Moral Hazzard and the Political Class

It has occurred to me in the past 6 months that Moral Hazard and credit markets work in tandem. Credit is the cornerstone of modern civilization. Without the evolution of the credit markets and the systems to utilize it, we would still be in the dark ages. The words used in an earlier post of Historian Naill Ferguson, "credit makes the world go round". Nevertheless, the current crisis, which I refer to as the "Great Deleveraging", has shown us once again that credit is also the fuel for a speculative mania. History is full of examples of this. The Dutch Tulip mania, the South Sea Bubble, the Mississippi bubble, Dot com Bubble, US/UK Housing bubbles, and the commodities bubble of ’08 are a few examples of speculative bubbles in recent history. Cheap credit creates bubbles, which in turn promote moral hazard. Much, but not all, of the current crisis is rooted in this cycle of boom and bust. But what about moral hazard created by the public sector, could it infect the private sector? Yes it can, and the current crisis has many of its roots in policy enacted by quasi-government institutions, and the US congress. Through out the market history of the US, the government has used financial crises as a spring board for more control over the private sector. The products of these historical seizures of power have manipulated the current market, and contributed the bubble and current crisis. The argument that the current contraction is due to the "free market" philosophy is intellectually dishonest. How can the market be free when there are so many actors manipulating it from Congress to the Federal Reserve. Financial crises in the 20th century led to the institution of more government interaction in the market, and led to the creation of moral hazard.

The over leveraging created by cheap credit, was a product of the post 9-11 moves by the Federal Reserve. Through much of this crisis, many of the talking heads have not touched on this. They also have not touched on the other two quasi-government institutions Fannie and Freddie that led to this massive example of moral hazard. These two institutions working in tandem have created the foundation for the current speculative bubble in housing. Members of the political class in an effort to expand home ownership endorsed this. It was a program of social engineering, and not at all economically feasible. Expanding the home ownership to those that could not afford it is not good business, and now we are paying the price for this experiment. After all, the road to hell is paved with good intentions.

Why has this not been mentioned too much in the mainstream media? I believe it has to do with shifts in political power in the United States. In our history, large shifts in political power usually couple with populist movements. Mr. Obama demonstrated this in both his primary and his election victories. It is much easier to invoke a populist rhetoric when in an economic crisis. One can always invoke the image of the “fat cat” in times of duress. This has been a tool of the Political class through much of our history. It provides a window to further the power and grasp of the political class over the people. The government in the aftermath of crisis created the institutions at the foundation of this crisis of confidence. The reality of the situation is that everyone is to blame. Just as the most recent post on this blog stated, “we are all responsible”. It is much easier to place the blame on “the other”. This has been a tool of totalitarian regimes through out the ages to increase their power. The government is using this tool as we speak to expand the power over the private sector. Congress currently is seeking to create a systemic risk regulator. Led by Barney Frank, this legislation would provide oversight to institutions that the government deems systemically significant. According to an op-ed in the WSJ today Peter Wallision argues:

"designation as a systemically significant company will in effect be a government declaration that that company is too big to fail. The market will understand -- as it did with Fannie and Freddie -- that loans to such a company will involve less risk than loans to its competitors. Counterparties and customers will believe that transactions with the company will generally be more secure than transactions with other firms that aren't similarly protected from failure."

Is this creating more institutions that will lead to much more of the same? Will moral hazard be created again by government back institutions, like it was with he CDO's that are at the center of this crisis? I believe it will. Wallison also mentions that the crisis was not created by the failure of institutions, but by an external event (mortgage backed CDO's). So all this will do is create more government control in the private sector, and possibly create another mass example of moral hazard created unknowingly by the political class.

The Panic of 1907 led to the creation of the Federal Reserve System and the 13th Amendment. The Congress created the Pujo hearings to investigate the crisis, and to attack the savior of crisis J.P. Morgan. These hearings also led to the 13th Amendment, which allowed the Congress to impose a Federal Income Tax. Fannie and Freddie were creations of the “New Deal”. The element of fear associated with a contraction or market panic, created the environment that spawned these quasi-federal institutions. The political class used the image of "the other" to expand their own power through populist rhetoric.

Now we sit at a turning point. Once again, a bubble inflated, and burst. There is a contraction in our economy, and people are scared. Our new President addressed a joint session of Congress for first time and fueled the flames of populism. He laid out his plan for the future. One in which the federal government has more impact in our lives. He proclaimed that, “only the Federal government has the resources to pull us out of the recession”. His new budget is, “a vision for America – as a blueprint for our future”. Once again, a crisis is the tool to expand the power of the political class and the bureaucracy. Remember that the first rule of the bureaucracy is to preserve and expand the bureaucracy. Mr. Obama’s rhetoric sounds a lot like central planning, but has only been addressed by a minority in the media.

Throughout the history of the modern United States we have fought with the beast of central planning. It aims to destroy the individual, which is the base of this great nation from society. Instead, it creates a society that clings to the teat of the state. With that, we become slaves, dependant on the state for every aspect of our daily lives. Eventually what we know as a bastion of innovation and freedom will disappear. The land of plenty will turn to a land of breadlines.

The current crisis is a complex one. I brought up the quasi-government institutions because they were the foundation of this Great Deleveraging we are experiencing. The private sector and the individual consumer are also to blame. The easy credit created a wave of mania, which infected every facet of our economy. The private sector underwrote loans that were not feasible. Consumers were just as high on the euphoria of cheap credit and used their homes, as ATM’s to consume even more. This contraction was much larger than normal, but in a capitalist system it is a normal occurrence. People act irrationally on both the way up in the business cycle and on the way down. However, once again the Political Class has taken an opportunity to grab more power. They are trying to grab the reins of the system from the people, and to place more of the private sector under their control.

Will we learn from the last attempt to control human nature through social engineering. It doesn't work. The current mortgage crisis was an attempt to achieve social justice, and it backfired. the 1992 Housing Bill set quota's for low incomed people. The Political Classes attempts in the past, to correct the flaws of human nature, have led to inefficient institutions and intellectual dishonesty. Remember the Great Society? Those programs failed miserably, and destroyed the neighborhoods it intended to help. The landscape of the urban north is still scarred by these policies. The promotion of low income home ownership coupled with the loose monetary policy by the Fed in the wake of 9-11 they created one hell of a bubble. Their future attempts will only create much of the same. Central planning is not efficient, If you are not convinced that this is their motive, remember the words of Rahm Immanuel, “a crisis is a terrible thing to waste”. Slowly we are walking down the road to serfdom. In the words of Friedrich Von Hayek, “We shall not grow wiser before we learn that much that we have done was very foolish”.