Dr. Frankenstein's Bubble: Made in Washington

Question: How bad is the economy going to get?

Answer: Much worse than it has to be.

Why: The nostrums being proposed by the Secretary of the Treasurer are destructive and noxious. Let’s face it, the Bush Administration is totally incompetent and can turn any cold into a fatal disease. I really wasn’t paying that much attention to what Secretary Paulson was saying so I didn’t realize precisely how stupid he was in regards to economics. The man is a blithering moron. Take this series of questions and answers with Paulson as an example:

Jon Healey: Many of the people we speak with don't like this because they see the results of the government's work being sustaining housing values that should have been allowed to come down.

Henry Paulson: Again, I've given my answer to that. I think what we're doing is avoiding a market failure that would have forced housing values down in a way that was not in the investors' interest, and in a way that the market wasn't intended to work.

Tim Cavanaugh: How can you force values down? Why aren't values finding their natural level?

Henry Paulson: The way values would go down is, as I've said, you'd have market failure...

Henry Paulson: ...What this will do will make a difference in that we won't have housing prices driven down in ways that distort the market because the industry wasn't able to come up with procedures to deal with an unprecedented situation.

Tim Cavanaugh: Is it distortion in the market when the market was already distorted up to a degree that maybe wasn't unprecedented, but was certainly unusual in American history?

Henry Paulson: So you'd like to see it distorted down too...
Peter Hong: Could you be a little clearer on what you mean by "market failure"?

Henry Paulson: As I've said, chaos...when I say market failure I say that we have an unprecedented situation, and the private sector has to find a way to deal with that. Otherwise you're going to see them drowning in people who can't make resets, whom they would ordinarily want to keep in a home.

Peter Hong: You used the phrase "distort down." Is it distortion or is it a correction?

Henry Paulson: What I want is markets to work. And I would define a market failure as the system not being able to cope with the wave, so that foreclosures took place that would not have taken place if there were smaller volume...

Peter Hong: But are house prices too high?

Henry Paulson: I'm not going to—foreclosures are bad for neighborhoods. You have needless foreclosures that are driving down prices, created by a situation that is unprecedented and that would under normal circumstances not have taken place.

Good God, didn’t this man take a basics Econ 101 course sometime in his life or is he intentionally ignoring market fundamentals for other reasons? First, lets get rid of the absurd idea that this crisis is one of “market failure”. Markets are doing precisely what they are supposed to do -- when a good is overpriced markets correct that price and bring it down.

So why is housing overpriced in America? Government policies pushed by short-sighted politicians (are there any other kind?) intentionally distorted markets to increase the demand for housing. The whole purpose of the government created monsters, Fannie Mae and Freddie Mac, was to make it easier for people who can’t afford a home to buy one. Easy-money policies from the Federal Reserve, cheap lending from government-backed institutions, increased the demand for housing faster than the supply thus pushing up prices. This gave the home owner the illusion of increasing wealth and they went on a spending spree increasing their debt believing the increased equity in their home would cover it. A good time was being had by all.

And there were lots of people willing to build homes in order to sell them to these people. In fact, there were lots more people building those homes then there should have been.

But why the distortion in building? Consider yourself an investor wanting to get a return on your money. If you purchase stocks, and the stocks went up, you paid capital gains tax on the increased value. If you invested in gold, silver, coins, or almost anything, and you received a profit on your investment you paid a capital gains tax on that profit --- with one major exception. You guessed it: housing!

Go back to 1997 and the so-called Taxpayer Relief Act of 1997 passed by the Congress. Here is a description of the law:

The relief act's primary provision for home sellers is the capital gains tax exclusion -- when you sell your home, if you qualify, you can keep, tax free, capital gains of up to $500,000 if you are married filing jointly or $250,000 for single taxpayers, or married taxpayers who file separately.
Your capital gain on the sale of your home is the selling price minus your cost basis. The cost basis is your purchase price, plus qualified purchase costs, improvements and selling costs, minus any accumulated depreciation, say for a home-based business. A professional can help you more specifically calculate your gain if you are not sure what qualifies and what doesn't.

Now a libertarian might say that tax relief is not a bad thing. But there is tax relief that can create problems. When you have a tax on all capital gains but one specific kind then tax relief linked to one investment alone it will distort investment patterns. The tax policy, in essence, lowers the return on all investment save the favored one. Thus more capital flows into the favored investment than into the others. The natural market is distorted. Some areas lack the investment they ought to have under natural returns and the favored area receives more investment than it would if on an equal playing field.

When one sector of the economy has too much investment the rate of return in that sector will eventually fall. Over investment drives down profits in that sector while pushing up profits in the underinvested sectors. Housing was over built and with each new house the pressure was increasing. The bubble had to burst. What Secretary Paulson is doing is trying to artificially pump up the bubble -- the very sort of policy which caused the problem in the first place. Somebody needs to point out that you don’t cure drunkenness with more alcohol and you don’t cure an economic bubble by re-inflating it.

Vernon Smith won the Nobel prize in economics and almost a year ago he wrote about the housing bubble and the cause.

Thank you President Bill Clinton for your 1997 action, applauded by the banks, the realtors and all citizens in search of half-millionaire status from an investment they could understand and self deceptively believe to be low risk; thank you for fueling the mother of all housing bubbles; thank you for enabling so many of us who bought second or third homes, and homes before construction began, which we then sold to someone else who dreamed of riches from owning homes long enough to sell to another fool.

Once again, try as we might and in spite of our political rhetoric, we have failed to help the poor in applauding government action intended to help ourselves.
The consumption binge is now over, and there is more than enough blame and souring loans to spread around. Congress, if its members can stop squabbling, wants desperately to sanctify it all with actions sure to launch at some future date the grandmother of all housing and mortgage-market bubbles. This august body has long forgotten that it set the stage for housing bubbles by creating those implicitly taxpayer-backed agencies, Fannie Mae and Freddie Mac, as housing lenders of last resort.

Smith notes that it would have been beneficial to allow “capital gains on all assets to go tax free, provided that the capital was reinvested....” But proposals to do that raise the shrill cries of the Statist Left who believe the benefits the rich. They preferred target “relief” and they picked housing to encourage more people to invest into this one sector of the economy. They told us this was helping the poor.

So where are the poor today? They bought houses that had inflated prices, prices inflated by the politicians and their “created in DC” bubble. They bought the houses that they couldn’t afford because the same politicians made it easier for them to do so through the lending distortions they put into effect. So they gave easy money to people to buy property that was overvalued. When the value of the property corrected itself, as was bound to happen, the same homeowners found that they were paying far more than the property was worth. Each month their were going shelling out money as if a property was worth X amount, when in reality it was worth far less. Basically the “caring” Left in Congress conned a lot of people into buying an investment that was bad for them.

Of course those people borrowed the money and most those loans ended up in the hands of the government-sponsored agencies Fannie Mae and Freddy Mac. Make no mistake these are entirely creatures put together by the Dr. Frankenstein’s in Washington. Now the conned home owners are defaulting, destroying their credit ratings, going bankrupt and being harmed in innumerable ways. So the morons who created this crisis, the politicians, are rushing to bail out the big moneyed institutions that leant the money. Damn the little guy tricked into making a bad investment by government policy, but bail out the corporate interests.

Once again we have another politically-created disaster where the most vulnerable people in society are being harmed. The harm was imposed on them by policies which the politicians, particularly the Democrats in DC, claimed were being implemented to “help” them. One basic principle to remember is that “help” from Washington almost always does more harm to the recipient being helped than it does good. Help from DC is like a rapist claiming he’s helping his victim learn new techniques for sexual pleasure. The victim ends up bloodied and beaten and it is only the rapists who gets his jollies.

After the poor home buyers were conned into buying overvalued property by the snake-oil salesmen from Washington they found themselves in a horrible position. When they start going under, and the institutions that hold their loans start hurting, the politicians rush in to rescue the institutions. And who is going to pay for that? The taxpayers. And that means higher taxes to cover the billions in bailouts. Washington tricked people into making bad investments. And when those people go broke and can’t pay off their loans Washington comes in and taxes the same people to save the asses of the corporate elite.

Once again it is clear that government intervention into the market does not help the poor. Quite the contrary. It is the poor who tend to pay the highest price for the intervention and receive the least benefits. Even under the best of the times the “benefits” are dubious and or a short-term nature with long-term consequences which make them worse off.

Keep an eye on Washington because this will be a perfect example of how alleged liberals in the Democratic Party will push through policies that help major donors to their parties while shafting the poor. It will also illustrate how government interference in the free market does not help the poor but harms them. And notice how this crisis has been evolving for sometime now but the political classes did nothing. As long as people were losing their homes the politicians were relatively silent. Once the defaults started hurting the billionaires that fund both parties the politicians jumped to life and demanded bail outs for the big boys. That is the nature of politics but I’ve written about that before.