Monday, February 16, 2009

Blanking out about the Bailout

ABC News ran a piece titled Stimulating Phoenix: City Looks for Bailout which detailed the dire housing market in Phoenix. At one point the narrator says that:

"Builders began to believe that they could build almost anything and there would be someone there to buy it," said Robert Mittelstaedt, dean of Arizona State University's business school. "I call it builders gone wild. So now we have 50,000 to 60,000 empty homes in the Phoenix metropolitan area."

The story leads you to believe that all of the builders in the Phoenix area (as well as throughout the rest of the country) mysteriously chose to build houses, offices, apartment buildings and condo complexes when they were not economically justified. As I’ve written in an earlier blog entry when virtually everyone in a market behaves the same way this usually is a sign they are responding to common signals or incentives.

When the pricing system works as it should the information necessary to make good decisions is readily available. When something prevents the pricing system from working correctly or if it is distorted to send false information, most if not all businessmen will act on this false or distorted information. However eventually reality has a nasty way of not abetting these attempts to rewrite the facts. But when it does what would have been a minor correction instead becomes a catastrophe. (For more detailed explanation of the business cycle and the current economic debacle see the Ludwig von Mises Institute web page.)

In the case of the real estate market two predominant forces helped create an environment in which normally prudent businessmen chose to pursue projects that proved to be unsupportable. One was the Federal Reserve’s setting interest rates (the price of borrowing money) lower than what would be the market rate. With inflation factored in the interest rate actually was negative. And second, the aggressive marketing by the management of Freddie Mac and Fannie Mae as “safe” investments because they were government backed. In both cases, the market signals were masked or completely shunted, leading investors, builders and entrepreneurs to conclude that their projects would be profitable. (Yes, greed played a role to but greed alone doesn’t explain what happened. The threat of losing one’s shirt in ill-advised investments tends to offset the desire to profit.)

Of course, these factors are rarely if ever mentioned in the news pieces and in the political debates. It’s more fun and much easier to find a convenient and well-worn villain: the greedy businessman. Of course, the same demagogues conveniently ignore the fact that at one time the greedy bankers “redlined” (didn’t offer loans) certain people and had to be “encouraged” via the Community Reinvestment Act to make such loans.

A number of premises escape scrutiny in the rush to pass the stimulus package.

  1. Should a central group, The Federal Reserve, set interest rates?
  2. Should the government force banks to suspend or abandon normal prudent underwriting in order to serve a goal of having everyone become home owners (regardless of whether they can afford it)?
  3. Should the government redistribute tax dollars from those who behaved responsibly to those who didn’t?
  4. Is it really the purview of government to bend or break economic principles to foster home ownership?

As long as we don’t put these questions under the harsh light of critical thinking we are doomed to not learn any lasting lessons from this fiasco.

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