Capitalism vs. Mercantilism In the Housing Crash

Frequently, attacks are made against “capitalism,” generally involving some variation on the statement that “it doesn’t work.”  As an example, I put up one of my favorite columnists (simply because he is so good at making me alternatingly laugh at his ideas and cringe at them), E.J. Dionne, Jr.  Note his assertions: “But in the current crisis, these ideas are falling, one by one, as even conservatives recognize that capitalism is ailing.” “What’s becoming the Panic of 2008 will mean an end to the latest Capital Rules era.”  But while the death of capitalism may be his point, it’s not really the point, as even he admits, with a thrown-away statement that “capitalism, in its current form, isn’t living by its own rules.”  It is, once again, the point that a true free market is the solution.

While Dionne asserts (with support from Ben Vernanke and Barney Frank) that the solution is more regulation, he misses his own argument.  He quotes Irwin Steltzer of the Center for Economic Policy Studies at the Hudson Institute: “You have to have the person who’s writing the risk bearing the risk,” he says. “That means a whole host of regulations. There’s no way around that.”  But Steltzer, too, misses the point.  The person who’s “writing”, or taking on, the risk, does not need to be the one bearing the risk–if that were true, we would not only not want state-run health insurance, we would also ban private health insurance, ban life insurance, ban auto insurance.  The problem is not, and could never be, risk being borne by someone other than the person taking it on.  The problem is, plain and simple, people being stupid.  The problem is not people selling mortgage-backed securities.  The problem is people who buy the mortgage-backed securities buying them without the ability, or the desire, to look into them and make sure they’re sound mortgages.  It is people investing heavily in mortgage-backed securities as though they were reliable when they are not.  It is, simply, bad financial decisions.

What can easily be missed (and I hoped to point this out above in my analogy to insurance) is the nature of mortgage-backed securities.  They are, in essence, pooled risk.  If, out of a given pool of mortgages at a Y% rate of return, X% can be projected to default, those mortgages can be pooled and treated as a single entity with a projected rate of return of (1+Y%) * (1-X%) – 1.  By selling pieces of that entity as securities with a return less than that projected rate, the seller can still expect to make money, while passing the risk of loss with others.  (Again, it’s the same thing as insurance.)  The problem was not with the idea, it was with the implementation.  They were selling the securities as though the rate of default were X%, when it was actually much larger.  It’s the same (from the buyer’s perspective) as selling insurance at below-recovery rates, such that most claims are at a loss.  As the old economics’ saying goes, “You can insure anything for the right price,” and, similarly, you can buy any mortgage-backed security, for the right price.  The problem is not in the mortgage-backed securities, it is in the buyers.

Here’s an analogy:  You go down to the grocery store for some produce.  But all of the produce (~the mortgage-backed securities) are all behind frosted glass with clear signs labelled “As Is”, so all you can tell about them is what kind of produce it is, i.e. oranges, potatoes, but not the quality.  But, you really need some oranges, so you buy some, even though they are priced the same as oranges you can select elsewhere.  You get home, and discover that all your oranges are moldy.  Similarly, people buying mortgage-backed securities were made aware of what kind of mortgages were involved, but didn’t have sufficient background information on the borrowers to know the true value of the security.  And now they are discovering that their oranges were moldy.  The problem is not with the store, analogically speaking, but with anyone being dumb enough to buy produce sight unseen.  With market discipline, either the store will close down, or prices will drop to the point that it is worth somebody’s money to take their chances on getting a moldy orange, because on average they’ll still come out ahead.  We don’t need the government to come in and say, “Stop selling oranges!”

As GK Chesterton pointed out, “The Christian ideal has not been tried and found wanting; it has been found difficult and left untried.”  Similarly, the free market has not been tried and found wanting; it has been found frightening and left untried.


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