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 September 2011 The Beloved Misallocation Misguiding the Invisible Hand
There are two aspects to the concept of market equilibrium. First, is the idea that individuals act in their own perceived best interest when both buying and selling. That's the key surprise in the theory in that everyone acting in their own interest results in pricing that is best for all. They aren't forced to seek the most utilitarian price, it happens naturally in a free market. And that's the second critical concept -- equilibrium will only naturally happen if there are no impediments to production and demand. An equilibrium price will still be established if the government intervenes through tax policy or regulation, but it won't be the same, stable equilibrium that would be attained in a truly free market. The Federal Reserve's recently completed quantitative easing two (QE2) is good example. In an effort to stimulate a sluggish economy, the Fed announced it would purchase $600 billion in government and mortgage-backed securities in the open market between January and June 2011. Each purchase added to the money supply driving up the number of dollars in circulation while simultaneously driving down their value. As a result, the dollar sank versus foreign currencies while commodities, typically priced in falling dollars, soared. In this case, both the credit and commodity markets saw prices distorted by government intervention. The effects of QE2 were fairly obvious, but there are other distortions investors may not realize. One of the greatest -- and most beloved -- is the federal tax deduction for homeowner mortgage interest. On its face, it appears innocuous enough, but as we saw in the 2007-2008 credit crisis, its good intentions can't offset its negative consequences in the broad economy.
Good Intentions Politicians realize this so it's no surprise that tax reform discussions always leave the home mortgage interest deduction off the table. No career politician in his or her right mind wants to go on record alienating the middle class voters who will ultimately determine who wins the next election. Just as Social Security has become the most Beloved Ponzi Scheme, the home mortgage interest deduction has become the Most Beloved Market Distortion. Don't misunderstand, calling it a market distortion doesn't condemn those taking the deduction, they're simply acting rationally in their own self-interest. Adam Smith would approve of this part of the equation. What he'd find questionable is the fact that the deduction exists at all. That's the problem. Homeownership is often cast at "The American Dream". By offering a tax deduction on mortgage interest, the government is attempting to help individuals achieve that dream. Without question, the intentions behind the deduction are good, but as mentioned earlier, the intention doesn't change the fact that it's a distorts the market. As the recent credit crisis so clearly illustrated, it not only distorts the real estate market, it adversely affects the credit and yes, even equity, market as well.
The Dream Becomes a Nightmare
Behind the scenes, the invisible hand was being misdirected. With interest rates moderating, individuals found they could qualify for larger loans even when their income remained unchanged. Some had less than spotless credit backgrounds, so sub-prime lenders sprung up to meet the demand. Although they charged above-market interest rates, they provided little protection if borrowers could not make payments. Nevertheless, more individuals were drawn into home ownership. Congress saw yet another way to curry favor with constituents. Realizing lower rates were making home ownership more affordable to lower income workers, Congress ordered quasi-governmental Fannie Mae and Freddie Mac to push banks to make more loans to them. With Congress regulating them, Fannie and Freddie were willing to comply. Although lenders making sub-prime loans were happy to collect the fees and issue the debt, they were less interested in servicing it. By packaging it up and selling it with other loans of higher quality, they could get it off their books at a profit, more cynically, before it went bad. Wall Street helped package and sell the resultant mortgage backed securities (MBS) to individuals and institutions. It wasn't a tough sale because investors were looking for higher yields than could be attained from super safe Treasury securities. Ironically, the strong demand for MBS actually kept their yields lower than they would have normally been. Many realized MBS were riskier than direct government debt, but believed the fact they were comingled loans of different quality would help minimize the risk. Not only that they, too, believed real estate prices would always go up. Homebuilders helped perpetuate this belief. Thanks to high demand made even higher by the growth of the sub-prime markets, homebuilders were enjoying quite a boom. As more and more properties sold, they sought new, and bigger projects. Analysts questioned their aggressive moves, yet they were rebuffed by homebuilders' CEOs and CFOs who projected rising sales throughout the near future. By 2007, the real estate bubble resulted in critical market distortions:
For those caught up in it, this American Dream became a nightmare when variable rate real estate loans reached the point where they would be reset. Interest rates has risen slightly, yet enough to cause the new rates to be out of reach for many sub-prime borrowers. As defaults began to rise, investors came face to face with the real risk in their MBS. It wasn't just individuals coming to this realization, it was institutions, too, many of which had not only bought and sold MBS, but derivatives based on them as well. Like all bubbles, once the first small hole emerges, the collapse begins and accelerates. By the fall of 2007, it wasn't just low-credit quality borrowers defaulting and/or declaring bankruptcy, it was also sub-prime lenders, banks, and even Lehman Brothers. Other major financial institutions were also on the precipice, but the government stepped in to save the likes of AIG and Merrill Lynch (now part of Bank of America as a result). At that point, credit suddenly dried up with no lender trusting any borrower. Homeowners saw rosy projections turned into deep losses in just a quarter or two. Those future profit estimates became loss projections as far as the eye could see. The housing market and its participants whether they be builders, suppliers, borrowers, or lenders have not still not recovered in late 2011.
Causes and Remedies Then again, perhaps none of this would have happened if individuals weren't encouraged to buy as much house as they could possibly afford. Not only that, that juicy mortgage interest deduction has always been a big incentive. "Your house is your best investment with Uncle Sam picking up part of the tab." Certainly you've heard pitches to that effect. Would any of this have happened if there was a major tax deduction for rent paid? So here's a question to ponder, and yes, it's heretical: Why does the U.S. tax code subsidize home ownership? It may the American Dream but so is being prosperous and successful yet the tax code certainly doesn't subsidize those desires. Homeownership is not a necessity and to tell the truth, it's hard to see how it's in the nation's interest to single it out for special treatment. One might think the tax dollars lost for this would be better spent as deductions for medical expenses or student loans. For a growing number of U.S. taxpayers the latter are more necessities than owning an abode. Of course nothing will ever change in this regard. There are certain laws that have tremendous support across a wide range of taxpayers/voters, that once initiated, they will never completely go away. Social Security and Medicare are two other examples. No matter how much of a burden they impose on today's workers or how insolvent they become, they will always have a broad constituency that will never let them go. As long as the tax code doles out breaks for mortgage interest paid, taxpayers can't be faulted for taking advantage. But when capital is as misallocated as it became in 2007, let's not blame the bankers or the homebuilders. Like the taxpayers taking advantage of the deduction, they're simply availing themselves of the opportunity to profit. That's that self-interest Adam Smith talked about and it's the same for the home buyers and investment bankers. If you misdirect the invisible hand, it comes back to slap you. Search this site! Just enter you key word or words:
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LASSICAL MACROECONOMICS IS BASED on Adam Smith's belief that free markets always tend toward equilibrium. Smith famously stated this concept his Wealth of Nations (1776) through an analogy of an "invisible hand" leading self-interested market participants to price their goods at levels where supply precisely met demand, what's come to be known as "market equilibrium". Any deviation from this price level will lead to over-production (excess supply) or shortages (excess demand). Although today's politicians tend to be more Keynesian, there are striking examples where fiscal policy clearly directs (or even ties) the invisible hand, leading to precisely the results Smith would have predicted.
