Cato on the housing crisis

The Cato Institute's view of the housing bubble and resulting financial crisis:

The housing bubble and its aftermath arose from market distortions created by the Federal Reserve, the government backing of Fannie Mae and Freddie Mac, and the Department of Housing and Urban Development and its Federal Housing Administration. Americans suffered through a severe recession in 2008 and 2009, a downturn unfortunately precipitated by perverse government policies.

Regarding bad decisions made by the private sector, the traditional remedy for severely mistaken investment policies was to shut and dismantle those firms making mistakes to stop the bleeding, to free their assets and personnel to go where they can add value, and to make room for firms with better entrepreneurial ideas. That sort of market restructuring should have been allowed to happen in the U.S. financial sector.

A financial market in which failed enterprises like Freddie Mac or AIG are never shut down is like an American Idol contest in which the poorest singers never go home. The closure of Lehman Brothers (and the near-closure of Merrill Lynch), by raising the interest rate that the market charges to highly leveraged investment banks, forced Goldman Sachs and Morgan Stanley to change their business models drastically. The most effective and appropriate form of business regulation is regulation by profit and loss.

The long-term remedy for the severely mistaken government monetary and regulatory policies that have produced the current financial train wreck is similar. We need to identify and undo policies that distort housing and financial markets, and dismantle failed agencies and departments, such as HUD, whose missions require them to distort markets. We should be guided by recognizing the two chief errors that have been made. First, cheap-money policies by the Federal Reserve do not produce sustainable prosperity. Second, delivering mortgage subsidies by imposing affordable housing mandates on banks and by providing federal support to Fannie Mae and Freddie Mac bonds can backfire in a tragic way that damages the broader economy.