Moralizing Our Way To Financial Debacle

THE BE YOUR OWN ECONOMIST ® BLOG

The following op-ed piece appeared in Tuesday, September 16th's edition of the San Francisco Chronicle, before the collapse and federal takeover of AIG.

Monday’s financial meltdown brought an analogous parable to mind.

Suppose your local fire department sold cigarettes and bedroom furniture, but refused to fight fires caused by smoking in bed. When the fire fighters arrived at the blazing home of a bedtime smoker, they returned to the firehouse without extinguishing the blaze. Their rationale: Avoid moral hazard. Don’t reward bad behavior. Their reasoning: We sell cigarettes and beds. We don’t tell people to smoke in bed.

You can imagine the neighbors’ reaction as the blaze leaped from structure to structure and the entire block went up in smoke. The fire fighters might say, “We don’t want to encourage smoking in bed, so we won’t fight those fires.” The neighbors would say, “Extinguish the blaze now. Make the moral case later.”

This metaphor reminds us of the federal government’s handling of the housing debacle. Lehman Brothers and Merrill Lynch are the latest victims. Fannie Mae, Freddie Mac and Bear Stearns preceded them. Are Washington Mutual and AIG next? And this short list does not include the hundreds of thousand of homeowners hit by foreclosure or the millions more struggling with debts they can not repay. Nor does it mention growing unemployment as the consequent recession unfolds and the trillion dollars of federal deficit that will arise due to that recession.

Federal authorities initiated the real-estate boom by depressing mortgage interest rates. Then they exacerbated conditions by refusing to adequately regulate mortgage-lending practices. The result: An unprecedented and unsustainable increase in real-estate values egged on by greed, skullduggery and tomfoolery. Then, when the boom went bust and home prices began to collapse, the federal government declined to come to the rescue of borrowers and lenders that the authorities deemed unworthy. The authorities invoked the doctrine of moral hazard, saying they did not want to use taxpayers’ money to reward bad behavior. “No bailouts” became a rallying cry and assistance was restricted to those borrowers least likely to lose their homes.

But where has this moralizing left us? We have lurched from one crisis to another, and still there is no end in sight. Abandoned dwellings blight neighborhoods, depressing the value of nearby structures. Home prices continue to fall, tempting ever-larger numbers of owners to walk away and leave their unpaid mortgages in the banks’ hands. Financial institutions fall like dominoes, creating additional turmoil in capital markets.

Suppose, instead, that the federal government had moved early and aggressively to assist borrowers and lenders facing foreclosure. The federal government could have reimbursed lenders who wrote down distressed mortgages to affordable levels. Assistance could have been restricted to homeowners living in primary residences, thereby excluding speculators, multiple-home owners and vacation-home owners. A way could have been found – such as a means test – to exclude those who falsely claimed inability to pay.

This would have stopped the runaway foreclosures, permitted homeowners to remain in their homes and eased the stress in financial markets. Home prices would have fallen, but much of the collateral damage could have been avoided.

But what about the moral hazard? Wouldn’t this plan assist those who had borrowed foolishly and wouldn’t it aid institutions that had loaned unwisely? Yes it would, But keep in mind the federal complicity in the real-estate mania. And, speaking of undeserving, also recall that the federal government’s economic-stimulus package issued tax rebates to almost every one. Is it possible that some of those beneficiaries are no more deserving than the stressed homeowners and mortgage lenders?

The real-estate collapse was ground zero for the current economic crisis. We could have focused relief on its immediate victims – both borrowers and lenders - rather than spread the tax rebates to those unaffected by the real-estate collapse. This may have curtailed the debacle. Now the federal government faces massive deficits as the resulting recession unfolds. Perhaps those deficits could have been mitigated with a bailout that risked a little moral hazard.

© 2008 Michael B. Lehmann