The Clinton Housing Bubble
December 18, 2007; Page A20
The joint housing and mortgage-market crisis once again reminds us that all financial implosions stem from the same cause: borrowing short and lending long without enough equity to weather periodic storms in the gap between.
But this bubble was different. Besides being fueled by housing purchases and repackaged loans, each with inadequate equity -- doubling down with other people's money -- at the end of the capital-gains rainbow was the right to take up to $500,000 of profit, tax free.
Thank you President Bill Clinton for your 1997 action, applauded by the banks, the realtors and all citizens in search of half-millionaire status from an investment they could understand and self deceptively believe to be low risk; thank you for fueling the mother of all housing bubbles; thank you for enabling so many of us who bought second or third homes, and homes before construction began, which we then sold to someone else who dreamed of riches from owning homes long enough to sell to another fool.
Once again, try as we might and in spite of our political rhetoric, we have failed to help the poor in applauding government action intended to help ourselves.
The consumption binge is now over, and there is more than enough blame and souring loans to spread around. Congress, if its members can stop squabbling, wants desperately to sanctify it all with actions sure to launch at some future date the grandmother of all housing and mortgage-market bubbles. This august body has long forgotten that it set the stage for housing bubbles by creating those implicitly taxpayer-backed agencies, Fannie Mae and Freddie Mac, as housing lenders of last resort.
Financial market innovators who invented securitization as a mechanism for creating a liquid national market for mortgages are now criticized for having caused an "agency problem." This is jargon for management not having good incentives to provide investors with "truth in packaging" of the underlying economic risk. But what does truth matter at the height of a bubble? These critics would solve the agency problem with more government regulation. Excuse me, but does not the political process have the biggest agency problem of all?
The Federal Reserve, with a default-risk tiger by the tail, feels handcuffed by its accountability and responsibility for avoiding a cascade of defaults in the highest quality obligations, as well as the bad investments seeking an asymmetric tax-free profit. Shades of Long Term Capital, the Savings and Loan crisis, and heyday of the myth of Portfolio Insurance -- historical cases of borrowing short to lend for what may turn out to be longer than expected. They are all conditioned on the existence of liquidity for sellers that can dry up with frightening speed.
Consequently we have the "independent" Fed being driven by market forces to accommodate the long-evident and glaringly least-defensible features of the housing/mortgage markets. Moreover, the moment the Fed abandoned its stance against inflation, the dollar, gold, oil and commodity prices signaled inflation, and now two months later consumer prices have confirmed the signal.
More daring than the action to exempt real estate from the capital gains tax -- and in lasting service to the poor -- would have been actions allowing capital gains on all assets to go tax free, provided that the capital was reinvested -- i.e., not consumed, and yes, good citizens, housing counts as consumption.
Unlike the latest housing bubble, the stock market "excesses" of the 1990s financed thousands of new ventures, some of which found innovative ways to manage the proliferation of new technologies. The result: astonishing, long-term increases in productivity still evident in the most recent quarter.
Adam Smith in his "The Theory of Moral Sentiments" (1759) saw the subtle truth that consumption by the rich has little effect on the welfare of the poor. That's because the income of the rich is largely invested in the tools and knowledge of production, which provide future long-term value for everyone: "The rich only select from the heap what is most precious and agreeable . . . though they mean only their own conveniency . . . [and] . . . the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements."
Expenditures on housing construction are not "improvements" yielding increased productivity and future new wealth to be divided with the poor. They are more akin to satisfying government-subsidized vanity.
Mr. Smith, a professor of law and economics at George Mason University, is the 2002 Nobel Laureate in economics.