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What caused the housing crisis? Perverse government incentives.

Form an academic paper by George Mason University Economics Professor Russell Roberts:

Beginning in the mid-1990s, home prices in many American cities began a decade-long climb that proved to be an irresistible opportunity for investors. Along the way, a lot of people made a great deal of money. But by the end of the first decade of the twenty- first century, too many of these investments turned out to be much riskier than many people had thought. Homeowners lost their houses, financial institutions imploded, and the entire financial system was in turmoil.

How did this happen? Whose fault was it? Some blame capitalism for being inherently unstable. Some blame Wall Street for its greed, hubris, and stupidity. But greed, hubris, and stupidity are always with us. What changed in recent years that created such a destructive set of decisions that culminated in the collapse of the housing market and the financial system?

In this paper, I argue that public-policy decisions have perverted the incentives that naturally create stability in financial markets and the market for housing. Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.

In the United States we like to believe we are a capitalist society based on individual responsibility. But we are what we do. Not what we say we are. Not what we wish to be. But what we do. And what we do in the United States is make it easy to gamble with other people’s money—particularly borrowed money—by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives. We must return to the natural incentives of profit and loss if we want to prevent future crises.

Related posts:
  • “If government doesn’t steer capital into housing, the capital doesn’t disappear; it could fund other job-creating businesses.”
  • What could be worse than Uncle Sam as the nation’s mortgage monopolist? How about Uncle Sam the monopoly landlord?
  • Obama’s “plan” for Fannie and Freddie? It’s FHA, as it turns out.

  • 2 comments

    2 Comments so far

    1. Dwight (Matt) Mathews May 26th, 2010 12:12 pm

      Great Post Greg!

      All I can say is; Good luck with that!!

      As long as there is Greed in our Genes, society will continue on until there is no tomorrow!

    2. Don Reedy May 26th, 2010 2:21 pm

      Consequences

      This word, the lack of which you describe above, means that things “follow” from actions that occur before.

      What followed in the decline and fall of the housing market was indeed the lack of any real consequence following on the heels of undue risk. Well, why stop there? I should say any on the heels of downright lies, damn lies, schemes, and greed.

      I trust that all the platitudes in the world cannot improve on the simple truth in your post; to wit, that what follows folly is failure.