In the Wall Street Journal, Culprits From Beltway Casting- The financial inquiry commission lets a crisis go to waste, (subscription required), takes exception to the partisan conclusion of the commission.   

The Financial Crisis Inquiry Commission reached a conclusion that appeared preordained. It was supported by the Democrats on the commission and rejected by the Republicans. The blame was heavily weighted to greed, derivatives and deregulation.  But greed is nothing new and apparently it isn’t quite clear from the conclusion when greed suddenly became a problem.  And it was not just derivatives, but derivatives tied to the housing and mortgage market. Fixed income derivatives seemed to have no similar problem.  And regulations have been growing, even under Bush.  Losses on mortgages, not tied to derivatives, were also severe.  Maybe it wasn’t de-regulation- but poor or misguided regulations or inattentive regulators.  Or maybe it was the interference of Congressmen with regulators after being plied with campaign contributions from the regulated.

Once again it is demonstrated that in the face of irrefutable evidence it is still possible to reach the wrong conclusion.

Blaming the economic crash on greed is like blaming an airplane crash on gravity.  It is a force to be acknowledged but serves no useful purpose in preventing the next crash.  There were clearly financial instruments allowed that should have been much more clearly regulated. But it is also true that government hubris especially at Fannie Mae and Freddie Mac drew the rules of the game that created this mess.  But the Democrats, almost by straight party line, rejected efforts to tighten controls of Fannie and Freddie, years before the crash.  But long before even the  Republicans and Alan Greenspan thought the risk was worth the potential benefit of expanding home ownership.

This crisis was a toxic mix of destructive government policy and poorly understood and poorly regulated toxic financial instruments.  Housing was the perfect tool because it served the purpose of vote buying government policy.  It was also the most dangerous because of its size and impact on so many people. By contrast Enron and WorldCom were record bankruptcies but posed no systemic risk.

But the problem was less from exotic financial instruments than from the same factor that causes all crashes: too much debt.  The greed of Wall Street villains, which is nothing new, was much less of a cause than the consumers who wanted houses they could not afford, and a government more than willing to accommodate them.

Ever since Michael Douglas’s character Gordon Gekko in the movie Wall Street declared “Greed is Good” capitalism has been cast in a sinister role that it has yet to overcome.

The movie speech was rumored to be taken from a speech given by Ivan Boesky at a college address. Boesky was indicted for insider trader, served time in jail and paid millions in fines.

Capitalism is not about greed; it is about economic self interest, and this is far more than a semantic distinction. When you take a job paying $10 an hour over the job paying only $8 an hour you are displaying economic self interest, not greed. And when you decide to take the job paying $8 an hour over the job paying $10 an hour because you like the conditions or the work at the lower paying job enough to sacrifice the higher pay you are also acting in your own economic self interest. Economics is about far more than money.

When you decide to take a steady job in a traditional workplace rather than make much more money in drugs and prostitution you are also acting in your economic self interest. It is when your economic self interest disconnects from moral and ethical considerations that it becomes greed.

The ultimate power is the power over your own destiny and environment, but power is most often considered in the control over others. Whereas economic self interest in about control over your own destiny, political self interest is about controlling others.

Capitalism is about people acting in each other’s own self interest and the society benefiting as a result. This works because achieving your self interest requires serving others.

Advanced economic theory also realized that self interest and sharing is not mutually exclusive. In “A Beautiful Mind” John Nash had a Eureka moment courting ladies at the beer hall with his college buddies. He realized that Adam Smith was wrong, or at least incomplete. He developed a theory of equilibrium in competitive game theory. Basically this meant that he realized that your best outcome was not to grab as much as you can for yourself, but that your chance of success was enhanced by assuring at least some success for your competitors. Not only are consumers’ well being enhanced by competition, but the outcome for the competitors themselves is improved.

In order to profit you have to provide a product or service some one else values. Bill Gates, Michael Dell, and Stephen Jobs are very, very wealthy because everyone values Microsoft Windows and Office, iPhones, Macs, and laptops.

Few people complain about the wealth of these techno entrepreneurs because they all provide value we understand. The same can be said of Warren Buffet.

Yet we are outraged at the fortunes made in the financial industry where record amounts of value have been destroyed while CEOs made millions in bonuses. We do not understand derivatives, collateralized debt obligations, and financial models: Apparently neither did the CEO’s and boards of the companies selling these products.

The Wall Street mess was the product of “crony capitalism” which is to capitalism what National Socialism (Nazism) is to socialism. Crony Capitalism is a perversion of the principles of capitalism that includes the freedom “for every man to make himself” to use the phrase of Abraham Lincoln. “Crony capitalism” has its roots in the mercantilist tradition of Alexander Hamilton. During our early years Hamilton saw a need for financial interests and the government to work “closely”. He favored a central bank and such “public private partnerships.”

Hamilton was strongly opposed by Jefferson who favored decentralization and saw the favoritism fostered by mercantilism and the influence such financiers could have over our government as a threat to liberty.

Fannie Mae for example was given special treatment and access to low interest funds available to no other financial institution, and exempted from both SEC and FDIC regulation, Fannie Mae lobbied Congress and plied their special regulators with large campaign contributions. Senator Chris Dodd, head of the Senate Banking Committee and then Senator Barak Obama were the two largest recipients.

But the real damage was not compromising two high profile Senators. Fannie Mae was given special privileges in order to carry out the political will of Congress to make housing affordable for people who shouldn’t buy homes. They created the hunting grounds for the unscrupulous.

Bonuses and bailout funds for Fannie Mae did not elicit near the outrage of AIG and the Wall Street banks. The public still thinks it was the ‘Gordon Gekko’ greed of Wall Street rather than the political greed of K Street.

We still blame the economic self interest instead of the political self interest. Articles decry the old capitalism and herald the new era of state capitalism. The last time we heralded state capitalism was in Italy in the 1920’s and 30’s.

Crony capitalism was not limited to Fannie Mac and Freddie Mac. There has been a revolving door between Wall Street and Washington for decades. As long as the complicated instruments served the political greed, political leaders were willing to ignore prudent financial principles and assume that the overpaid magicians knew what they were doing.

The financial scandals of the 1980’s, the S&L collapse under George H Bush, the collapse of Long Term Capital in 1998, The collapse of the high tech bubble should have been a warning that high salaries and bonuses are not synonymous with competence.

But the solution is not to promote more crony capitalism, also called state capitalism or my favorite term used in the book “Nudge” (Richard Thaler and Cass Sunstein) , ‘Libertarian Paternalism’  (my vote for oxymoron of the year).

By now we should have learned that when business gets in bed with the government, somebody gets screwed.

The default belief  of our economic history of the last 100 years has been an acceptance of the dynamic growth of capitalism punctuated by excesses of market greed that have to be corrected by the singular wisdom of government regulation.

On closer examination many of those moments of market greed and excess look more like incompetent government meddling caused the problem.

During the Depression of 1929 we saw 10,000 banks collapse in the United States. Yet during that same period the number of bank failures in Canada were zero.  Was Canada spared the depression that engulfed the United States? No, but Canada was spared a regulation that prevented banks from crossing state lines.

Bending to pressure to protect local banks from encountering big business center banks, they got relief and protection from the Federal government in the restriction of interstate competition.  But that also severely limited their flexibility in dealing with a crisis, a limit that did not exist in Canada where risks were spread over larger areas and underutilized assets could be easily relocated.

Yet to respond to the bank failures that the government largely caused they created the FDIC (Federal Deposit Insurance Corporation).  FDR opposed the FDIC because he saw it would create a sanction for reckless behavior and penalize prudently run banks.  FDR capitulated in a compromise and the FDIC began by insuring deposits for $2500 in 1934. It was raised to $5,000 in 1935, $10,000 in 1950 (Truman), $15,000 in 1966 (Johnson), $20,000 in 1968 (LBJ again), $40,000 in 1974 (Nixon), and then $100,000 under Jimmy Carter in 1980.  Bush raised it to $250,000 before he left office, but it is due to revert back to $100,000 in 2013.

Ten years after Carter raised the limit we experienced the Savings and Loans meltdown, caused by the excessive risk taking in that industry. The government again intervened and created the Resolution Trust Corporation (RTC) to dispose of failed thrift institutions taken over by regulators after January 1, 1989 in an orderly manner.

The FDIC created the moral hazard FDR feared. It privatized the profits and socialized the risks.  This behavior was repeated, but on steroids, with the implicit assumption of risk by Fannie Mae and Freddie Mac.

Housing was deemed a federal priority, and helping the poorer people get into housing has been a priority since Fannie Mae was created again by FDR in 1938.  But housing prices were highest and least affordable in select areas where local ordinances had restricted supply and raised prices far more than in areas were market forces prevailed.

Tax policies such as mortgage interest deductions and preferred capital gains treatment increased the demand for housing. The Community Reinvestment Act, passed under Carter but exploited under Clinton and Bush, pressured banks to make mortgage loans to less and less qualified buyers. Fannie Mae guaranteed loans, clearing the ratings agencies which had a government protected franchise; to give higher ratings than these mortgage backed securities could have conceivably obtained on the merits of their assets. This widened the market for these securities and caused even more money to be driven into the housing market from all over the world creating the bubble that had to burst.

To compound the damage the government required a mark to market rule for valuing these mortgage loans at the worst possible time; when no market existed.  The market to market rule causes valuations to go to extremes, high and low.  This caused capital to dry up and regulations required banks to rebuild capital reserves instead of making loans. Then at a time when information was critical to valuing these securities, the government suspended short selling, a critical source of such information.

During the recent financial disaster, Canada did not exhibit near the real estate collapse we did in the United States.  In Canada they had far less exposure to sub prime loans, large down payments were still required while we all but eliminated down payments for the poorest home buyers in the name of ‘compassionate conservatism’, and mortgage borrowers in Canada were still held personally liable for their loans. Canada had tougher and more prudent lending standards, but they avoided the fiasco foisted on us by well intentioned but misguided moral supremacists on the government payroll.

The government in the U.S. inflated this bubble as eagerly as any on Wall Street, but our government “had a much bigger pump”.

Seventy five years ago we could have looked to our northern neighbor and learned better behavior instead of demonizing capitalism. Today we can learn the same lesson, but again we seek to demonize the private sector for conditions created by incompetent government regulation. Wall Street clearly has its demons to account for, but its greed was enabled and often encouraged by incompetent regulations and policy that has a long history.

As we crave more government oversight we should ask who will oversee the government that has demonstrated such spectacular failure.

Studying the financial bubbles we can see several common characteristics.

During the bubble inflation we see markets taken to an extreme by financial greed, but as Walter Sowell so appropriately metaphored on the housing bubble, “blaming the crash on greed is like blaming an airplane crash on gravity”; it is accurate but not very useful. We have had greed with us since the Garden of Eden.  Why does it only seem to rear its head to an extreme only every few years?

We see common sense dissolved in ‘new paradigms’, ‘permanently high plateaus’, ‘irreversible trends’, and ‘progressive thinking.’  Motivated by financial gain we believe whatever will support our belief in the unsupportable.

During the dot.com bubble we accepted billion dollar valuations of companies with no customers, no available products and only promising markets.  As 25 year old entrepreneurs became billionaires we believed that they were smart. There is this common aspect of bubbles that equates wealth with intelligence.  We want to believe that our new wealth is a reflection of our superior insight rather than mere luck.

When these bubbles burst and reality restores common sense we do not want to accept our own foolishness for buying into the speculative fever, we want to blame someone.  The geniuses who adorned the magazine covers as the faces of the bubbles either become villains or fade to obscurity.

In the distant past bubbles were fueled by individual greed buying into bad ideas, or at least good ideas taken to an extreme. But more recently bubbles have been enlarged by government policy.  Beyond just misguided monetary policy, the recent housing bubble was fueled by government policy that added to the demand for housing by pushing programs to help people buy homes who could not afford them.  By eliminating down payments and guaranteeing otherwise obviously risky loans the Government through Fannie Mae and Freddie Mac created one of the biggest bubbles seen to date.

The cover of Newsweek with the picture of Al Gore as “The Thinking Man’s Thinking Man” strikes me as a sign of a new bubble inflating. The subtitle “Al Gore’s new plan for the planet” is the hubris of bubbles.

We never seem to recognize bubbles when we are in the middle of them. They only seem visible when they burst.  Yet the new green industrial complex is growing with massive investments that seem guided more by wishful thinking and paranoia than common sense and reason.

From the administration’s stated belief that green energy will provide the jobs that will lift us out of massive unemployment and recession to the policies that will create the drive to capitalize on the new government direction, we now see massive investment into irrational markets.

Al Gore is the chairman of Generation Investment Management, an investment firm making capital investments in firms with potential to capitalize on the green movement and policies. He is also founder and chairman of the Alliance for Climate Protection, an outfit promoting the green economy. With money from people interested in promoting the public interest of environmentalism, the Alliance for Climate Protection is spending $300 million to promote the lifestyle that will benefit the investments of Al’s firm.

To be sure others besides Al Gore are on Capitol Hill promoting climate bills that will financially benefit their own interests.  Members of the Bush administration were chastised for their oil interests and criticized for letting it influence their policy decisions.  But we are assured that those now promoting their financial interests in their preferred energy sector are altruistic.

Gore is the face of the green industrial complex, but there are many seeking to profit from their foresight and concern to help save the planet. Gore is a genius for getting public policy firms to advertise heavily to support the market for his investments. The best entrepreneurs from the previous bubbles were never able to get $175,000 to make speeches promoting their industry. Gore may be the first green billionaire.

As in previous bubbles skeptics are marginalized, often demonized. As in so many previous bubbles delusional certainty is hurled at skepticism and reason more like an offensive than a defensive weapon . Gore boldly claims, “The debate is over.”

Believers who do not know which end of the test tube the cork goes into post scientific articles to confirm their belief. Confirmation, not information, is the object of their reading.

As I read about the genius of Al Gore on the cover of Newsweek,  I recall the prophetic words of John Kenneth Galbraith in his book , “A Short History of Financial Bubbles,” .

“Genius is before the fall.”

In a New York Times Article Paul Krugman took exception to another who laid blame for the financial crisis on Fannie Mae.  In Contending with Paul Krugman, part II, Charles Lane takes exception to Krugman. An excerpt:

What is the point of trying to absolve Fan-Fred in the first place? To the extent that Krugman is merely trying to show that the real culprits are to be found elsewhere — on Wall Street — then I suppose this is a worthy exercise in some academic sense. But apportioning blame for the Great Panic of 2008 is a bit like trying to figure out “the” cause of World War I. If ever there was an overdetermined historical event, this was it. There’s more than enough blame to go around; everyone should be held accountable.

I can understand why a liberal would want the government to support housing opportunity for low-income people. But I cannot understand why a conscientious liberal would support Fan-Fred. What is “progressive” about a couple of megacorporations populated by highly-paid executives who enriched their shareholders and themselves by exploiting a boatload of special government breaks — from an implicit federal debt guarantee to exemption from state and local taxation? When anyone proposed tighter regulation, such as raising their capital requirements, limiting their product line or anything else, pretty much, Fannie and Freddie mobilized an immense and widely feared Washington lobbying operation, greased with campaign cash.

No, Fannie and Freddie, or their congressional enablers, did not “cause” our current predicament. But they were definitely part of the problem. Over many years, they directly and indirectly encouraged over-investment in single-family housing; and their activities during the bubble contributed to making the bust, when it came, both bigger and more costly to taxpayers than it might have otherwise been.

Fannie Mae alone was not responsible, but it is equally dangerous to absolve its roll.  The more we seek demons and partisan blame the more we miss the systemic causes that need correction, and the more we risk a repeat shortly down the road.