To Boost the Economy, Burst the Regulatory Bubble

Article excerpt

From housing to Wall Street, government prodding and over- regulation have caused more problems than they've solved.

When Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act last month, the rationale for yet another monolithic regulatory bill was that the economic and housing bubble crisis was caused by too little regulation.

In fact, the evidence is becoming increasingly clear that over- regulation and Washington interference were the major culprits.

All bubbles burst, so the key question is not "Why did housing collapse beginning in 2007?", but "Why did the bubble appear in the first place?"

The answer has many facets, but a common element is government support for home ownership.

History of interference

As far back as 1913, Uncle Sam carved out a tax deduction for interest that has since become the politically sacrosanct but economically unsound tax break for home loans. Essentially, this is welfare for the wealthy, since it primarily benefits rich homeowners. Even worse, a comparison with other countries that don't provide such a deduction shows that this tax break doesn't necessarily help home ownership.

Government increased its role in housing during the Great Depression with the creation of Fannie Mae, which was designed to create a liquid secondary mortgage market, thus freeing lenders to make more loans. Washington expanded this effort in the 1970s by creating Freddie Mac.

Prior to the federal government getting into the business of financing houses, banks didn't need a lot of regulations to keep them from lending to borrowers with poor credit history. Without the moral hazard of knowing that they could unload questionable mortgage loans on to taxpayer-supported entities, banks required at least a 20 percent down payment and a satisfactory credit history.

But over time, as the government passed regulations such as the Community Reinvestment Act of 1977 to encourage lending to marginal borrowers, banks were pressured into unloading their loans on the government, thereby letting the taxpayers assume the risk of nonpayment. As a result, banks didn't have to worry about nonpayment, only about how many fees they could generate by originating the loans.

This trend accelerated during the Clinton years when Congress made the first $500,000 of capital gains on the sale of a home tax free, making real estate a very lucrative investment. And the Clinton administration pushed excessively high quotas on Fannie and Freddie to buy mortgages made to low-income borrowers.

In 2004, President Bush helped put the icing on the cake when he pushed for a new "Zero Down Payment" program for federally insured home loans. Soon thereafter, a whole new bracket of income-earners could afford homes.

Given the distorting nature of these incentives, what is remarkable is not that the mortgage market collapsed, but that the collapse was not even more severe. Nor was the purported rationale of these heavy-handed regulations - that it would encourage home ownership - ever vindicated.

Many other developed countries have achieved far higher rates of home ownership without encouraging banks to make bad loans, allowing banks to unload loans on taxpayers, or rewarding their richest citizens with tax benefits and subsidies of up to a million dollars for buying the most extravagant homes. …