Government is the cause of market failure, not its solution

PUBLISHED : Tuesday, 17 April, 2012, 12:00am
UPDATED : Tuesday, 17 April, 2012, 12:00am


Leung Chun-ying believes a more interventionist government would be a good thing.

According to the front page of last Thursday's South China Morning Post, Hong Kong's next chief executive thinks 'the government should intervene to prevent market failure and keep property prices at a level affordable to the public'.

Well, I've got some unwelcome news for C.Y. Government intervention doesn't prevent market failure. Quite the opposite: more often than not it's government interference that causes markets to fail.

If you don't believe me, you only have to look at what most people agree is by far the biggest incidence of market failure in recent economic history: the US financial crisis of 2008.

The popular narrative insists the crisis was caused by the excessive greed of investment bankers, abetted by hands-off politicians in thrall to Wall Street's financial donations.

It's a simple story, with easily identifiable villains. And it has an obvious solution: more government involvement in markets.

But as the acerbic American critic H.L. Mencken once remarked: 'There is always a well-known solution to every human problem - neat, plausible, and wrong.'

This case is no different. Look more closely at the evidence, and it soon becomes apparent that the US financial crisis wasn't caused by too little government intervention in the economy, but by too much.

Some trace the origins of the crash right back to the administration of Franklin Roosevelt, which in the 1930s began to provide federal support for home-buyers.

But the real causes can be found in the 1990s. Eager to give America's poor - who come disproportionately from its ethnic minorities - a greater stake in the US economy, Washington set out to encourage wider home ownership.

Spreading property ownership, believed officials, would foster aspiration, reduce crime levels, improve educational performance and, of course, win votes.

There was one obvious problem, however. Bank credit officers were reluctant to lend to would-be home buyers from poor neighbourhoods on the grounds that they were less likely to be able to repay their debts.

Unfortunately, this conservative lending policy looked a lot like racial discrimination. In 1995, Washington tweaked the Community Reinvestment Act to press banks into giving mortgages to borrowers from low income areas, threatening to penalise them if they failed to lend equally to ethnic minorities.

At the same time, government-sponsored enterprises like Fannie Mae and Freddie Mac were instructed to increase the proportion of their portfolios devoted to mortgage loans in poor neighbourhoods. The GSEs complied with a will. As the chart (above) shows, their balance sheets exploded as they took on trillions of US dollars in new mortgage debt.

The intention was worthy enough: to make home ownership more affordable. But affordability was achieved only by abandoning credit standards as banks reduced the downpayments required on home purchases to zero.

The result was an explosion of 'sub-prime' lending to borrowers who had no equity stakes in their homes and who were always likely to struggle to meet their debt service obligations.

And of course, with credit so readily available, home prices shot up, encouraging even more unsuitable buyers to enter the market. As the second chart shows, nationwide house prices rose 150 per cent in just 10 years. By the middle of the last decade, the US was experiencing a full-blown credit-fuelled property bubble.

When borrowers were no longer able to pay their debts, the bubble burst and everyone began to cry: 'Market failure'.

But in reality the market failure had happened years before, not as a result of bankers' greed or politicians' neglect, but rather as a direct consequence of government interference in the market for political ends.

Let's hope C.Y. learns the lesson before he puts his thoughts on government intervention into action.