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Why Adding Bureaucracy Won't Halt the Housing Market Blues

Housing-Market / US Housing Jan 06, 2010 - 05:42 AM GMT

By: Money_Morning

Housing-Market

Best Financial Markets Analysis ArticleMartin Hutchinson writes: U.S. Federal Reserve Chairman Ben Bernanke's latest thesis is that the home mortgage bubble had little to do with record low interest rates, and was actually much more a problem of regulation.


It sounds plausible - until you give it some real thought. After all, I believe that humanity has already tried a system with tight, vigorously enforced regulations, and no price mechanism.

It was called the Soviet Union.

Okay, that was a bit of a cheap shot - to some extent. Bernanke stated that "borrowers chose and were extended mortgages that they could not be expected to service over the longer term." That appears to make the problem one of regulation: The types of mortgages that banks should be permitted to offer should be limited to ones that borrowers have a reasonable chance of servicing.

In theory this makes sense. However, it is a prime example of what I in the past have referred to as the "Keynesian Bureaucrat Fallacy," or KBF.

Under the KBF, wise bureaucrats - who, like economist John Maynard Keynes, were presumably educated at Cambridge and steeped in the traditions of the Bloomsbury Group - will decide the appropriate regulations for every sphere of the economy.

They will then enforce them with draconian rigor, forcing the economy to behave in a way that optimizes economic welfare, measured by whatever means the bureaucrats devise. Irrational market-based signals - such as the price mechanism, will be ignored - unless the bureaucrats decide it is safe to take account of them.

Keynes would claim that the Soviet Union never tried his theories. Technically, he was correct. In that unhappy society, there was far too much corruption, far too much vodka, far too much cruelty and not nearly enough wisdom for Keynes and his Bloomsbury Group soul mates ever to find it truly congenial. After all, Keynes' wife - the ballerina Lydia Lopokova - was herself a refugee from the Soviet "paradise."

Nevertheless, the problem lay not in the Soviets' flawed implementation of Keynes' dirigiste fantasies, but in the theory itself. As such post-Keynes "public choice" economists as Nobelist James M. Buchanan have discovered, you simply can't get good enough bureaucrats for the Keynesian system to work.

In real life, the bureaucrats themselves have objectives of power, control and ideology that prevent them from imposing the wise regulations that Keynes would prefer. Government bureaucracies aren't all-knowing umpires of the economic market. In fact, the bureaucracies are actually participants in that market. And they are as driven by their own private objectives as any businessman or trader. Corruption is just the most obvious of the myriad problems that occur in practice.

Once you accept this reality, the theory falls down.

Writing regulations governing what kind of home mortgages people are allowed is thus impossible, without defining the product so narrowly you restrict necessary choice. In general, in any kind of free market, you have to rely on the rationality of both parties to the transaction. Banks will normally only write home mortgage loans if they think they will get repaid. And borrowers will only take them out if they think the house they are buying is fairly priced and they are confident of being able to service the debt. Provided the market is not irrationally exuberant or irrationally fearful, dodgy home mortgages will be only a minor problem.

However, we do know that interest rates and money supply have a huge effect on the housing market. And we knew this before 2002, despite what Bernanke and Fed-chairman predecessor Alan Greenspan would have us believe.

Allowing rates to get too low and money to slosh all over the place may not cause inflation - if, at the same time, China is manufacturing up a storm and lowering costs in other parts of the economy. But the artificially low rates will certainly raise what Keynes liked to call the "animal spirits" of borrowers and lenders.

And that will cause those borrowers to behave irrationally.

Borrowers will take out silly mortgages because they think house prices will rise and bail them out. And brokers will see the chance of quick commissions - even if the loans are not repaid - because rising house prices will make the loans good.

I understand Bernanke's wish to absolve himself of blame. But his preference for putting in more regulations over allowing the price mechanism of interest rates to work in the housing market didn't work when Gosplan (Russia's central economic planning commission) tried it, and it won't work now.

Now more than ever, it's obvious we need a new Fed chairman. Let's hope the U.S. Senate in a couple of weeks does its duty to the U.S. economy and votes Bernanke down.

[ Editor's Note : Some experts have labeled the U.S. bailout as "Bernanke's Folly" - and with reason: With all the debt the United States has taken on, the country is facing a financial mess that will take years to fix. But investors who are willing to act boldly and invest decisively will find an unparalleled profit opportunity hidden behind the piles of financial refuse.

With his Permanent Wealth Investor trading service, longtime global investment banker Martin Hutchinson has time and again demonstrated the ability to ferret out those profit moves. With a combination of gold, hefty dividend payers and stocks that are ready to rocket, Hutchinson has already secured windfalls for subscribers. To find out about Hutchinson's latest moves, please click here.]

Source:http://moneymorning.com/2010/01/06/bernanke-housing-bubble/

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