Wednesday, August 19, 2009

*Economics In One Lesson*

Even though it first appeared in 1946, Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics by Henry Hazlitt has some fascinating things to say about events happening right now. I was particularly struck by this:
Government guaranteed mortgages, especially when a negligible down payment or no down payment whatsoever is required, inevitably mean more bad loans than otherwise....They encourage people to "buy" houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared to other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief, in the long run they do not increase overall national production but encourage malinvestment.
At first glance I thought this was incredibly prescient. But then I had second thoughts. After all, it isn't the government guaranteed loans that have gone bad in the latest crisis. Otherwise banks wouldn't have toxic assets. They would be made whole by government guarantees and it is the government that would have the toxic assets. (They do anyway, but that is a function of the response the current crisis.)

On the other hand, it's not that hard to argue that government guarantees distort the market; and it is these distortions that started us down the path of ruinous activity in the mortgage markets. Activity whose negative effects eventually spilled over into other parts of the economy.

In light of recent history though, Hazlitt is far too optimistic about the private market's ability to avoid the negative consequences outlined above, which he sees as the outcome of government intervention only. His confidence in the market seems thoroughly misplaced when he writes:
Most lenders, therefore, investigate any proposal carefully before they risk their own money in it.... The private money will be invested only where repayment with interest or profit is definitely expected.
He was right about the expected profit part; but lenders weren't counting on repayment in order to obtain their profit. It wasn't the government extending loans to people with no realistic chance of repayment, it was the private mortgage industry. It wasn't the government giving mortgages to people who provided no documentation as to income or credit history, it was the private mortgage industry.

The proliferation of liar loans and incredibly stupid behavior by so many involved in mortgage transactions however, does not mean that Hazlitt was wrong about the consequences of government intervention; but it is clear that his notions about the free market's ability to avoid such negative outcomes seems outdated.

What isn't diminished at all and is, in fact, reinforced by the latest economic crisis is what Hazlitt calls the single lesson that contains the whole of economics:
The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.
It is absolutely clear that many in the financial industry were either ignorant of or willfully disregarded this simple notion. It is demonstrable almost to the point of being indisputable that much of the financial activity in our recent past consisted of the pursuit of narrowly focused short term profit with little or no thought given to the "longer effects" or the consequences "not merely for one group but for all groups."

Finding a way to teach both our government and our industries Hazlitt's lesson, and getting them to put it into action, is essential to our future prosperity and our continued economic security.

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