Who’s really to blame for the financial meltdown?

According to a MinnPost.com post by Doug Grow, Rep. Keith Ellison is “steamed” that blame for the financial meltdown is being placed on “poor blacks.”
 
“Poor blacks caused this,” said Ellison, Minnesota’s the 5th District congressman, scornfully (as quoted by Grow) “That’s what we’re supposed to believe. Little ACORN (Association of Community Organizations for Reform Now) caused this. The mighty captains of Wall Street got taken down by little ACORN and poor black people. That’s what you’re hearing on the right. The gall and audacity of this is beyond imagination.”
 
I’m not going to question the sincerity of Ellison’s outrage. I would like to think that I can empathize with it despite the handicap of being white and male. I’ll even grant that there are people throwing around the CRA argument from an ideological bent with little understanding of the act itself, and there may be people who really are placing the blame for the meltdown on the poor black people. They are setting up straw men, but so is Ellison.

The problem with the Community Reinvestment Act has little whatsoever to do with poor black people per se. That CRA loans account for “at most, 20 percent of the bad loans that have led to the collapse” is “at best” ancillary to the issue. The CRA is certainly not the primary cause of the meltdown. The relevant issue, however, is the economic impact of the Community Reinvestment Act – both the visible consequences – increasing homeownership especially in minority communities – and the unseen consequences, the trade-offs, many of which are unknowable, resulting from government intervention in the housing market.
 
It’s the unseen consequences of the Community Reinvestment Act that have the most significant impact on the current crisis.
 
Trade offs
Economics is all about trade-offs. In a market-based economy, individuals decide what those trade-offs are going to be. Prices are set based on demand, and demand is always at a price. Interest is the price of capital. In a market system interest rates are based on money supply and demand for products and services. Credit expands until individuals acting within the market decide the price of capital (interest) is too steep at the margins – the cost of borrowing the next dollar outweighs the personal value of the end the borrowing would achieve.
 
In a managed economy, when government intervenes in the market on behalf of one industry or pushes a specific social goal – passes a Community Reinvestment Act – that action alters the market for capital. The Community Reinvestment Act with its implicit (now explicit) government guarantee to lenders that Fannie Mae and Freddie Mac would provide liquidity for their mortgage loans created a virtually risk-free investment with an artificially high return. This caused two problems.
 
First, guaranteed low risk and artificially inflated reward caused money to flow into housing that otherwise would have been more effectively invested in other segments of the economy. Eventually, the bubble had to burst – an unsupported money expansion can’t go indefinitely.
 
When housing prices fell, homeowners saw their equity decline. As mortgages flipped “upside down” (subprime or otherwise) – properties were worth less than their mortgages. Holders of mortgaged-backed securities, absent a true market, had no means to price their investments. Lacking a market and under the “mark-to-market” accounting rules of the Sarbane Oxley Act (another bit of panic-inspired legislation), those securities are virtually worthless. They have a value, but lacking a market, no one can actually determine what that value is. The result is what we see today – a drying up of liquidity in the credit market.
 
Government intervention and deregulation
Was that entirely the fault of the Community Reinvestment Act? No. And it definitely wasn’t the fault of “poor black people.” But soaring real estate values motivated more financial institutions to want in on the market. They had capital to lend, but the market they wanted in on was not an open market. It was highly regulated with legal barriers to entry. That brings us to the second consequence of government intervention – deregulation.
 
Government intervention in housing lured capital away from where it had had been profitably flowing. Deregulation enabled investment banks to get in on the real estate action. Playing outside the bounds of market discipline in a virtually risk-free market where weighing the possibility of gain against the probability of loss was unnecessary, is it really a surprise that greed and recklessness ran amok?
 
You can’t regulate greed out of human nature any more than you can legislate the money out of politics, but that impossible task is what a government managed economy must resort to. In a market system, greed is controlled by the discipline of risk vs. reward. Congressman Ron Paul identified the moral culpability in the housing market collapse as the “huge unconstitutional and immoral transfer from working Americans to holders of GSE debt (Government Sponsored Entity, e.g. Fannie Mae).” He is right.
 
Rep. Ellison may be outraged by the implications of others and his own inferences vis-à-vis the Community Reinvestment Act, but the act is symptomatic of the pervasive intrusion of government into the housing market and the economic damage and moral hazard such intervention creates. The Community Reinvestment Act and deregulation of investment banking are flip sides of the same coin. “Risky” loans motivated by the CRA are not the cause of the meltdown, nor is human greed. Each play a role and both were enabled by damaging government intervention in what otherwise would be a free and open market.
 
“Greed” may not be the right word, but where is the virtue in a person expecting society to finance a home he cannot afford? Ironically, while the CRA provided a path to home ownership for some, the investment it was funneling from other parts of the economy lowered the standard of living for many more – economics is always about trade-offs. The question is, who decides what those trade-offs are going to be? In this case is it going to be the secretary of the Treasury or individuals bound by the market discipline of risk and reward?
 
If one finds reason for outrage in the collapse of the financial markets, one will need a superlative adjective when the Social Security, Medicare and Medicaid bills come due.