers would have a far lower default rate than those he made to whites. The data, however, showed no such differences.

Regardless, lending institutions were subjected to a firestorm of media abuse. Under pressure from both Congress and the White House, federal regulatory agencies loosened lending rules and imposed penalties on lenders failing to meet politically dictated racial quotas.

In 1993 the Department of Housing and Urban Development (HUD) began legal actions against mortgage bankers who declined “too many” minority loan applications. HUD also pushed Freddie and Fannie to increase their purchases of low- and moderate-income (LMI) mortgages. In 1995 regulators required banks to prove they were making a mandated number of loans to LMI borrowers, directing them to use “innovative or flexible” lending practices to achieve their quotas. Still other ways were found to pressure banks into making risky loans. For example, when Congress repealed legislation prohibiting banks from affiliating with securities and insurance companies, it denied the restored freedom to banks with CRA ratings below “satisfactory.” Similarly, regulatory permission for mergers and for opening branch offices was tied to banks’ CRA community service activities, such as hiring minorities, making donations to approved nonprofit organizations, and earmarking loans for minority-owned businesses.

In 1999 the New York Times reported that Fannie Mae, under increasing pressure from the Clinton administration to buy more LMI loans, encouraged banks “to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.” Clinton’s successor, George W. Bush, contributed to the expanding bubble as well, signing the American Dream Downpayment Act in 2003, which provided, and still provides, down-payment subsidies to low-income home buyers.

The drive to make homes more affordable actually made them less so. Prices soared as hundreds of thousands of first-time home buyers flooded into the market. Still, few people buy a home outright; most take out a mortgage. As long as the monthly payments were affordable, home sales could continue apace. To drive monthly payments down, politicians and lenders only needed to get a bit more creative. With plenty of reserves thanks to the Fed’s easy-money policies, banks were more than eager to step up. No-down-payment loans became commonplace, as did adjustable rate mortgages (ARMs) and even so-called “liar loans” for which borrowers were not even required to show they could pay the money back. It did not matter because, of course, housing prices would continue rising forever. If anyone defaulted on his mortgage, the lender would just foreclose on the house and resell it for a tidy profit.

According to Peter J. Wallison and Edward J. Pinto in Forbes (Feb. 16, 2009), in late 2004:

[The chairmen of Freddie and Fannie] were telling meetings of mortgage originators that the GSEs were eager to purchase subprime and other nonprime loans.

This set off a frenzy of subprime and Alt-A [rated between subprime and prime] mortgage origination, in which—as incredible as it seems—Fannie and Freddie were competing with Wall Street and one another for low-quality loans. Even when they were not the purchasers, the GSEs were Wall Street’s biggest customers, often buying the AAA tranches of subprime and Alt-A pools that Wall Street put together. By 2007 they held $227 billion (one in six loans) in these nonprime pools, and approximately $1.6 trillion in low-quality loans altogether.

From 2005 through 2007, the GSEs purchased over $1 trillion in subprime and Alt-A loans, driving up the housing bubble and driving down mortgage quality.

Critics argue that only 6 percent of the subprime loans made to low-income home buyers were provided by CRA-covered banks. However, CRA loans contributed disproportionately to the defaults. According to Bank of America’s October 2008 quarterly report, CRA loans represented only 7 percent of its total mortgage lending, yet these loans made up 29 percent of its mortgage losses.

CRA Infection

The CRA’s largest impact, however, was that it led to an overall drop in lending standards. As Thomas E. Woods, Jr., reported in Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse, “The push for relaxed lending standards for low- and middle-income borrowers was so pervasive and systematic, persisting for a full decade, that it is no surprise that it should have spilled over into the standards for higher-income borrowers as well.” Low standards did more than just “spill over,” however. HUD pressured mortgage lenders not subject to the CRA to sign “Memoranda of Agreement” stating they would make more loans to minority and low-income borrowers. Countrywide Financial was the first lender to sign and, perhaps not coincidentally, the first lender to go bankrupt when the housing bubble burst. Once hailed as a leader, Countrywide is now reviled as a “predatory lender.”

Speculators, availing themselves of zero-down-payment loans and ARMs, purchased house after house with no intention of actually living in any of them. Instead they resold them as prices continued climbing. In the end, a number of homes were built strictly as investment vehicles. “Flipping” homes in this manner could be very lucrative—right up until the housing market crashed. Many speculators, caught between sales, defaulted on their mortgages. Because they had put little or nothing down, the losses were borne by whichever institutions held the mortgages when the music stopped—or by the taxpayers.

Many homeowners, seeing the value of their houses soar during the boom years, cashed in by refinancing their homes at the higher market values and pocketing the difference. When prices tumbled back down, they were left owing more money on their homes than they were now worth. Some, like the speculators, simply walked away.

Still, critics point out that the dollar value of CRA loans paled in comparison to the leveraged debt that Wall Street investors amassed. Imagine an upside-down pyramid of debt with the pyramid’s apex serving as its base. This apex was made up of home mortgages. Piled on this relatively small base were trillions of dollars in leveraged derivatives such as credit-default swaps (essentially insurance against bond or, in this case, loan failure) and other mortgage-based securities.

As top-heavy as this inverted pyramid was, the fact remains that it could have survived had its base been solid. Instead, its foundation was riddled with bad home loans because the government had coerced banks and other lending institutions into handing out money to people who could not afford to repay it. Further, Congress demanded that Freddie and Fannie buy hundreds of billions of dollars’ worth of these subprime loans, enabling lending institutions eagerly to make even more such loans with no incentive to vet borrowers. Investors were blinded to the risks by triple-A ratings handed out by a government-sanctioned cartel of credit rating agencies evaluating the mortgage-based securities.

Three years after the housing bust, the Federal Reserve is still following easy-credit policies. Last September it doubled down with an announced purchase of $400 billion in longer-term Treasury securities hoping to lower long-term interest rates and thereby boost spending and investment. At the same time the government is continuing to pressure banks to make risky loans and sell them to Freddie and Fannie, which were taken over by the government after they went bankrupt. (Last fall Freddie said it needed to borrow $6 billion more from the Treasury after it lost $4.4 billion in the third quarter of the year.) The new twist is that federal regulators are now suing banks for doing what the government demanded, and is still demanding, that they do. This is not too surprising given Washington’s need to pin the blame on someone, anyone, other than Washington. The politicians and regulators also need to be looking ahead, though, for the villains on whom they can blame the new and bigger bust that they currently have in the works. It is nothing short of breathtaking. But then, blowing bubbles always is.

In this environment, it’s natural that the government—and in particular the presidential candidates—are offering their “solutions.” As we’ll see, most of these proposals would only make things worse. To see why, we first need to understand what went wrong in the housing market.

To put it simply, there was an unsustainable bubble in home prices. From June 2001 to June 2006, the ten-city composite index mentioned above rose a whopping 89 percent. Now an average annualized return of over 13 percent isn’t bad, especially when you can live in the investment or rent it out for income. Consequently, more and more people entered the housing market. Some bought more expensive homes than they otherwise would have, and others even began buying homes purely as investments to “flip” once they had appreciated. As in any market, when prices exploded producers began cranking out more product—homebuilders were very busy, and their stock did very well during this period.

Another important part of the story is the revolution in financing that blossomed at the same time, which both benefited from and exacerbated the housing boom. In a traditional arrangement people in a community deposit funds with the local bank, which pays them a low interest rate in return. Then the bank takes this large pool of individual deposits and grants mortgages to qualified applicants, charging them a higher (but fixed) interest rate to compensate both for the bank’s overhead and the possibility of default. To make sure its loans went to responsible borrowers, and to align everyone’s incentives, the bank would insist on a hefty down payment, often 20 percent of the price of the house.

Yet things didn’t always happen this way during the recent housing boom. Rather than conventional fixed-rate mortgages, eager buyers were granted adjustable-rate mortgages (ARMs) that offered low upfront rates, which would then reset down the road. This allowed people to buy much more expensive homes, because they could handle the monthly payment at the “teaser” rate. Many buyers figured they could either flip the house before the ARM reset, or they could refinance at that time into a fixed mortgage.

Besides ARMs, other unorthodox practices occurred. People might be granted interest-only mortgages, where the borrower treads water with each payment, or even “negative amortization” ones, where the principal owed to the bank actually grows over time. Naturally, people signing up for all of these low-pain mortgages didn’t have money for a down payment, and here too the banks were very obliging. Before discussing the innovations on the mortgage-holder side of the market, I should stress that the above patterns aren’t as crazy as they now appear in retrospect. If home prices had continued their double-digit rates of appreciation, these practices all made perfect sense. It was only when the housing market collapsed that the borrowers were caught with their pants down.

On the banking side, here too practices deviated from the old ways. Rather than keeping mortgages on their balance sheets, local banks would sell them off to middlemen, who would ultimately pass them on to the giant investment banks headquartered on Wall Street. These organizations would turn to their “financial engineers” to bundle pools of mortgages into a new entity, broadly classified as a collateralized debt obligation (CDO). Outside investors could then buy bonds issued by the CDO. The flow of monthly mortgage payments into the CDO funded the flow of coupon payments to the bondholders. In the event of defaults, there were pre-determined rules for which CDO bondholders took the hit first. Naturally, the riskier classes (or “tranches”) of CDO bonds offered higher rates of return at the outset.

The growth in popularity of CDOs allowed institutional investors to participate in the booming housing market. Someone managing a pension fund didn’t have to do research on employment and default rates in Sacramento to gain exposure to real estate; all he had to do was buy bonds issued by the relevant CDOs. The high ratings granted by Moody’s and other agencies satisfied contractual and regulatory requirements, and reassured these outside investors that such investments were safe. Sure, any individual borrower could default, but the Ph.D.s at the investment banks had quantified the risks so everybody (apparently) knew exactly what he was buying into.

Of course, the party ended once housing prices peaked, and things turned ugly when prices began falling sharply. Most obvious, homebuilders were caught flat-footed, with more inventory in the pipeline that now had no buyers. But the fall in prices also   devastated those borrowers who had been banking (literally) on the opposite expectation; with negative equity and no buyer, they were stuck with mortgage payments (especially those with resetting ARMs) they couldn’t afford.

As is well known, the housing bust wreaked havoc in the credit markets as well. CDOs involving real estate were suddenly dangerous. The mathematical models that had previously been used to value them were obviously deficient, yet market prices weren’t available because nobody wanted to purchase the securities. Thus beginning in August 2007 and continuing to this day, banks have been reluctant to lend to each other because they couldn’t really trust the solvency of their counter-parties. (A bank asking for a short-term loan might have $1 billion in mortgage-backed securities on its books to pledge as collateral, but how much were those assets really worth?)

Because of banks’ reticence to lend not only to regular people but also to each other, the housing bust led to a much broader credit crunch. The process was a vicious circle. Spooked by the debacle, banks became much more stringent in their standards when evaluating new mortgage applications. This has only intensified the fall in house prices, as willing buyers can’t obtain financing.

How Government Caused the Trouble

Now that we have a better grasp of exactly what happened, the next issue is, “Why?” The typical answer is greed, on the part of investment banks, real-estate brokers, and speculators. But unless someone can explain why financiers and speculators were greedier in the mid-’00s than at other times, this explanation isn’t too helpful.

The free-market economist has learned from many different examples that when individuals and firms systematically make boneheaded decisions that lose them gobs of money, there is usually a government policy driving the madness. And in the housing bust, the pattern holds.

First and most obvious, the Federal Reserve had an easy-money policy to try to rescue the economy from the dot-com crash. In 2001 alone, the federal funds target rate was slashed from 6.50 percent down to 1.75 percent; the target eventually reached an incredibly low 1 percent by June 2003, where the Fed held it for an entire year. Then from June 2004 through June 2006, the target was steadily hiked back up to 5.25 percent. Although the correlation isn’t perfect, when the federal funds rate is cut, other interest rates—including mortgage rates—generally fall with it. Given the close connection between mortgage rates and home prices, even mainstream analysts have blamed the Fed for its role in the housing crisis.

Another obvious government distortion resulted from the actions of the Federal Housing Administration (FHA), which provides insurance for mortgage holders in the event of a default by borrowers. To see the connection between the FHA’s activities and the housing boom, we need only quote from the main page of its website: “Unlike conventional loans that adhere to strict underwriting guidelines, FHA-insured loans require very little cash investment to close a loan. There is more flexibility in calculating household income and payment ratios.”

Implicit Government Guarantees

Freddie Mac and Fannie Mae, major participants in the secondary market for mortgages, also share a portion of the blame. They buy mortgages from originators (banks, thrifts, credit unions, and so on), package them into bundled securities, and then sell the new assets to outside investors. As so-called government-sponsored enterprises, they do not directly receive tax dollars or explicit government assistance. However, many investors believe there is an implicit federal guarantee behind these agencies, and their regulatory requirements are also looser than for their purely private-sector counterparts.

Because of these advantages, when mortgage originators know a loan will be eligible for purchase by Freddie Mac and Fannie Mae, they can charge home buyers lower rates than would otherwise be profitable. Indeed, part of the official mission of these companies is to make the dream of homeownership attainable for millions of low- and moderate-income families. When trying to understand why so many obviously unqualified people were able to obtain financing during the housing boom, we shouldn’t ignore the role of large intermediaries explicitly designed to “soften” the strict requirements of the pure market.

Pressure to loosen underwriting standards was placed on private lenders as well in the name of avoiding discriminatory “redlining.” Stan Liebowitz, an economics professor at the University of Texas at Dallas, has been a critic of such political correctness for over a decade. In a February 5 New York Post op-ed (http://tinyurl.com/2ahdkd), he explains how beginning in the 1980s, activist groups such as ACORN (Association of Community Organizations for Reform Now) agitated against lending practices that yielded fewer approvals for minority and other low-income applicants.

In 1992 the Boston Fed produced an academic study that purportedly verified this bias in lending and distributed a manual for lenders that said the use of “arbitrary or outdated” criteria could be evidence of discrimination. Some of these criteria included income verification and the credit history of the mortgage applicant.

In 1995 the fuzzy-sounding 1970s Community Reinvestment Act (CRA) was strengthened. Henceforth, all banks and thrifts that enjoyed deposit insurance had an affirmative duty to lend throughout the regions in which they accepted deposits, notably including poor neighborhoods. If they received bad marks on this score, they could be subject to direct or indirect sanction, such as having merger plans held up by the Department of Justice. Studies by both the Federal Reserve and Harvard’s Joint Center for Housing Studies found that the CRA achieved its goal—namely, higher rates of homeownership in poorer communities.

Although some defenders of the CRA have pointed out that half the subprime loans were made by institutions outside the law’s purview (http://tinyurl.com/3sjcfj), surely government and activist efforts to shame lenders into loosening standards must play some role in our story. To quote Liebowitz:

Ironically, an enthusiastic Fannie Mae Foundation report singled out one paragon of nondiscriminatory lending, which worked with community activists and followed “the most flexible underwriting criteria permitted.” That lender’s $1 billion commitment to low-income loans in 1992 had grown to $80 billion by 1999 and $600 billion by early 2003.

Who was that virtuous lender? Why—Countrywide, the nation’s largest mortgage lender, recently in the headlines as it hurtled toward bankruptcy.

In an earlier newspaper story extolling the virtues of relaxed underwriting standards, Countrywide’s chief executive bragged that, to approve minority applications that would otherwise be rejected “lenders have had to stretch the rules a bit.” He’s not bragging now.

Finally, there is the matter of the ratings agencies. Had they done their job properly, and given more accurate estimates of the riskiness of the rather exotic CDOs with which many investors were unfamiliar, then the housing boom would not have gained so much momentum. As usual, critics of capitalism attribute their mistakes to simple greed or even corruption.

Yet we have to ask: Don’t agencies such as Moody’s and Standard and Poor’s have an incentive for honest and accurate reports? Aren’t they suffering now for their wildly overoptimistic ratings, the way Countrywide and other lenders have either gone bust or are on the verge of doing so?

The answer is no. State and federal regulations of entities such as banks, insurance companies, and broker-dealers often rely on the creditworthiness of the bonds on the books of these organizations. Naturally the government then has to specify which ratings agencies are legitimate for this purpose; a banker can’t simply get a letter from his brother-in-law declaring his bonds to be “investment grade.” Although space does not permit a full treatment here, suffice it to say that the major ratings agencies are largely shielded from open competition (http://tinyurl.com/5akgq3). Consequently they will not be ruined by the housing bust, and it is no wonder then that they were so reckless with their profitable (at the time) evaluations.

Now that we understand the problem with the housing and credit markets, and how misguided government policies caused or at least greatly exacerbated the mess in the first place, we can quickly evaluate the likely effectiveness of some of the recent and suggested moves to fix things:

Cutting the federal funds rate. From September 2007 through April 2008, the Fed cut its target rate from 5.25 to 2 percent. Not surprisingly, things are still awful in the housing market, and the credit markets are still unsettled. As we’ve seen above, it was arguably Fed rate cuts that caused the housing boom in the first place. At this point, everyone is spooked; newly created dollars won’t flow into housing, but rather some other sector, such as commodities.

Bailouts of firms judged “too big to fail.” The Federal Reserve Bank of New York notoriously assisted with JPMorgan’s rescue of Bear Stearns in March on the grounds that its collapse would have led to widespread panic and further failures. As many critics have argued, such rescue attempts lead to a “moral hazard” that will only further encourage risky practices in the future. For a market to work, we need to rely on the profit-and-loss mechanism. Bear Stearns was heavily invested in mortgage-backed securities (MBS) and should have been left to suffer its fate on the open market. The only way to reward firms that wisely eschew hot items during a boom is to allow their competitors to go bust.

Accepting mortgage-backed securities as collateral for short-term loans. On March 11, the Federal Reserve announced the Term Securities Lending Facility, authorized to lend up to $200 billion of the Fed’s holdings of Treasury securities to primary dealers in 28-day loans. The Fed agreed to accept MBS as collateral for these loans. The move promoted “liquidity” because it is much easier to raise cash in the market with bonds issued by the federal government (Treasuries), rather than securities tied to mortgages at risk of massive defaults.

There are several problems with this arrangement and others like it. First, it obviously puts taxpayers on the line if the primary dealers default and the Fed is stuck with (grossly overvalued) MBS. Second, it intensifies the moral hazard discussed above; it benefits those who hold a large amount of MBS—precisely the investors with poor foresight. Finally, it perversely encourages holders of MBS to keep them off the market, since the Fed will accept them at an unrealistic book value.

To repeat, the problem in the credit markets isn’t simply the massive losses from bad loans. It’s also the uncertainty caused by the large holdings of derivative assets tied to mortgages. Only when institutions bite the bullet and begin selling these assets, presumably at large losses, can realistic market prices be established. Only then will banks be able to assess each other’s creditworthiness, and only then will they begin lending freely to one another. Government efforts to prop up the MBS market perversely stall this shakeout.

Rewriting contracts in favor of the homebuyer. Senator Hillary Clinton has been the most aggressive in this area. In December she called for a 90-day moratorium on certain types of foreclosures, and a five-year moratorium on ARM resets. Although these measures would help some existing homeowners in the short run, they would make it harder for newcomers to obtain financing to purchase a house. After all, the reason a bank is willing to lend out such large sums to a young couple is that the loan is secured; the bank can take possession of the house if the couple defaults. As far as ARM resets, it obviously doesn’t help the beleaguered holders of MBS to be told that the government has codified their fears of nonperformance.

A federal “loan substitution” program. In a March 7 op-ed in the Wall Street Journal (http://tinyurl.com/2zo6nm), economist Martin Feldstein proposed that the federal government pay off 20 percent of the mortgages of homeowners who opt into the program. They would repay the government over 15 years at the rate earned by two-year Treasurys (1.6 percent when Feldstein was writing). The point of the plan would be to encourage homeowners—especially those with negative equity—to continue making their monthly mortgage payments, rather than walk away.

Feldstein said the plan would be financed “by issuing new two-year debt until the loans are fully repaid, thus eliminating any net cost to the government.” It is rather shocking that Feldstein, chairman of the Council of Economic Advisers under President Reagan, didn’t consider that some of the participants in the plan might default on their debt to the government. As usual, the taxpayer would ultimately foot the bill for this massive handout to the mortgage industry.

Enhanced regulation. Almost every “serious” commentator on the housing crisis, including the allegedly laissez-faire Treasury Secretary Henry Paulson, has called for enhanced government oversight of the financial sector. It is ironic that in February the constraints on Freddie Mac and Fannie Mae were considerably loosened to allow them greater leeway in buying mortgages—and this just as the companies were reporting losses in the billions of dollars in the fourth quarter alone of 2007.

Where Do We Go from Here?

There are two distinct approaches the government can take to discourage institutions from engaging in reckless financial transactions. One is to let them do whatever they want (subject to prohibitions on outright fraud and theft) and let them go bankrupt if they screw up. The other is to hold their hands every step of the way, bailing them out of trouble but also second-guessing every decision they make.

In light of the complex and quickly moving financial system, as well as the politicians’ own dismal record on matters of honest bookkeeping, I think the first approach is far more sensible.

Unfortunately, even some nominal friends of markets have argued the housing crisis is too serious to ignore. If the government sits back waiting for prices to hit bottom, we are told, there will be unacceptable ripple effects throughout the rest of the economy. Yet as we have seen, most of the proposed interventions would make the housing crisis worse; any alleged ripples would turn into tidal wives. Beyond that observation, we should also remember that prices really do serve a function in a market economy. The politicians have already caused real damage, and people need market prices to know how to make the best of a bad situation. Propping up home prices at unrealistic levels will simply waste tax dollars and hamper the correction.

Our current housing and credit crises are quite serious—perhaps the worst since the Great Depression. As usual, the free market is not to blame; numerous government policies caused or exacerbated the situation. The host of “solutions” being implemented or  recommended will only make matters worse.

Ever since its founding in 1913, the Fed has described itself as an independent agency operated by selfless public servants striving to fine-tune the economy through monetary policy. In reality, however, a non-political governmental institution is as likely as a barking cat. Yet, the myth of an independent Fed persists. One reason this myth persists is that statist textbooks have helped perpetuate it for decades.

From 1948 until about 1980 Paul Samuelson’s Economics was the best-selling introductory economics text. Generations of students were introduced to economics by Samuelson. Although not as popular as it once was, Samuelson’s text (now co-authored with William Nordhaus) is still widely used. According to the 1989 edition:

The Federal Reserve’s goals are steady growth in national output and low unemployment. Its sworn enemy is inflation. If aggregate demand is excessive, so that prices are being bid up, the Federal Reserve Board may want to slow the growth of the money supply, thereby slowing aggregate demand and output growth. If unemployment is high and business languishing, the Fed may consider increasing the money supply, thereby raising aggregate demand and augmenting output growth. In a nutshell, this is the function of central banking, which is an essential part of macroeconomic management in all mixed economies.

For about the past fifteen years the top-selling economics text has been Campbell McConnell’s Economics, which echoes Samuelson and Nordhaus’s idealistic statism:

Because it is a public body, the decisions of the Board of Governors are made in what it perceives to be the public interest . . . the Federal Reserve Banks are not guided by the profit motive, but rather, they pursue those measures which the Board of Governors recommends. . . . The fundamental objective of monetary policy is to assist the economy in achieving a full employment, noninflationary level of total output.

These are mere wishes, not statements of facts, for there is voluminous evidence that the Fed—like all other governmental institutions—has always been manipulated by politicians.

The Fed as a Political Tool

When the Fed was founded, it was controlled by two groups, the Governors’ Conference, composed of the twelve regional bank presidents, and the seven-member Federal Reserve Board in Washington. In 1935 the Fed was reorganized to concentrate nearly all power in Washington. Franklin Roosevelt packed the Fed just as he later filled the U.S. Supreme Court with political sycophants. Roosevelt appointed Marriner Eccles, a strong supporter of deficit spending and inflationary finance, as Fed Chairman, although Eccles had no financial background and lacked even an undergraduate degree. In those years the Fed was really run by Eccles’s political mentor, Treasury Secretary Henry Morgenthau, Jr., and thus ultimately Roosevelt.

Later presidents were no less willing to influence supposedly independent Fed policy. According to the late Robert Weintraub, the Federal Reserve fundamentally shifted its monetary policy course in 1953, 1961, 1969, 1974, and 1977—all years in which the presidency changed. Fed policy almost always changes to accommodate varying presidential preferences.^[1]

For example, President Eisenhower wanted slower money growth. The money supply grew by 1.73 percent during his administration—the slowest rate in a decade. President Kennedy desired somewhat faster money creation. From January 1961 to November 1963, the basic money supply grew by 2.31 percent. Lyndon Johnson required rapid money creation to finance his expansion of the welfare/warfare state. Money-supply growth more than doubled to 5 percent. These varying rates of monetary growth all occurred under the same Fed chairman, William McChesney Martin, who obviously was more interested in pleasing his political master than in implementing an independent monetary policy.

Martin’s successor, Arthur Burns, was such a staunch supporter of Richard Nixon that he lost all professional credibility by enthusiastically endorsing Nixon’s disastrous wage and price controls. Even though his staff informed him in the fall of 1972 that the money supply was forecast to grow by an extremely robust 10.5 percent in the third quarter, Burns advocated ever faster growth before the election. The growth rate in the money supply in 1972 was the fastest for any one year since the end of World War II and helped re-elect Richard Nixon.

However, President Ford called for slower monetary growth as part of his Whip Inflation Now program, and the Fed complied with a 4.7 percent growth rate. But when Jimmy Carter was elected, Burns again complied with presidential wishes by stepping up the growth rate to 8.5 percent. Carter did not reappoint Burns, but the latter’s successors were equally cooperative. The money supply increased at an annual rate of 16.2 percent in the five months preceding the 1980 election—a post-World War II record.

In 1981 Donald Regan, Ronald Reagan’s Treasury Secretary, advocated, and got, more rapid monetary growth. A year later the President himself met with Fed Chairman Paul Volcker to lobby for slower growth, which was dutifully produced by the Fed. More recently, Alan Greenspan has reportedly been most accommodating to President Clinton.

Both Sides Benefit

The Fed is obviously influenced by the executive branch. But the relationship between the Fed and administrations runs far deeper. As Robert Weintraub observed, such contact has been and continues to be fostered by cross planting of high level personnel in both directions. Officials have also met weekly for decades. But personal contact is not necessary for the Fed to allow itself to be used as a political tool. The administration’s policy views are generally well known. Economist Thomas Havrilesky has even developed an index of executive branch signaling, based on newspaper accounts of the administration’s monetary policy preferences as reported in the Wall Street Journal.^[2] And as Weintraub concluded, a Chairman of the Federal Reserve Board who ignores the wishes of the President does so at his peril.

The Fed and presidents alike benefit from this arrangement. Economist Edward Kane has argued persuasively that the Fed’s ultimate political function is to serve as a political scapegoat when things go wrong. Writes Kane: Whenever monetary policies are popular, incumbents can claim that their influence was crucial in their adaptation. On the other hand, when monetary policies prove unpopular, they can blame everything on a stubborn Federal Reserve and claim further that things would have been worse if they had not pressed Fed officials at every opportunity.^[3] In return for this favor, the Fed is allowed to amass a huge slush fund (discussed below) by earning interest income from the government securities it purchases through its open market operations.

A Demand for Inflation?

It is also well established that politicians use the Fed as a tool of money creation to advance their own re-election. As Robert J. Gordon wrote in the Journal of Law and Economics more than 20 years ago: Accelerations in money and prices are not thrust upon society by a capricious or self-serving government, but rather represent the vote-maximizing response of government to the political pressure exerted by potential beneficiaries of inflation.^[4]

Gordon is wrong in denying that government is inherently capricious and self-serving, but he’s got a good point: Politicians are naturally inclined to finance government handouts to special-interest groups with the hidden tax of inflation, which hides the true costs of government from the taxpaying public. Joining with election-minded officials in favor of expansive monetary policies is a low-interest-rate lobby, led, argues Edward Kane, by builders and construction unions and by financial institutions that earn their living by borrowing short to lend long.

The Fed underwrites an enormous volume of research, some of which is very good. But, as Business Week magazine once observed: There is disturbing evidence that the research effort of the bank’s 500-odd Ph.D. economists is being forced into a mold whose shape is politically determined by the staff of the Federal Reserve Chairman. Some Fed economists admit that political expedience is the rule. Says former Fed economist Robert Auerbach, the practice at the Bank where I worked was to clear research through the Board of Governors and to ‘persuade’ economists to delete material that the Board or the Bank officials did not like.^[5]

Thus, all Fed research should be taken with a grain of salt. However, one recent study in particular deserves special attention. In 1992 Boston Fed research director Alicia Munnel published a report claiming to find persistent mortgage loan discrimination against minorities in Boston. The study, used to justify racial quotas for bank loans, was fatally flawed. The data were hopelessly jumbled. Equally important, the report failed to control for creditworthiness—credit ratings, job history, income, and so on. When confronted with these facts by Peter Brimelow and Leslie Spencer of Forbes magazine, Munnel admitted: I do not have evidence . . . no one has evidence of lending bias.

Taxpayer-Funded Lobbying

The Fed also uses its privileged position—and especially its multi-billion dollar slush fund generated by interest income on open market purchases—to lobby. Its preferred method is to pressure member banks, which it regulates, to lobby for it. It also recruits a small army of academic researchers, who benefit from Fed research grants, visiting appointments, and invitations to conferences at exotic locations, to testify on its behalf at Congressional hearings.

For instance, in the late 1970s Representative Henry Reuss introduced a bill authorizing the General Accounting Office to audit the Federal Reserve system. It was defeated because, as Reuss later explained, with the Federal Reserve Board in Washington serving as the command center, a well-orchestrated lobbying campaign was mounted, using the members of the boards of directors [of the regional banks] as the point men. In a speech to the American Bankers Association after the GAO bill was defeated, the Richmond Fed’s chairman, Robert W. Lawson, congratulated the assembled commercial bankers for their success: The bankers in our district and elsewhere did a tremendous job in helping to defeat the General Accounting Office bill. It shows what can be done when the bankers of the country get together.^[6] Academics conducted themselves in an equally disgraceful way, warning of potential abuses and assuring Congress that the Fed could be trusted to behave responsibly.

For decades, believers in the public interest theory of Fed behavior blamed the Fed’s failures to ensure price stability on the agency’s incomplete knowledge and difficulty fine-tuning the economy. But research suggests that the Fed’s abysmal record in controlling inflation reflects not mere incompetence, but the way in which the Fed is organized.

Until the Fed’s creation, there was no overall upward trend in the price level. Inflation occurred during wars, but prices then gradually declined to their former levels. Since the establishment of the Fed, however, there has been a continuous upward surge in prices. Public choice scholars believe that an important reason why the Fed has caused so much inflation is that it benefits from inflation. Since the entire operation has been funded since 1933 from revenue acquired through interest payments on government security holdings, the Fed has an incentive to purchase securities (thereby expanding the money supply) more than it has an incentive to sell them. Purchasing government securities is a source of income to the Fed, whose income is earned by the interest paid on the securities. Selling securities, on the other hand, causes a loss of income.

The Fed is constrained to return excess revenues to the Treasury, but enjoys great discretion over its budget and managed to spend over $2 billion on itself in 1996. Fed officials live quite well on their revenues. As a recent General Accounting Office report revealed: The Fed has 25,000 employees, runs its own air force of 47 Learjets and small cargo planes, and has fleets of vehicles, including personal cars for 59 Fed bank managers. . . . A full-time curator oversees its collection of paintings and sculpture.^[7] The Fed held $451 billion in accumulated assets as of 1996, when it was engaged in building for itself several expensive new office buildings. The number of Fed employees earning more than $125,000 per year more than doubled (from 35 to 72) from 1993 to 1996; even the head janitor (known as the support services director) is paid $163,800 in annual salary plus benefits. Money is lavishly spent on professional memberships, entertainment, and travel.

Economist Mark Toma has studied the Fed’s spending habits and believes that the Fed does in fact conduct monetary policy with an eye toward how its managers and employees can themselves profit from it. That means instituting a bias toward bond purchases and money creation.^[8] Similarly, William Shughart and Robert Tollison contend that the Fed behaves exactly like many other government bureaucracies, padding its operating expenditures by increasing the number of employees on its payroll.^[9]

That is, the Fed uses staff expansion to reduce the amount it must return to the Treasury. Thus, when engaging in expansionary policies, write Shughart and Tollison, the Fed can both increase the supply of money and increase the size of its bureaucracy because the two goals are served by open market purchases of securities. Contractionary policies, on the other hand, force the Fed to lower its profits and staff. Because of this unique financing mechanism, argue Shughart and Tollison, the Fed has been more successful in enlarging its employee staff over time than the federal government as a whole. This employment effect, moreover, may partially explain why the Fed has apparently been more willing to engage in expansionary than in contractionary monetary policies.

Regulation as a Political Tool

The Fed also uses its vast regulatory powers for political purposes, rather than to promote the public interest. The Fed’s authority is vast, but is most abused through enforcement of the Community Reinvestment Act of 1977. Under the CRA, the Fed must assess a bank’s record of meeting community needs before allowing a bank to merge or open a new branch or even an automatic teller machine. An entire industry of nonprofit political activists routinely files protests with the Fed, which must be evaluated before the bank can win Fed approval. The activists typically threaten to stall mergers or branch expansions unless banks give them—not the poor in their communities—money, a practice that many bankers consider pure blackmail.

For example, the Chicago-based National Training and Information Center threatened to delay a merger by a Chicago bank unless it received $30,000 to renovate its office. The bank agreed, and also gave $500,000 to other leftist organizations. In Boston, left-wing activist Bruce Marks, the head of the Union Neighborhood Assistance Corporation, filed complaint after complaint with the Fed over Fleet Financial Group’s community lending record until Fleet agreed to give $140 million to his organization and to make $8 billion in loans to individuals and businesses favored by Mr. Marks. We are urban terrorists, Marks explained to the Wall Street Journal.^[10]

The CRA is frequently used as a means of racial extortion. For example, the Fed, under the direction of former Governor Lawrence Lindsey, found statistical disparities in lending, i.e., the percentage of loans granted by the Shawmut Services Corporation to blacks and Hispanics did not match the groups’ proportion in the population. Yet no individuals complained of discrimination and the Fed did not claim to have found any victims. In fact, between 1990 and 1992, when the discrimination allegedly occurred, Shawmut’s mortgage loans to blacks and Hispanics more than doubled, and the mortgage rejection rate fell by 45 percent and 26 percent, respectively. However, the Fed employed 150 people to go out and find people who claimed to have been discriminated against by Shawmut and to offer them $15,000 each, effectively robbing the company of $1 million.

Conclusions

Any government monopoly will be corrupt and inefficient, but the Fed may be the worst government monopoly of all. Not only does it operate for its own advantage in the name of promoting the public interest, and offer government officials political cover for their self-interested policies, the Fed also allows no escape. One can at least refuse to do business with, say, the government school monopoly by homeschooling or by sending one’s children to private schools. But one cannot avoid the effects of the Fed’s monetary monopoly. It is time to depoliticize and denationalize our money.

2. Thomas Havrilesky, Monetary Policy Signaling from the Administration to the Federal Reserve, Journal of Money, Credit and Banking, vol. 20, no. 1, February 1988.

3. Edward J. Kane, Politics and Fed Policymaking, Journal of Monetary Economics, vol. 6, 1980, p. 206.

4. Robert J. Gordon, The Demand for and Supply of Inflation, Journal of Law and Economics, vol. 18, 1975, p. 808.

5. Robert D. Auerbach, Politics and the Federal Reserve, Contemporary Policy Issues, Fall 1985, p. 52.

6. Ibid., p. 53.

7. John R. Wilke, Fed’s Huge Empire, Set Up Years Ago, Is Costly and Inefficient, Wall Street Journal, Sept. 12, 1996, p. 1.

8. Mark Toma, The Inflationary Bias of the Federal Reserve System, Journal of Monetary Economics, vol. 10, 1982, pp. 163-190.

9. William Shughart and Robert Tollison, Preliminary Evidence on the Use of Inputs by the Federal Reserve System, American Economic Review, June 1983, pp. 291-304.

10. Susan Alexander Ryan and John Wilke, Banking on Publicity, Mr. Marks Got Fleet to Lend Billions, Wall Street Journal, Feb. 11, 1994, p. A-5.