Wednesday, July 16, 2008

Brilliant Blog Post on GSE's by Larry Summers

Courtesy of Creative Capitalism:

Here is a really good creative capitalism idea. All Americans benefit from increases in home ownership because of the values like hard work, community, and respect for property that ownership instills. Families want desperately to own their own homes and accumulate equity. Yet it is very hard for conventional banks that borrow money over the short term to lend over the kind of 30-year horizons that best help families buy houses.

How can the objective of ownership be best supported and how can the most adequate financing be assured? Voila, creative capitalism! How about chartering private companies as government sponsored enterprises with the mission of promoting home ownership affordability? Give them boards with some private representatives and some public representatives. Make clear that government stands behind their capital market innovations so they can borrow more cheaply and pass the savings on. Exempt them from the state local taxes that others pay. Give them specific objectives on affordability that they must meet. Rely on a special government regulator to assure that they balance their social responsibility with their drive to profit. Harness the profit motive to meet a social objective.

This is roughly the rationale behind Fannie Mae and Freddie Mac. I would submit that it is about as good or as bad as most creative capitalism ideas involving joint profit making and social objectives. But one hopes that ee are now witnessing the end of this particular experiment in creative capitalism: the government is moving to pick up the pieces of the mess the GSEs have made and their shareholders are losing most of their money.

What went wrong? The illusion that the companies were doing virtuous work made it impossible to build a political case for serious regulation. When there were social failures the companies always blamed their need to perform for the shareholders. When there were business failures it was always the result of their social obligations. Government budget discipline was not appropriate because it was always emphasized that they were "private companies.” But market discipline was nearly nonexistent given the general perception -- now validated -- that their debt was government backed. Little wonder with gains privatized and losses socialized that the enterprises have gambled their way into financial catastrophe.

I wonder how general the lesson here might be. My fear is fairly general. Inherent in the multiple objectives urged for creative capitalists is a loss of accountability with respect to performance. The sense that the mission is virtuous is always a great club for beating down skeptics. When institutions have special responsibilities it is necessary that they be supported in competition to the detriment of market efficiency.

It is hard in this world to do well. It is hard to do good. When I hear a claim that an institution is going to do both, I reach for my wallet. You should too.

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