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Sub-Prime Thinking

The Forgotten Man, Amity Shlaes’s compelling and highly readable reinterpretation of the Depression and the New Deal, is a timely reminder of the way in which government policy can have counterintuitive effects, sometimes of a disastrous nature. Shlaes suggests that, in the Depression era, misguided policies incited and then prolonged the financial crisis, saddling us with the hugely expanded federal government that struggles to manage our economy today.

How is the government doing at that task? Over the past few weeks, and especially over the past few days, financial markets worldwide have been roiled by a credit crisis. That crisis was sparked by a real-estate bubble and a lending boom that are in no small part an unintended consequence of U.S. government policy.

The government encourages home-ownership by offering a significant tax break for mortgage interest. This is one of the few deductions that is not subject to the dreaded alternative minimum tax, which has begun to squeeze the middle class. As with any other subsidy, the effect of the mortgage-interest tax break can be to encourage consumers to buy more housing, and more expensive housing, than they may need.

At the same time, the highly-regulated lending industry was permitted to let the sub-prime mortgage sector grow wildly in the middle of a real-estate boom, with exotic adjustable-rate and interest-only loans enabling all sorts of unqualified buyers to purchase homes on the premise that rising prices would eliminate the risk of default.

These sub-prime loans were cut up and repackaged by investment banks as collateralized debt obligations, which became a favored instrument of unregulated hedge funds. But prices could not rise forever. Financial gravity has now set in. The two government policies that formerly were operating in parallel are now colliding.

As falling real-estate prices make the underlying collateral insufficient to pay off the debt, a number of lending institutions and hedge funds trading in collateral debt obligations have gone belly up, triggering a world-wide panic. The Federal Reserve, which several months ago was pooh-poohing the risks posed by real-estate weakness, has now been forced to step in and reduce the lending rates for banks.

This is a crisis, in other words, that few, including few in government, foresaw. It leads one to wonder what other major risks are lurking hidden in our financial system. Have we really faced the implications, for example, of the fact that China is such a major investor in U.S. Treasury Bonds?

I seldom agree with the New York Times‘s Paul Krugman, and I am not sure I agree with him today when he writes that “it’s hard to avoid the sense that the growing complexity of our financial system is making it increasingly prone to crises—crises that are beyond the ability of traditional policies to handle.”

But it is past time to think imaginatively about hidden dangers to our financial system.

Who should do such thinking? Shlaes’s The Forgotten Man makes it clear that when it comes to a financial crisis, government is the most important actor, and also the least reliable source of insight.



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