Tag Archives: Freddie Mac

It’s Time to Change the Incentives of Regulators

One of the primary reasons that regulation slows down economic growth is that regulation inhibits innovation.  Another example of that is playing out in real-time.  Julian Hattem at The Hill recently blogged about online educators trying to stop the US Department of Education from preventing the expansion of educational opportunities with regulations.  From Hattem’s post:

Funders and educators trying to spur innovations in online education are complaining that federal regulators are making their jobs more difficult.

John Ebersole, president of the online Excelsior College, said on Monday that Congress and President Obama both were making a point of exploring how the Internet can expand educational opportunities, but that regulators at the Department of Education were making it harder.

“I’m afraid that those folks over at the Departnent of Education see their role as being that of police officers,” he said. “They’re all about creating more and more regulations. No matter how few institutions are involved in particular inappropriate behavior, and there have been some, the solution is to impose regulations on everybody.”

Ebersole has it right – the incentive for people at the Department of Education, and at regulatory agencies in general, is to create more regulations.  Economists sometimes model the government as if it were a machine that benevolently chooses to intervene in markets only when it makes sense. But those models ignore that there are real people inside the machine of government, and people respond to incentives.  Regulations are the product that regulatory agencies create, and employees of those agencies are rewarded with things like plaques (I’ve got three sitting on a shelf in my office, from my days as a regulatory economist at the Department of Transportation), bonuses, and promotions for being on teams that successfully create more regulations.  This is unfortunate, because it inevitably creates pressure to regulate regardless of consequences on things like innovation and economic growth.

A system that rewards people for producing large quantities of some product, regardless of that product’s real value or potential long-term consequences, is a recipe for disaster.  In fact, it sounds reminiscent of the situation of home loan originators in the years leading up to the financial crisis of 2008.  Mortgage origination is the act of making a loan to someone for the purposes of buying a home.  Fannie Mae and Freddie Mac, as well as large commercial and investment banks, would buy mortgages (and the interest that they promised) from home loan originators, the most notorious of which was probably Countrywide Financial (now part of Bank of America).  The originators knew they had a ready buyer for mortgages, including subprime mortgages – that is, mortgages that were relatively riskier and potentially worthless if interest rates rose.  The knowledge that they could quickly turn a profit by originating more loans and selling them to Fannie, Freddie, and some Wall Street firms led many mortgage originators to turn a blind eye to the possibility that many of the loans they made would not be paid back.  That is, the incentives of individuals working in mortgage origination companies led them to produce large quantities of their product, regardless of the product’s real value or potential long-term consequences.  Sound familiar?

“The last thing we can do is go back to the same failed policies that got us into this mess in the first place.”

I’ve heard this a great deal lately. I suspect I’ll hear it even more over the next three months. Whatever could it mean? Presumably, the speaker is worried about the sorts of micro and macro policies that were pursued in the years prior to the Great Recession:

  • Perhaps he thinks it was bad policy for federal spending as a share of GDP to leap from 18.2 percent in 2001 to 25.2 percent in 2009 (this was the largest such increase in ANY 8 year period since WWII).
  • Or perhaps he thinks it was bad that net federal debt went from 32.5 percent of GDP in 2001 to 54.1 percent of GDP in 2009 (a post WWII high).
  • Or maybe the speaker thinks it was ill advised for the Bush Administration to be far more aggressive than its predecessors in pursuing discretionary, Keynesian-style countercycle fiscal policy. There were no fewer than four such measures during the Bush years: cash rebates in 2001, investment incentives known as “bonus depreciation” in early 2002, tax rebates in 2003, and of course, the 2008 stimulus bill which included more rebates.
  • Perhaps the speaker thinks it was a bad idea for the Bush Administration to impose 30 percent tariffs on imported steel.
  • Or maybe he thinks it was bad for the Bush Administration to introduce (an unfunded) Medicare prescription drug benefit, the first major entitlement program since the Great Society.
  • Perhaps he thinks it was bad for the Bush Administration to reintroduce industrial policy by signing the Energy Policy Act of 2005, creating the Department of Energy loan program that ramped-up the government’s adventures in venture capitalism.
  • Perhaps the speaker thinks that in the years leading up to the crisis, monetary policy became unhinged from a restrained, rules-based approach?
  • Or perhaps the speaker thinks that the government sponsored enterprises, Fannie Mae and Freddie Mac, systematically encouraged over-leveraging in the housing industry?
  • Or maybe that capital requirements encouraged investors to load up on mortgage-backed securities.
  • Or maybe he thinks that, once the crisis hit, the Bush Administration shouldn’t have undertaken the most comprehensive and far-reaching bailout of private industry in U.S. history, one that resulted in the federal government buying stake in or bailing out hundreds of financial firms.
  • It must be that the speaker was worried that in aggregate these policies had seriously undermined the economic freedom of the U.S., as evidenced by the precipitous fall in measured economic freedom from 2001 to 2009:

If this is what the speaker was getting at, then I couldn’t agree more! Hopefully, he’s proposing ideas to reverse course: spending reductions to bring spending in line with taxation, entitlement reform to put the nation’s budget on a sustainable course, tax reform to close loopholes and reduce rates such as the corporate tax rate, financial reforms to finally end too big to fail, regulatory reforms to reduce distortions in the marketplace, health care reforms so that market forces can actually operate in that industry, and other economic reforms to restore a level playing field in American business.

….Or, maybe the speaker is just focusing on one policy that marginally moved the nation in a market direction, the temporary reduction of all personal income tax rates, including the top marginal rate from 39.6 percent to (gasp!) 35 percent. And maybe the speaker is hoping that no one will notice that on just about every other policy dimension, the previous administration was anything but laissez faire.