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 2008 Fannie Mae (and its sibling, Freddie Mac) both failed. Their debts were assumed by the federal government. The loss imposed on taxpayers was recently estimated by the Congressional Budget Office at $325 billion through 2011, with additional losses to come.

In the above-mentioned report Stiglitz and his coauthors noted the view that there was an implicit government guarantee that enabled Fannie and Freddie to borrow at below-market interest rates. Their estimates of taxpayer risk were based on the assumption that “the implicit government guarantee on GSE debt is equivalent to an explicit guarantee.” In Freefall, by contrast, Stiglitz declares, “Fannie Mae began as a government-sponsored enterprise but was privatized in 1968. There was never a government guarantee for its bonds; had there been, its bonds would have earned a lower return, commensurate with U.S. Treasuries.”

That statement is seriously misleading. Fannie (and Freddie) had an all-but-explicit guarantee and received other favored treatment from the government. Reflecting the implicit guarantee, their bonds paid lower yields than those of other private financial institutions. Their borrowing-cost advantage was worth billions per year.

The misleading treatment of Fannie Mae and Freddie Mac is just one example of a pervasive feature of Freefall: It often traffics in ideological spin. Stiglitz notices the mote of ideological bias in the eye of “those who have done well by market fundamentalism,” but ignores the beam in his own.

Free of false modesty Stiglitz describes himself as a member of “a small group of economists” who in the years before 2008 “tried to explain why the day of reckoning that we saw so clearly coming had not yet arrived.” He views himself as a courageous outsider, but it is difficult to share Stiglitz’s outsider picture of himself in light of the well-placed insider roles he has occupied during his career: chairman of the President’s Council of Economic Advisers (1995–97) and chief economist at the World Bank (1997–2000).

A major theme of Freefall is that incentive-distorting government regulations had little to do with the financial crisis. The plot line of his narrative is indicated by the title of chapter six: “Avarice Triumphs over Prudence.” The crisis happened in a “deregulated market,” or a market characterized by “lax regulation,” and so “it was something that Wall Street did to itself and to the rest of society.” He writes of “the deregulatory frenzy of the 1980s, 1990s, and the early years of [the 2000s],” and “the current rush to deregulation,” events not evident in the actual historical record.

Stiglitz makes his case for government intervention by holding free markets to the straw-man standard of frictionless efficiency. He touts his own academic research as showing that when the conditions for perfectly frictionless efficiency are not satisfied, “there [are] always some government interventions that could make everyone better off.”

This is argument by existence proof: The brief for government intervention is that we can imagine a case in which it improves things. It could make everyone better off—assuming an ideally omniscient and benevolent intervener. Might not actual government interveners fail to meet the conditions for their own perfection? Might they fail to know just where and how to intervene?

At least Stiglitz recognizes that government policies played a crucial role in creating the housing bubble. He notes that the Federal Reserve’s loose monetary policies under Greenspan fueled the housing boom and acknowledges the role of the moral hazard fostered by too-big-to-fail policies. He points out the cronyism involved in bailouts to Wall Street, particularly from the Federal Reserve Bank of New York.

Stiglitz offers a straightforwardly Keynesian analysis of the Great Recession, blaming it on insufficient aggregate demand. Therefore the government should “attack with overwhelming force” in the form of massive stimulus spending, an approach he suggests might be called “the Krugman-Stiglitz doctrine.”

Overall the book is a patchwork of nonscholarly accounts of historical events beside attempts to render scholarly economic theories into plain language. In many places the book disappointingly reads as though the author lacked the time to state his case systematically and coherently, to anticipate the strongest objections to his arguments and state them fairly, then address them carefully with evidence.

In a world of uncertainty, waste—the destruction of value—is inevitable. Human action, which aims to replace inferior circumstances with superior circumstances, often involves laboring to transform scarce resources from a less useful form to a more useful form. For example, I transform money earned by my labor into raw beef (by using time and gasoline to drive to the supermarket and engaging in exchange), then I transform the raw beef into a medium-well hamburger through the time-consuming process of cooking. If after I eat the hamburger I wish I had done something else with the money and time (say, bought a chicken), I will regret my course of action and feel I’d wasted both.

We have all devoted time and resources to some project that we later realized was the wrong project. That’s the price of imperfect knowledge, which plagues all human beings. If we’re lucky some of the resources we used might be salvageable and put to other purposes, but the time, effort, and other resources are gone.

The same thing of course occurs in commercial production. An entrepreneur buys inputs and hires labor, thinking the finished product will bring a price that covers costs and yields a competitive return—only to find that people don’t want the product, or not badly enough to pay the anticipated price. The loss represents the destruction of value: The value of the inputs before the transformation took place turned out to be greater than the value of the finished product.

As I say, this happens because our knowledge is imperfect. It’s too bad, but perhaps not a tragedy—just a fact of life we learn to live with and minimize. The tragedy occurs when government intervention distorts price signals and induces people en masse unwittingly to make value-destroying plans. That’s part of the story told by the Austrian theory of the business cycle. In the present economic case the Federal Reserve’s low-interest-rate policy in the early 2000s and several federal agencies’ decade-long easy-housing policies induced builders to produce too many houses relative to what the demand would have been without those unsustainable policies. The result was the infamous housing boom and inevitable bust. With housing prices apparently on an unstoppable upward trajectory, and government-backed Fannie Mae and Freddie Mac—not to mention too-big-to-be-allowed-to-fail banks—willing to buy lenders’ mortgages no matter how shaky, builders and buyers were found in great abundance. Buying more house than one could afford seemed smart when one could get a low teaser rate on an adjustable-rate mortgage for a low-to-no-down-payment home and expect its price to rise significantly in six months. When the higher rate kicked in, one could refinance or sell and walk off with the equity.

But when interest rates rose, the bubble burst, and demand plummeted, this smart scheme turned sour. Houses stood unsold, and many people couldn’t pay their mortgages, refinance, or sell at a profit. Foreclosures skyrocketed and the multitude with underwater homes simply disappeared, leaving banks holding a slew of vacant houses that cost money in taxes, code violations, and so on.

As a result, banks now would rather donate the properties to government-created nonprofit land banks and pay for the demolition than hold them and hope for future sales. This is happening in Cleveland, and the Washington Post reported that similar programs were being discussed elsewhere.

How does this relate to the waste identified by the Austrian business-cycle theory? To the extent the homes were vacated and allowed to deteriorate because of the process described above, the demolitions represent destruction of value attributable to government. In the absence of the unsustainable bubble-inflating policies, some of those houses wouldn’t have been built.

In the case of older homes, fewer newly built houses would have competed with them in the real estate market. They would still be occupied and therefore would have been maintained. (There would have been no Great Recession and high unemployment.) Demolition would not have been an attractive alternative.

The tragedy is that because of government policy, demolition is the most attractive alternative. Think of the resources and labor—now seen to have been squandered—that went into making each house. Imagine what products might have been created instead. It’s worse than that: Products always summon complementary products. A housing boom stimulates the production of related shopping centers, office parks, and myriad smaller facilities and products. The resources required to make those things also would have gone elsewhere. Now all those resources, along with much labor and time, are gone because people in government thought they knew how to plan the housing market.

* * *

Georgia and Alabama have joined Arizona in enacting a tough law directed at undocumented immigrants. As Scott Beaulier, Darrick Luke, and Daniel Smith demonstrate, this is already damaging their economies.

Andrew Morriss has been to Graceland, where he found that the lap of luxury in which its fabulously wealthy late resident lived doesn’t look so luxurious today.

Conventional wisdom holds that without the welfare state, the poor would be in dire straits. But what if, as Gary Chartier suggests, government is responsible for the poor’s condition in the first place?

If public policy created the housing bubble, the bursting of which has caused so much misery, can it really be a good idea to reinflate the bubble? Richard Fulmer says that according to political logic, the answer is yes.

The more government controls the curriculum, the more inimical schooling becomes to education. Peter McAllister explains.

The eurozone is in trouble, leading Robert Murphy to explore the possibility that it was a colossal mistake in the first place.

Regulation at the national level gets the lion’s share of attention from market advocates. But let’s not overlook the planning mentality more locally. Sam Staley surveys the taxicab industry.

Here’s what our columnists have whipped up: Donald Boudreaux audits the economics textbook writers. Robert Higgs explains why there’s so little investment. John Stossel brands government a job destroyer. Charles Baird looks at the latest outrage against free speech. And Tyler Watts, bombarded with claims that we couldn’t live without FEMA, responds, “It Just Ain’t So!”

Books on libertarianism, the economy, socialism, and the threat to freedom occupy our reviewers.

—Sheldon Richman

srichman@fee.org

In a world of uncertainty, waste — the destruction of value — is inevitable. Human action, which aims to replace inferior circumstances with superior circumstances, often involves laboring to transform scarce resources from a less useful form to a more useful form. For example, I transform money earned by my labor into raw beef (by using time and gasoline to drive to the supermarket and engaging in exchange), then I transform the raw beef into a medium-well hamburger through the time-consuming process of cooking. If after I eat the hamburger I wish I had done something else with the money and time (say, bought a chicken),  I will regret my course of action and feel I’d wasted both. Being able to know the future would have avoided the waste.

We have all devoted time and resources to some project that we later realized was the wrong project. That’s the price of imperfect knowledge, which plagues all human beings. If we’re lucky, some of the resources that we used might be salvageable and put to other purposes, but the time, effort, and other resources are gone.

The same thing of course occurs in commercial production. An entrepreneur buys inputs and hires labor, thinking the finished product will bring a price that covers costs and yields a competitive return – only to find that people don’t want the product, or not badly enough to pay the anticipated price. The loss represents the destruction of value. That is, the value of the inputs before the transformation took place turned out to be greater than the value of the finished good made from those inputs.

As I say, this happens because our knowledge is imperfect. It’s too bad, but perhaps not a tragedy — just a fact of life we learn to live with and seek to minimize. For one thing, it doesn’t happen to everybody at once. At any given time, many plans are succeeding.

Distorted Signals

The tragedy occurs when government intervention distorts price signals and induces people en masse unwittingly to make value-destroying plans. That’s part of the story told by the Austrian theory of the business cycle. In the present economic case the Federal Reserve’s low-interest-rate policy in the early 2000s and several federal agencies’ decade-long easy-housing policies induced builders to produce too many houses relative to what the demand would have been without those unsustainable policies. The result was the infamous housing boom and inevitable bust. With housing prices apparently on an unstoppable upward trajectory, and government-backed Fannie Mae and Freddie Mac — not to mention  too-big-to-be-allowed-to-fail banks — willing to buy lenders’ mortgages no matter how shaky, builders and buyers were found in great abundance. Buying more house than one could afford seemed smart when one could get a low teaser rate on an adjustable-rate mortgage for a low-to-no-down-payment home and expect its price to have risen significantly in six months. When the higher rate kicked in, one could refinance or sell and walk off with the equity.

But when interest rates rose, the bubble burst, and demand plummeted, this smart scheme turned sour. Houses stood unsold, and many people couldn’t pay their mortgages, refinance, or sell at a profit. Foreclosures skyrocketed and many people with underwater homes simply disappeared, leaving banks holding a slew of vacant houses that cost money in taxes, code violations, and so on. (For a sense of the magnitude of this colossal mess, see this.)

As a result, banks now would rather donate the properties to government-created nonprofit land banks and pay for the house demolition than hold them and hope for future sales. This is happening in Cleveland, but the Washington Post reports that similar programs are being discussed elsewhere.

“At the end of August,” the Post reports, “the nation’s banks, along with Fannie Mae and Freddie Mac, had an inventory of more than 816,000 foreclosed properties on their books waiting for a buyer, according to RealtyTrac. An additional 800,000 are working their way through the foreclosure process.”

Value Demolished

How does this relate to the waste identified by the business-cycle theory? To the extent the homes were vacated and allowed to deteriorate because of the process described above, the demolitions represent destruction of value attributable to government. In the absence of the unsustainable bubble-inflating policies, some of those houses wouldn’t have been built or in the case of older homes, fewer newly built houses would have competed with them in the real estate market. They would still be occupied and therefore would have been maintained. (There would have been no Great Recession and high unemployment.) Demolition would not have been an attractive alternative.

The tragedy is that because of government policy, demolition is the most attractive alternative. Think of the resources and labor — now seen to have been squandered — that went into making each house. Imagine what products might have been created instead. It’s worse than that: Products always have complementary products. (See Steven Horwitz on this point.) A housing boom stimulates the production of related goods and facilities — shopping centers and office parks, for example, but myriad smaller things also. The resources required to make those things also would have gone into other products. Now all those resources, along with much labor and time, are just gone — forever – because people in government and its central bank thought they knew better how to plan the housing market and the macroeconomy.

It’s sad enough that we waste precious resources and labor because we are fallible. It’s so much sadder when this happens because government policies lead rational people to make stupid decisions.

Beginning in 1992, the government required Fannie Mae and Freddie Mac to direct a substantial portion of their mortgage financing to borrowers who were at or below the median income in their communities. The original legislative quota was 30%. But the Department of Housing and Urban Development was given authority to adjust it, and through the Bill Clinton and George W. Bush administrations HUD raised the quota to 50% by 2000 and 55% by 2007. . . .

Research by Edward Pinto, a former chief credit officer of Fannie Mae (now a colleague of mine at the American Enterprise Institute) has shown that 27 million loans—half of all mortgages in the U.S.—were subprime or otherwise weak by 2008. That is, the loans were made to borrowers with blemished credit, or were loans with no or low down payments, no documentation, or required only interest payments.

Of these, over 70% were held or guaranteed by Fannie and Freddie or some other government agency or government-regulated institution. Thus it is clear where the demand for these deficient mortgages came from.

More.

Economists are prone to write turgid prose and employ a jargon-filled style. Not these two gems. Each author is a deservedly well-regarded economist, eminent in his field, but their books are written for the layman. Both draw on detailed academic research, but neither requires the reader to wade through thickets of citations.

Taylor poses these questions: “What caused the financial crisis? What prolonged it? What worsened it dramatically more than a year after it began?” His answer in each case is first and foremost “specific government actions and interventions.” The heart of his argument is a criticism of Fed monetary policy under Alan Greenspan in the aftermath of the collapse of the dot-com bubble. The Fed cut interest rates and continued cutting aggressively, taking the short-term interest rate under its control (the federal funds rate) down to 1 percent. The rate stayed at 1 percent for a year. Other market interest rates fell as well. The artificially low cost of borrowing fueled the housing boom.

Taylor uses a figure to compare housing starts as they actually occurred in the boom with a counterfactual simulation—as they would have occurred had the Fed adhered to policies that began in the early 1980s and continued into the 1990s. The result: “No Boom, No Bust” in housing. Not everyone agrees that monetary policy was so benign throughout the period dubbed the “Great Moderation.” But the Fed’s cheap money policy after 2000–01 brought back volatility in housing and the economy last seen in the 1970s.

Taylor explains how the Fed exported its easy money to other countries (especially the European Union), drawing them into the crisis. He also examines the many other complications, including such issues as the actions of Fannie Mae and Freddie Mac, and the role of securitization. His analysis of the many policy missteps in response to the crisis is masterful. These policy errors prolonged the crisis.

While Taylor covers a broad array of issues, focusing particularly on monetary policy, Sowell focuses
on the housing market itself, chronicling the “skyrocketing rise” in home prices. From 2000 to 2005 the median sales price of a single-family home rose 53 percent, from $143,600 to $219,600. In the priciest markets, like New York City, Los Angeles, and San Diego, prices escalated at an even more rapid rate (79, 110, and 127 percent, respectively). How could home prices have increased so much in such a short period, then fallen so fast?

Sowell also asks the commonsense questions. “When it comes to the home mortgage boom and bust, who was to blame? The borrowers? The lenders? The government? The financial markets?” He answers yes to all the above and notes that “economics cannot explain such things.” Politics drove the housing boom, and he turns to the politics.

First, there is the wonderfully misnamed policy of “affordable housing.” Never precisely defined, it is
a complex combination of misguided policies. They include policies to lower borrowing costs, down payments, lending standards, and, generally, costs of homeownership. Instead they have together combined to increase housing costs. As Sowell observes, it is precisely where government intervention in housing is the greatest that housing costs are highest.

Government housing policies have been at war with themselves. Sowell cites the case of housing in coastal California, now one of the highest-priced markets in the country. As late as 1969, however, home prices there were affordable by a number of measures and in line with home prices in the rest of the nation. In the 1970s California began introducing land-use restrictions that drove up costs for lots and their development. He examines alternative explanations for the rapid escalation in prices and concludes it was the land-use policies that were responsible for astronomical housing costs in coastal California.

California’s land and housing policies were extreme, but not unique. So we have longstanding policies restricting the supply of land and homes meeting policies to stimulate demand. When demand is stimulated and supply restricted, prices will necessarily increase. Land-use restrictions, affordable housing, and easy credit caused the housing boom and bust.

For the full story, I recommend these two estimable books to Freeman readers.

The Foundation for Economic Education is pleased to announce that Richard W. Fulmer of Humble, Texas, is the winner of the second annual Eugene S. Thorpe writing competition. Mr. Fulmer holds a bachelor’s degree in mechanical engineering from New Mexico State University and for over 20 years has worked as a systems analyst in the energy industry. With Robert L. Bradley, Jr., he is the author of Energy: The Master Resource. His article, “Legends of the Fall: The Real and Imagined Sources of our Bubble Economy,” is published below.

We have for the better part of a century now lived in a world of fiat money, and fiat monetary systems are sophisticated versions of central planning. The belief system that supports them carries an inherent hubris that the planner’s vision of the future is sufficiently precise to chart the path of the chaotic interaction of variables that made up an economy. It is a recurring myth, with consistent historical outcomes. Mr. Fulmer’s paper goes directly to first causes and discusses the real estate bubble as a predictable consequence of our central- banking system.

One hundred eighty-two authors responded to FEE’s call for papers in competition for the 2009 Eugene S. Thorpe Award, and many wrote eloquently of multiple secondary causes. The unintended consequences of the Community Reinvestment Act? Fannie, Freddie, Ginnie, and assorted ill-conceived cousins? Zigging instead of zagging by our central bankers? Political opportunism and legalized graft? All surely true. Greed and other venal motives? Of course. But it misses the point to blame either human motivation or human error. The problem is systemic and foundational. It’s not what people do with or to the system—it’s the system itself.

The selection committee thanks all the contestants for their contributions. The rules allow for only one winner, but special recognition and honorable mentions are in order for several of the runner-up contributors. Erin Mundahl of Independence, Minnesota, wrote of government policies that disrupted the natural brakes on risk taking: “Free-market policies naturally limit risk exposure. Regulations which encouraged or even mandated an expansion of risk counteracted this natural limitation.” The risks were ultimately socialized to the taxpayers. The returns accrued to the congressional and bureaucratic elites that benefited both financially and politically. Government operates outside the confines of the natural constraints imposed by profit and loss, and grants political rewards based on the social choices valued by bureaucratic actors.

Charles N. Steele of Hillsdale, Michigan, observed that government not only did what it shouldn’t; government also failed to do what it should. A free market cannot function without the supportive infrastructure of the rule of law, and one of the legitimate functions of government is to prosecute criminal activity. Mr. Steele observes that “Deception, false representation of products, and failure to live up to contractual terms are not legitimate methods of competition in the free market. They are criminal activity, and the free market requires that such activities be policed.” Just so.

From Nero to FDR, emperors and their kin have listened to the sirens of monetary manipulation. The voices are enchanting and sing of wealth without work. But the ships of many states have foundered on the rocky shores to which such fantasies inevitably draw them. Real wealth creation cannot be manipulated; it results from increased efficiencies of resource allocation and production. A drunken Saturday night party may be fun while it lasts, but the Sunday morning hangover that follows is a predictable consequence of the shortsighted behavior that created it. Unless and until our system of monetary creation and control is redesigned to benefit from the power of market pricing mechanisms, we can expect the recurring cycle of boom and bust to continue.

Congratulations to Richard W. Fulmer on his winning article.

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Businesses, competing for consumer dollars in a free market, must deal with the world as it is in order to survive. Politicians, competing for constituent votes, spin facts to recreate the world as they want it to be in order to gain support for their policies, hide mistakes, and shift blame. In this world of spun reality, the failure of government intervention provides the rationale for still more intervention. So spins the endless cycle in which legislatures create unintended consequences, condemn “market failure,” and demand further legislation. Government grows in crisis, even if it created the crisis.

Our current financial problems provide an illustration of this all-too-familiar pattern. In response to the housing bust, politicians hid behind long-discredited myths, moving swiftly to lay blame variously on Wall Street greed, oil speculation, investors’ animal spirits, deregulation, unrestrained capitalism, predatory lending practices, and, of course, the business cycle. Yet even a brief look at the facts reveals government intervention throughout.

The Monetary Cycle

Supply and demand regulate prices in a free-market economy. Increased borrowing (demand for loanable funds) or decreased saving (supply) leads to rising interest rates (prices). Conversely, lower interest rates stem from less borrowing, more savings, or both. More saving means that consumers favor future consumption over current spending. Banks, with rising deposits on hand, drop their interest rates to compete for borrowers. Capital investments deemed infeasible when interest rates were higher now appear attractive. Companies borrow to expand productive capacity, anticipating future rising demand made possible by rising present consumer saving.

Suppose, however, that the government intervenes to artificially lower the price of money. Reduced interest rates make saving less attractive and consumption more so. At the same time businesses, taking advantage of lower rates, borrow to fund expansion. Prices rise as consumers and producers compete for scarce resources—a sack of seed corn cannot be both eaten and planted. Sales increase and markets boom. Eventually, however, the central bank must raise interest rates to prevent inflation, and the boom goes bust. Businesses find that they have overinvested or invested in the wrong things.

Such malinvestment is an unsustainable allocation of scarce resources to create goods and services for which there is insufficient demand. A correction occurs when resources are reallocated to produce what people actually want. Corrections can be very painful as industries that overexpanded during the boom now downsize, shedding employees and suppliers. Avoiding the adjustments, however, simply postpones the pain. Resources often continue to be poorly invested, compounding the damage and making the inevitable correction that much more agonizing when it comes.

Boom and bust cycles nearly always result from monetary expansions that disrupt the price signals regulating an economy. Such expansions preceded Holland’s Tulip Mania in 1636–1637, the nineteenth-century banking panics in the United States, the Great Depression, the dot-com bubble, and the current housing debacle.

Ironically, these monetary cycles are called “business cycles,” as if they were an inherent part of the free market. Proponents of some business-cycle theories believe that, left unregulated, businesses will overproduce, creating a glut of unwanted goods. Factories must then reduce production or even shut down until the glut is eliminated.

Yet what mechanism would drive businesses in different industries across an entire nation to produce unwanted goods? How could, to cite the most recent example, home builders in California, Nevada, Arizona, Florida, and markets in between have simultaneously misread local demand to such an extent? A nationwide spike in greed? Irrational exuberance? Bankers’ bonuses? A simpler, more rational explanation is that they were misled by government policies that artificially inflated housing prices, giving the appearance of greater demand than was actually there. Overproduction is a symptom, not a primary cause.

The Housing Bubble

Early in the new millennium, the Federal Reserve slashed interest rates in response to the dot-com collapse and the 9/11 attacks. Other nations’ central banks soon followed suit. Now awash in liquidity, investors from around the world needed investments that would yield returns higher than the rate of inflation. Coincidentally, American local and federal policies—including land-use restrictions, preferential tax treatment, buyer subsidies, and regulations favoring low-income buyers—had made investing in residential housing more attractive than other options. Housing prices rose as homeowners upgraded and renters became owners.

Home loans were sold in the secondary mortgage market, which is dominated by the government-sponsored enterprises: the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). Mortgages were then bundled into “packages” in order to diversify risk. Individuals and institutions worldwide purchased these packages as investments. “Derivatives” such as credit-default swaps (essentially insurance against bond or, in this case, loan failure) and other such securities created a “multiplier effect,” as these investment vehicles were based on other vehicles that were, in turn, based on mortgages.

The complex system that resulted was inherently unstable and was made more so by regulations that coerced lending institutions into making home loans to borrowers who could not afford to repay them. In addition, Congress encouraged Freddie Mac and Fannie Mae to buy trillions of dollars worth of these “subprime” loans, enabling lending institutions to engage in even more such dangerous lending with little (or reduced) incentive to vet borrowers.

Credit-rating agencies, members of a cartel created by the Securities and Exchange Commission, gave unrealistically high ratings to packaged debt containing subprime loans. Basel II, an international banking accord, similarly understated the associated risks and encouraged banks to hold mortgage-backed securities by requiring them to keep smaller cash reserves to back such instruments than it required for traditional loans. Implicit government support for Freddie Mac and Fannie Mae and the “Greenspan put” (an unstated Federal Reserve policy of injecting liquidity into the economy in response to any serious difficulty) encouraged investors to take risks in the belief that the government would cover any losses.

Speculators exploited zero-down loans and “adjustable-rate mortgages,” intended for disadvantaged home buyers, and began “flipping” homes (buying houses only to quickly resell them at a profit). In some cases, houses were built strictly as investments—built to be sold and sold again, not to be occupied. Such overbuilding could not be sustained and, when the Federal Reserve raised short-term interest rates—contracting the money supply—the bubble burst. The value of investments based on bundled home mortgages quickly plummeted.

Mark-to-market accounting rules enforced by the Securities and Exchange Commission (SEC) compounded the problem. SEC rules required financial instruments to be valued at current market prices, amplifying the effects of both boom and bust. Mortgage-based securities, overvalued when housing prices soared, became undervalued as the panic grew and financial institutions saw their assets become virtually worthless almost overnight.

The key intervention and primary cause of the entire cycle of events, however, was the Fed’s initial monetary expansion. Government policies all but dictated that the resulting boom would be concentrated in residential housing and that the eventual bust would be far worse than it would otherwise have been. Even without these policies, though, a boom would still have occurred. Perhaps it would have been concentrated in another sector of the economy; or perhaps there would have been a general rise in capital investment. Either way, once the Federal Reserve triggered the expansion, a boom was inevitable. And, because the boom was artificial (that is, the credit expansion was not based on real savings), a bust had to follow.

Government control of a nation’s money supply guarantees boom and bust cycles. To illustrate this, imagine a car with some very special features. Its windshield is frosted so that the driver cannot see where he is going, and its side windows are just clear enough to allow him only a vague idea of where he is. The rear window alone affords an unobstructed view. Finally, the steering linkage is on a 30-second delay. The car will not change course until half a minute after the driver turns the steering wheel.

Now imagine trying to drive such a car. You steer a straight course as long as you see the highway stretched out behind you in the rear view mirror. When the road curves, you realize it only after the fact. You turn the wheel to get back on the highway, but nothing happens. So you turn the wheel some more. Again, nothing happens, so you turn the wheel still farther. Suddenly, the steering kicks in, and the car veers wildly. Desperately, you swing the wheel in the other direction, but the car continues turning the other way. What follows is a series of violent overcorrections ending in a crash.

Trying to regulate a nation’s money supply works about the same way. Central bankers cannot see into the future. They see only dimly where they are, and it is only in hindsight that their vision is clear. The impact of adjustments they make to the money supply may not be fully felt for a year or more. Such a system, like our car, is inherently unstable.

In response to the bust the Federal Reserve has moved quickly to re-inflate the economy, just as it had done after the dot-com collapse. The result is being termed a “recovery,” but more likely it is another overcorrection, the beginning of yet another boom and bust cycle, and a further misallocation of scarce resources. We cannot spend our way into prosperity. Production, not consumption, creates wealth.

The Road Back

We face two basic issues: How do we recover from the current recession, and how do we stop monetary boom and bust cycles? The answer to both is to increase economic freedom.

Our immediate problem stems from an imbalance between money and goods and from resource misallocation resulting from government interference with the market. The money-goods balance can be restored by shutting off the federal money spigot. This requires reining in government spending (which competes with the private sector for scarce resources), cutting taxes, and freeing markets. Correcting the misallocation of resources requires eliminating the policies that favor residential housing over other consumer needs.

The longer-term problem of taming boom and bust cycles can be addressed only by eliminating the Federal Reserve’s money monopoly. Repealing legal tender laws (which grant a monopoly on the creation of media of exchange to the Federal Reserve) would free Americans to choose forms of money that both meet their needs and maintain their value.

Before any of this can happen, though, the myth of the “business cycle” must be dispelled. Legends are luxuries we cannot afford. Reality is not optional.

The Times pointed out that San Francisco, one of the priciest real estate markets in the country, had no government-insured mortgages two years ago, but now “the government is guaranteeing an average of six mortgages a week here. . . . The Federal Housing Administration is underwriting loans at quadruple the rate of three years ago even as its reserves to cover defaults are dwindling.”

Some of those loans are surely questionable.

The Times explained that 27-year-old Mike Rowland and his friends were able to buy a two-unit apartment building for almost a million dollars. “They had only a little cash to bring to the table but, with the federal government insuring the transaction, a large down payment was not necessary.”

“It was kind of crazy we could get this big a loan,” Rowland said.

Yes, it was crazy. Such policies do not end well. Young Rowland gets that. Even the Times does: “With government finances already under great strain, the policy expansions are creating new risks for American taxpayers.”

But our leaders plunge ahead, with your money. Has the administration forgotten that today’s financial mess was precipitated in part by government’s moves to encourage mortgage lending to unqualified or at best unproven borrowers? In the 1990s, the Federal Reserve Bank of Boston, concerned that blacks and Hispanics were “underserved,” issued guidelines to banks stating: “Policies regarding applicants with no credit history or problem credit history should be reviewed. Lack of credit history should not be seen as a negative factor. . . .”

Soon, the lower standards spilled into the prime-mortgage market. The risk to lenders seemed small because government-sponsored Fannie Mae and Freddie Mac happily bought the dubious loans. An entire financial edifice was built on these securitized mortgages and derivatives based on them.

Then the good times ended. Interest rates rose. Home prices flattened and then declined. Then those AAA mortgage-backed securities became “toxic.”

Re-Inflating the Bubble

After all that, it’s crazy that government still subsidizes housing rather than letting the market work. The economy will recover from recession only when it is allowed to discover the real value of assets like houses. But the government refuses to allow this to happen. FHA has been blowing air into another bubble while other agencies do everything they can to boost prices.

This includes leaning on and bribing banks to ease mortgage terms for people in default. The Obama administration announced that it would increase that pressure because “the banks are not doing a good enough job,” said Michael S. Barr, assistant treasury secretary for financial institutions. Some Democrats want to go further. They demand that the government compel mediation over defaulted mortgages or empower judges to change the terms.

This sounds humane, but it is typical political shortsightedness. When government helps delinquent borrowers to get easier loan terms, it simultaneously makes it harder for marginal borrowers to get loans in the first place. That’s because lenders must now factor in the likelihood that a judge will change the terms.

The know-it-alls in Washington “help” Americans by hurting them.

Why won’t the government let housing prices seek their own level? After a Washington-inflated bubble, that would seem to be the wise thing to do. Sure, some people get hurt when prices fall, but others—prospective home-buyers—are helped. By artificially raising prices, the Realtor-Construction-Banking-Big-Government Complex cheats honest low-income people who would otherwise have been able to afford a first home without begging the government for help.

Home ownership, all else equal, is a good thing. But when government lumbers into the market and subsidizes folly, that’s a very bad thing.

Ill-conceived policies to encourage homeownership channeled cheap credit into housing markets. Land-use and zoning policies restricted the supply of housing in key desirable markets. In The Housing Boom and Bust, Thomas Sowell of the Hoover Institution has shown how these policies brought about a crisis in housing and finance.

Others have told the story from a number of perspectives and with varying emphasis on different factors. My purpose here is to focus on the policy responses to the crisis and ask whether they have been helpful or harmful.

TARP

On October 3, 2008, Congress enacted the law creating TARP (the Troubled Asset Relief Program), which was authorized to spend up to $700 billion to purchase troubled assets from financial institutions. A little more than a month later, then-Treasury Secretary Henry Paulson announced that rather than buying troubled assets, the Treasury would use the money for capital injections into banks in return for preferred shares.

Regardless of one’s attitude toward bailouts generally, Paulson’s original plan was a recipe for disaster. To help the banks he would have needed to overpay for the assets to the detriment of the taxpayers. If he had paid then-current prices, accounting rules would have forced all firms holding such assets to write them down (not just those selling the assets). Financial institutions holding dubious mortgage-backed assets were desperately trying not to write them down because that might have threatened their depleted capital base. It is fair to say that Paulson failed to grasp the underlying problems at these institutions when he first proposed the program.

TARP became a capital-relief plan. It harkened back to the Reconstruction Finance Corporation (RFC) of the Great Depression. Under Jesse Jones and in conjunction with Franklin Roosevelt’s Bank Holiday, all the nation’s banks were examined and divided into the good, the bad, and the ugly. Call it his version of a “stress test.” Those deemed beyond hope were never reopened. Those troubled but salvageable were eligible for RFC capital injections. Jones also extracted resignation letters from senior management of institutions being bailed out. If he deemed existing management best suited to run the bank, it could stay. If not, it was replaced.

In comparison, Paulson’s strategy was “ready, shoot, aim.” Banks received government injections of money to replace depleted capital, with nothing explicit extracted in return. There were vague promises that banks would resume lending but there was nothing enforceable. The banks were stress-tested only after having received government funds. There were second and even third rounds of bailouts for some banks, indicating they had been weaker than thought. We know that at least one—CIT, a financial institution that received $2.3 billion in TARP money—should have been allowed to close. Instead it eventually filed for bankruptcy, and the taxpayer funds were lost.

Moreover, in what has become a national disgrace, existing management at bailed-out banks remained in place. The Bush administration failed to impose even the level of control exercised under FDR.

On the one-year anniversary of the announcement of Paulson’s reversal on TARP, I was asked by Newsweek for my assessment. “It hasn’t done what [Paulson] said it would,” I said. “Yes, it saved some banks from going under, but did it restore the health of the banking system? Absolutely not.” I stand by that assessment today.

What Does Government Stimulate?

The fiscal response to the crisis of the Bush/Obama administrations has been to spend their way out of the recession. In the process the nation’s debt has skyrocketed. There are deficits and debt as far as the eye can see, and our children’s future has been mortgaged. The 2009 fiscal deficit was double that of 2008. It is running at 10 percent of GDP, and former Fed governor and Bush adviser Larry Lindsey estimates deficits will run at 7 percent of GDP for a decade.

Because of the work of Milton Friedman and his monetarist followers, countercyclical fiscal policy fell under a cloud. First, they argued that recessions are difficult to forecast and we only typically know we have entered one after the fact. The monetarists also argued that fiscal policy was subject to the cumbersome legislative process and thus could not be quickly implemented. Once spending began, its effects were only felt slowly. All this wisdom was forgotten in the panic of the Bush administration and then more so in the Obama administration.

The Economic Stimulus Act of 2008, passed in February of that year, mainly sent $100 billion in checks to households in early summer to stimulate consumption and jump-start the economy. As Stanford economist John Taylor, author of Getting Off Track, has shown, the money did nothing and the economy slid into recession later that year. Any economist worth his salt knows that temporary government cash infusions will likely be saved and at best have transitory effects on spending.

Undaunted by that failure, the Obama administration decided to up the ante on the theory that there had just not been enough fiscal stimulus. It replaced billions in spending with trillions in spending: the stimulus package added on to TARP. In the next section I also discuss Fed spending masquerading as monetary policy.

What is the record? It appears that the recession may have ended in the third quarter of 2009. That would make it less than one year in duration–not atypical in that sense. Most of the Obama stimulus money has yet to be spent. (Recall Friedman’s arguments on fiscal policy.) It may be good electoral politics to claim credit for a still-nascent recovery. But it is poor economics. More likely, the self-adjusting forces of the market have been at work.

Clearly, nothing the government has done has been able to lower the unemployment rate. GDP is an abstraction; being out of work is a reality. In October the unemployment rate exceeded 10 percent. (It fell back to 10 later.) A broader measure of unemployment exceeded 17 percent. These numbers put the flesh on the skeleton of policy debates. More ominously, we now are seeing indications that wage rates are falling. As the Wall Street Journal reported, Professor Kenneth Couch of the University of Connecticut estimates that displaced workers returning to work will on average take a 40 percent pay cut.

Double-digit unemployment rates and double-digit wage cuts are depression statistics. In what way is government spending “stimulating”? In an editorial the Wall Street Journal concluded that “no matter how hard or imaginatively the Administration spins, the reality is that the stimulus has been the economic bust that critics predicted it would be.”

Indeed, the labor story helps us to see the dark side of stimulus spending. A good chunk of it has gone to state governments to support bloated budgets in the face of collapsing revenues. Those fiscal transfers are being done, at least in part, to placate public-sector unions, which want to protect the incomes and pensions of their members.

Fiscal stimulus has failed. What about the monetary variant?

Monetary Stimulus

The Fed’s response to the crisis has drawn mixed reviews among free-market economists. Some approve of the Fed’s easing in 2008–09 as a response to an increased demand for money (falling velocity). Nearly all market-oriented economists are disquieted by the explosion of the Fed’s balance sheet as it takes on more and more assets of dubious quality. It will be extremely difficult for the central bank to dispose of such assets when it inevitably comes time for it to tighten. The Fed will likely suffer losses, and such losses impact the taxpayer. (The Fed’s surplus is paid to the Treasury.)

Many economists have been critical of the Fed for its targeted-credit policies, which amount to credit allocation. They favor one sector at the expense of others, and constitute fiscal policy rather than monetary policy. The Fed’s leadership is dismayed at its loss of approval by the general public and fears calls for greater political oversight. But the backlash is of the Fed’s own making.

In the end its fortunes are tied to the economy’s. Most Americans do not know the technicalities of monetary policy. But Fed Chairman Ben Bernanke has taken an active and public role in defending the policy response to the crisis (under both Bush and Obama). Under Bernanke the Fed has promised much and delivered little.

Just as Americans fear the spending and budget deficits, many understand that easy money helped get us into the crisis. Now Dr. Bernanke has prescribed the strongest dose of cheap money ever administered. How can the elixir that caused the boom cure the bust?

The Bernanke Fed is engaged in a policy of reflating (re-inflating) the economy: stimulating money demand to restart economic growth. It justifies the policy on the basis of Professor Bernanke’s own research that shows the evils of deflation. But what prices is he trying to prop up? All prices? Even in hyperinflations, some prices fall. Is he trying to prevent downward adjustment in wages? As suggested above, wage rates in hard-hit sectors may be falling at double-digit rates. Is he preparing for double-digit price inflation? If so, gold is underpriced at $1,000 an ounce.

Astute observers increasingly fear that what is being reflated is another asset bubble. At present, the asset bubble is concentrated in commodities (such as gold, copper, and oil) and Asian real estate. In what is known as a carry trade, global investors are borrowing dollars at low interest rates to invest in property in cities like Hong Kong and Singapore. Instead of bringing prosperity to Americans, the Fed’s policy is fueling speculation. Instead of production in the United States, the Fed’s easy money is creating paper wealth for Asian property owners.

The rise in commodity prices is perhaps most ominous. The U.S. economy remains weak and unemployment elevated. Yet Americans are already paying higher prices for gasoline. They are facing the prospect of renewed inflation and economic weakness: stagflation. That would be an updated version of the economy of the 1970s. The Fed is thereby impoverishing Americans. Is it any wonder many are calling for a reconsideration of its role?

Posner describes well-known events—the failure of investment banks Bear Stearns and Lehman Brothers, the series of bailouts by the Treasury and the Federal Reserve, the stimulus package passed by Congress—then tries to explicate the causes of the crisis. His account, unfortunately, merely hews to current conventional wisdom.

Here’s a capsule version: Deregulation of banks combined with cheap and easy credit to cause interlinked debt and real estate bubbles. “Free market ideology” left banks and other financial firms free to take huge risky bets on mortgages, which they did. In 2007–08 the twin bubbles collapsed, resulting in a steep downturn in economic activity. The government had to shore up the system with extraordinary measures. The long-term solution is more government action to restrain and supervise financial institutions, although Posner would wait until the dust settles before reregulating.

It’s true that some household borrowing was channeled to risky instruments like adjustable-rate mortgages and much of the lending by banks was turned into complex securities backed by debt. When property prices declined and foreclosures spread, the values of these securities also declined, decimating bank balance sheets. But all that is a consequence not a cause of the trouble.

At the heart of the story is the ready availability of credit that fueled excessive borrowing and lending. Posner describes how the Fed flooded the economy with money in the early 2000s in response to the collapse of the previous bubble in stocks. However, he claims that even without the Fed’s loose monetary policy, an alleged global capital surplus brought in enough money from abroad to keep interest rates low.

That claim is dubious. Yes, Asians saved a lot, but other people, notably Americans, saved relatively little. In the world as a whole there was no surge in saving to drive down interest rates. It was the Fed’s easy money that pushed markets into a credit binge.

Posner’s line is that “Laissez-faire capitalism failed us, but government allowed the preconditions of depression to develop and wreak havoc with the economy.” He discusses the Federal Reserve’s culpability for the crisis, granting that it “would be a powerful argument against re-regulation,” but places more blame on that hobgoblin, “free market ideology.” The “free market” canard requires one to ignore that the United States hasn’t had anything close to a free financial market in a century.

Major mistakes by experts pose a challenge for Posner’s way of looking at behavior. For example, he describes Fed Chairman Ben Bernanke’s neglect of the warning signs of an impending crash as “extremely puzzling.” As a proponent of neoclassical economics, Posner assumes that people act rationally in the sense of making the best choices in view of all available information. And the Fed must be even more rational than the rest of us.

Another academic tribe, behavioral economists, attributes the crisis to human quirks like herding or imitation. Posner rejects those explanations on the ground that such behavior is not really irrational. On regulatory issues, however, he does not differ from behavioral economists who assume that government experts are trustworthy because they’re better informed than the general population.

Long before the currently fashionable behavioral school emerged, F. A. Hayek criticized the neoclassical rationality premise but came to a different conclusion from today’s proregulation behavioral economists. He found that government agents possess less wisdom than the market, which pools the knowledge of many individuals. The “fatal conceit” (as Hayek put it) that government knows better has resulted in economic disasters ranging from the Soviet Union to the Federal Reserve’s destabilizing policies.

Now the Fed is to become an even more powerful regulator of vaguely defined “systemic risk.” Posner grasps that “The successive Federal Reserve chairmanships of Greenspan and Bernanke must be reckoned prime causes of the financial crisis,” but even so agrees with President Obama that more government intervention is needed.

As a reform, Posner advocates the consolidation of agencies like the Securities and Exchange Commission into one top regulator along the lines of Britain’s Financial Services Authority. He appears oblivious to the fact that this authority with its overarching powers did not save Britain from financial crisis.

This highlights the book’s great flaw: Posner clings to the myth of benign government rationalism.