Republican candidate Herman Cain says the unemployed should blame themselves for their plight. (One wonders if Cain would have said that to the one fourth of the nation who were unemployed during the height of the Great Depression.) Current Republican ideology wants to blame economic problems on government. Therefore, the other Republican candidates imply the unemployed might blame the president for their plight -- although they absurdly state that government can't create jobs.
Yet the primary cause of our economic meltdown was not government. (Those who see the source of the problem as Fanny Mae and Freddie Mac should recall that those two actually lost market share to their private-sector competitors during the height of the bubble.) Nor was the cause individual law breaking such as Bernie Madoff-type Ponzi schemes -- that is why so few have gone or will ever go to prison. Rather, the primary cause of the housing bubble and the economic meltdown was the perverse financial incentives which encouraged people to engage in activities that were harmful to society as a whole.
The housing bubble added $8 trillion to the value of housing. When this huge speculative bubble burst, house prices fell (with the average homeowner losing $70,000) and then economic activity slowed.
The private sector had every incentive to create the housing bubble.
There were huge profits made off of it and although the rest of society has to live with the consequences of powerful people taking huge gambles for their own benefit, many of those powerful will enjoy a lifetime of luxury from the profits they made at the time.
Any realtor will confess that they would much rather sell a $300,000 house than a $200,000 house. Realtors had incentives to give the housing bubble all the momentum they could. At the height of the housing bubble,David Lereah was the chief economist of the National Association of Realtors. He was the most frequently quoted authority on the housing market and his views regularly appeared in the most powerful and conservative papers in the nation such as the Wall Street Journal. This "Prophet of Boom" clearly set forth his views in a 2005 book, "Why the Real Estate Boom Will Not Bust and How You Can Profit from It."
Dean Baker spotted the housing bubble in 2002 and made the maximum effort to alert the public about the dangers of the housing bubble, even writing an article about it in this paper in 2003. Baker observed that the media ignored Lereah's material interest in selling real estate and took his claims at face value. Baker's awareness of the media's pro-business biases caused him to start a blog called Beat the Press. He details how the entire economy was honeycombed with wrong incentives:
* Appraisers created the highest appraisals possible since their incentives were to offer appraisals that served the interests of the parties that hired them.
* The housing bubble was enlarged because those who issued mortgages had little real incentive to care if mortgages would be paid off since they were quickly sold.
* Private rating agencies such as Standard and Poor's often slapped the highest rating possible on securities that turned out to be junk. It was well understood that if they did not do so, the creators of the securities might not use that rating agency again.
* There was enormous incentive for financial innovation to create complex financial instruments that almost no one understood. Transparent markets tend to be competitive and competition drives down profits and fees. As the profitability of finance grew there was more incentive to take more risks with less capital.
* Those who collected fees on the mortgages created had incentives to create as many mortgages as possible, even if they turned out to be bad.
* Consumers often had strong financial incentives to buy the most expensive house they could get into. If houses are appreciating at 15 percent annually, the person with a $300,000 house makes an extra $15,000 a year over the person with a $200,000 house. In some California markets, houses appreciated over 200 percent in a decade. There are not many businesses where one could grow their money that fast.
* Since the executives of the largest institutions were paid by stock options, they went all out to increase their firm's stock price even when that involved creative accounting. They did this by moving potential loses off balance sheets. Thus, Lehman Brothers claimed its net worth was $26 billion shortly before its demise, but its balance sheet had a hole of almost $200 billion.
* Executives had an incentive and the ability to design compensation packages that benefited them at the expense of others. Compensation was based on short-term performance and sometimes even after disastrous failures CEOs pocketed millions.
How can Republican candidates or anyone deny that perverse incentives primarily created the bubble? Was it government that caused the real estate industry to take steps inflate values? Did government cause the rating agencies and appraisers to do their overrating? Unfortunately, market forces include tons of wrong or perverse incentives, which encourage activities that are harmful to society as a whole.
Often, the belief that there is little need for government regulation of the economy is based on the idea that as firms maximize their profits they are helping to maximize the well being of society. If the last decade proved anything it was that theory was false.
Jones lives in West Haven.
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