The high-tech, productivity-driven U.S. economy is more durable and flexible than its liberal-left critics will ever admit. It is a private-sector free-enterprise economy, not a government-planned one. Innovation is strong and entrepreneurial spirits are high. The four prosperity killers, a paradigm coined by Arthur Laffer many years ago, all look dormant: inflation, taxes and regulatory burdens are low, while free trade keeps expanding." Larry Kudlow, February 29th, 2007, Wall Street Journal

For as long as I’ve been around to take notice, the political right have been smug in the belief that their grasp of economics, and relatedly their economic agenda, is superior to that of their counterparts on the left. To some extent, this can be traced to the political affiliation of various groups in the labor force- entrepreneurs and MBAs are more likely to be conservatives, public employees and blue-collar workers are more likely to be liberal, and so on. However, some of it can be attributed to the fact that liberal concepts of exploitation and corporate malfeasance, strike those converted to neo-classical "supply side" economic thinking, its intellectual appeal and seemingly counterintuitive conclusions, as coarse and unsophisticated. This is to say that, for a conservative, the argument that raising taxes rates lowers government revenue feels more sophisticated, by coincidence of the fact that the conclusion flows from an elegant theory, and because it is in fact counterintuitive, especially by the lights of those fixated on economic injustice.

In any case, while this fundamental tenet of the conservative identity has existed for some time, it was profoundly confirmed in their consciousness by a series of historical events. Taken together, the high inflation and unemployment late 1970s, the subsequent disinflation, economic and capital market boom of the 1980s under Ronald Regan, and the coup de grace, the collapse of the Soviet Union in 1991, so accorded to the conservative view of the world that the subsequent discord of events such as the economic successes of the Clinton administration and failures of the first and second Bush administrations have done little to shake (pop?) it. In fact, it is no stretch to say that the conservative accounting of those events have been ‘fitted around the policy’, to borrow a phrase: that conservatism is good for economic well being of all society’s members, while liberal policy is not, (for example by the relative popularity of a ‘theory’ that attributes the Clinton economy to the Regan administration).

It is in that context that it is clear to see why this latest financial and economic debacle, following after 8 years of unfettered Republican policy on taxes, regulation, monetary policy and trade, represents nothing less than a theodicy for the conservative movement. The panic among we have seen in bond traders and Wall Street board rooms has paled in comparison to the panic amongst the ideologues of right wing think tanks, heretofore so convinced of the unparalleled strength of our system, economy and capital markets, and so disdainful of the worry warts and naysayers who’d voiced concerns about trade deficits, consumer indebtedness, unregulated derivatives markets and so on. Their panic has resulted in a headlong rush to explain away the problems as functions not of deregulation and markets, but of regulation and governments- to seek out the usual culprits (Democrats).

Predictably, their success in rapidly marshalling a pat story has only been exceeded by that of their efforts to publicizing it, and in bite size rhetoric fitting for political ads. As the story goes, Democrats through their creation of the Community Reinvestment Act (CRA) in the Carter administration and by their coddling of the Government Sponsored Enterprises, created "subprime", a class of mortgages intended for bad credits, and caused it to grow. In addition to their own participation, the GSEs, (by as yet unidentified means), coerced private banks to lend to these bad credits, all of which eventually led to the demise of the agencies and the "sub-prime" crisis. (as regards those ‘bad credits’, more than a few right wing proponents have omitted the innuendo and simply classified these bad risks "minorities". Lest one see this as aberration, it should be pointed out that one of the fathers of supply side economics, Arthur Laffer, refers to the minimum wage as the "teenage black unemployment act". Apparently teenage blacks are the preponderant source of labor whose value is less than the minimum wage).

Most prominently, this argument was articulated by Kevin Hassett, advisor to Republican Senator John McCain's presidential campaign, co-author of the notorious dot-com cheerleading tome Dow 36,000 and resident polemicist at the reliably craven American Enterprise Institute, in his column on Bloomberg which was linked to by the conservative web site, The Drudge Report this past Monday. The perfunctory headline of Hassett’s ostensible examination of the developments that led to the debacle unfolding in the markets: "How the Democrats Created the Financial Crisis". Mr. Hassett’s version of this narrative omits laying the blame for the crisis on the doorstep of the politically defunct Jimmy Carter and the CRA, presumably to more plausibly attribute foresight to his employer and villainy to his opponent, but the remainder of his piece follows the script.

The problems with this story are many, varied and utterly comprehensive. Most obviously, it is far from clear the bit of legislation Hassett claims would have kept Fannie and Freddie from purchasing or insuring subprime paper would have actually done so, in spite of its stated intent to "eliminate [the GSEs] investments in risky assets". Reason being that under the then best practices, the relative risk of investments (model driven or not) was been determined by grades passed out by credit rating agencies in the pay of issuers and underwriters- a station notably arrived at by blind ideological faith in the rating agencies ability to regulate themselves notwithstanding the still warm bodies that had proved their inability to do so a few years previously. In an case, as Hassett himself points out, the agencies had purchased only subprime ABS that were rated AAA, marking something of a monkey wrench in his counter factual. Moreover, the legislation in question does not fit easily in the timeline of events. Subprime mortgages have existed for decades, and meaningful participation in those markets by the agencies began in 2003. Left unstated is whether everything would have been hunky dory without their participation in the subprime market altogether, in which case the 2005 legislation was irrelevant, or whether it was just the last two years of that participation that precipitated the problem.

That aside, Hassett’s thesis that the government agencies were uniquely culpable for the problems in the subprime market simply does not hold water. Notwithstanding this feature of markets that AEI so revere, he provides no evidence that no other buyers or guarantors of top rated tranches of subprime deals would step into the void in a parallel world where the GSEs did not exist. Indeed, as a few of the recently unemployed have noticed, the writedowns resulting from senior tranches of subprime CDOs have rained down far and wide across the private and foreign official sector, and neither have the monolines done quite so well. AEI credulousness aside, clearly both functions were replete with alternate players that would’ve been all too willing to pick up the slack.

The Federal Reserve Flow of Funds data confirm this sensible conjecture. As it turns out, private and foreign official institutions were buyers of all manner of asset backed paper from 2003 to 2007, rated AAA on down. During that time the stock of outstanding agencies increased by $.55tn, while the stock of outstanding "ABS" increased by $1.850tn, 3 times greater. Much of the reason for that lopsided growth was the flat to negative growth in Fannie and Freddie’s combined books of business by consequence of their accounting scandals- itself an example of just how easily these agencies could be displaced by a credit market awash in unprecedented liquidity. Hassett even seems not to notice the irony that during this period the GSE’s share of subprime market actually decreased, as Gennie Mae increasingly lost business to a private label marketplace that was willing to lower underwriting standards.

The better question though is why wouldn’t private industry so willingly participate in the subprime market? The market segment itself exists, not because of the CRA, but due to 1980s banking deregulation that loosened the interest rates and terms banks could charge on such loans. The nothing short of blatantly obvious fact is that financial companies weren’t participants in the subprime market for their health, and they certainly weren’t there to satisfy government regulation, (witness Countrywide’s steering borrowers to subprime loans that could’ve qualified for better). They were there because it was profitable. And when the banks’ borrow short lend long business model went flat with the yield curve in 2005, credit, and especially mortgage credit, became the only game in town with the juice to satisfy the voracious sector’s bloated balance sheets and payrolls. Meanwhile, the rating agencies were more than willing to sign off on just about anything their paymasters desired, their own profits booming all the while, while the regulators led by Alan Greenspan’s vigorously waving pom poms were under the delusion that the markets police themselves. The cat was well and truly away and how did those mice play! They piled in to every god forsaken exotic credit- not only in subprime, but across a swath of bad lending extending into prime and Alt-A mortgages, commercial mortgages, home equity lines of credit, auto loans etc. etc. etc.- and reaped bonanza profits until the fall.

Speaking of the Maestro, Mr. Hassett’s ode to revisionism even manages to go so far as to frame Chairman Greenspan, (under whose stewardship of the US financial system the GSEs mandate went from subsidizing home ownership to underwriting marketplace liquidity as their book of business went from $.16tn to $4tn), as the Cassandra of this systemic crisis. Referencing his testimony to Congress near the very end of his 18 year tenure as Federal Reserve Board Chairman, Hassett recalls that:

"…in 2005 Alan Greenspan told Congress how urgent it was for it to act in the clearest possible terms: If Fannie and Freddie ``continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, they potentially create ever-growing potential systemic risk down the road,'' he said. ``We are placing the total financial system of the future at a substantial risk.'

Quite apart from Hassett’s dishonest conflation of the risks Greenspan references in his testimony with the subprime credit risk of his polemic’s thesis (the government is not proposing using $700bn in taxpayers money to bail out the banks because they own GSE paper or for interest rate rises)- the fact is that this is the same Alan Greenspan who, along with the braintrust at the American Enterprise Institute, praised ‘innovations’ in the mortgage market (along with all other capital market ‘innovations’ from credit default swaps to quantitative risk models), publicly refused to acknowledge the housing bubble even as its obviousness became manifest, openly encouraged Americans to take out ‘lower cost’ (and higher risk) adjustable rate mortgages, and most notably refused to impose regulations on these practices even as '>their notoriety grew exponentially, and even though such regulation was well within the remit of the Federal Reserve. And that list is a very abbreviated version of an 18 year catalogue of Chairman Greenspan’s atrocious mistakes. AEI’s powers of historical revisionism would be the envy of the Soviet Union truth ministry.

It should be pointed out this refutation of AEI propaganda is not meant to imply that the government sponsored enterprises were not instrumental in delivering us to this precipice. They were, if not by the manner outlined by Mr. Hassett or any of the other self-serving/preserving ideologues on the right. Rather, the GSEs helped to bring us to where we find ourselves and sowed the seeds of their inevitable demise by allowing themselves to be used for 20 years by Chairman Greenspan and other powerful officials as underwriters of marketplace liquidity and benefactors of the financial industry. So when Lawrence Lindsey took to the pages of the Wall Street Journal in August of last year to ask the agencies to "step up" and bail out the housing, mortgage and credit markets, he was merely (at the time) the latest in a long line of bipartisan officials to do so. Lindsey, President Bush’s former chief economic advisor whose 2002 forecast of the cost of the Iraq War still stands a chance of only being wrong by a single order of magnitude, showed that there was no contradiction between full throated support of ballooning these two massive systemic risks and advocacy of a deregulated ‘free’ (if occasionally dependant) marketplace:

There are alternatives to regulation and trial lawyers. Fannie Mae and Freddie Mac, which have been enjoying implicit government subsidies for years (and making the requisite campaign contributions to maintain them), should be asked to step up to the plate. In particular, they can play a role in creating refinancing options for people who may be in distress. The private marketplace is coming up with numerous innovations designed to help keep people in their homes -- ideas that will be stopped in their tracks by the fear of litigation and excessive regulation. Both the IRS and the SEC should change some of their regulations to facilitate the process.

Which brings up a related point you won’t hear from the right. If it weren’t for the GSE’s bailing us out since the breakdown in the securities market in July of last year, the bottom would have already fallen out from both the housing market and the financial industry, and of course the economy. As of now, the GSEs account for 75% of mortgages being written, and I would assume as of this latest rout in the credit markets, even more so. Without them, there simply would be no credit on hand for the housing market, and sales and prices would crater with attendant consequences.

So where does that leave us? More or less where we started- without any kind of meaningful examination of the events that led us to where we are today. I will get to that in my next installment on this blog.

<blockquote>The high-tech, productivity-driven U.S. economy is more durable and flexible than its liberal-left critics will ever admit. It is a private-sector free-enterprise economy, not a government-planned one. Innovation is strong and entrepreneurial spirits are high. The four prosperity killers, a paradigm coined by Arthur Laffer many years ago, all look dormant: inflation, taxes and regulatory burdens are low, while free trade keeps expanding.” Larry Kudlow, February 29th, 2007, Wall Street Journal</blockquote>