Financial Socialism: Yes We Can
November 13, 2008 10 Comments
The recent financial troubles have opened debates in certain quarters about something called “capitalism”. Do the bailouts mean the end of “capitalism”? Did the “free market” fail? Does this prove socialism is better?
I have some problems with the terms of this debate. For one thing, I think I agree with a point often made by James Bowman that there’s really no such thing as “capitalism”. There’s no “ism” about “capital” that embodies a philosophy or ideology that anyone seriously subscribes to. Bowman suggests that the term “capitalism” was an invention of early socialists, a label they could slap on what they opposed (primarily, private property) so they could oppose it more effectively. I suspect he is right.
If you think about it, what gets called “capitalism”, in most discussions, is really just freedom. Am I free to give you X in exchange for Y? Are you free to give me Y in return? All most “capitalists” really want is for the answer to be yes. That is not any kind all-pervading ideology about “capital” that justifies glorifying it with a separate “ism”; all that “capitalists” (such as myself) are saying is that people should be free to exchange their stuff with each other if they wanna. Don’t call me a fricking “capitalist” just for that, for crissakes. If anything, I’m a freedomist. If person 1 has X and wants Y more, and person 2 has Y and wants X more, and they decide to swap X and Y, then freaking LET THEM for crying out loud.
The people who espouse this supposedly antiquated and hard-to-defend concept (let them!) get called “capitalists” and are often painted as somehow evil and uncaring. The people who postulate that person 1 and person 2 sometimes shouldn’t be allowed to swap X and Y even if they wanna, well they get called enlightened or “liberal” or “progressive”. It’s truly bizarre, this inversion of language that has taken place. Somehow a person who wants to butt in and say “you guys, NO, you CAN’T swap X and Y, because I don’t want you to!!” is called a “liberal”.
Anyway, I’ve gotten sidetracked. My point is just that I find these debates to be loaded, misleading, and irritating from the get-go.
But a more specific issue came up in private email discussions with a friend recently. The subject was the bailout of (we thought, at the time) the securities market, and what that meant for the free market. Were banks now being socialized? Was this national socialism? Was this the end of the free market?
In answering, I came up with a crazy hypothesis about the mortgage market that I’m afraid may actually be more correct than not: the mortgage market already was socialist, and had been for several decades.
Here’s the way that mortgage bonds seem to work, based on the on-the-job crash course I’ve had the past year. (This is not particularly original and I believe Arnold Kling regularly makes many of the same points.) Anyway, Local Bank makes a loan to a borrower who meets criteria XYZ (these criteria have to do with FICO and loan-to-value and such; details aren’t that important except to note in passing that they are numerical and, obviously, can be – and are – gamed). Is this because Local Bank thought making a loan to the borrower was a great idea and they objectively liked the cash flows they’d be getting from the borrower? And, did Local Bank create criteria XYZ themselves, as a guideline for loans they’d be willing to take on balance sheet?
In a truly free market, the answers would seem to have to be yes and yes. In reality, the answers are no and no. Criteria XYZ are actually specified by a quasi-private corporation, really an off-balance-sheet (but of course, now on balance-sheet) government agency, called FNMA or “Fannie Mae”, which says to Local Bank and all Local Banks like it: “If you make loans satisfying criteria XYZ, we’ll automatically buy them, sight unseen.” And of course, that’s why the Local Bank did it; because a
government agency “government-sponsored enterprise” has been standing there, since the 1930s, ready to reimburse the Local Bank for making that loan, while letting the Local Bank keep a fee for their trouble. Free market!? So far, looks more like a funding subsidy. As a side note, yes Fannie was created during the New Deal. And if you ask Wall Street mortgage types why it should exist at all, you’ll likely hear something mumbled about ‘affordable housing’.
Yeah, housing sure has been ‘affordable’ these past 20 years has it not?
Anyway, it gets better.
Once the loan is delivered into a “qualifying” pool (i.e. meeting criteria XYZ) of loans, all bought by Fannie Mae (or possibly Freddie Mac, created later in the ’70s to “compete” with Fannie), it gets “securitized” and wrapped. In English this just means that investors can buy a stake in the cash flows of the loan pool, and Fannie guarantees against losses. If the borrowers in the loan pool start welching on their mortgages, Fannie – i.e., taxpayers – will make up the difference out of pocket. So this is actually more like a direct subsidy to cash-strapped homeowners from the government, funneled through banks. Free market!??
Now wait though. Why would investors want to buy a mortgage bond rather than just the loans themselves? Why would banks want to package and sell their loans this way? The texts all talk about leverage and being able to spread risk and participate in a more-predictable cash flow, but two things here are key: 1. the need to create “AAA”-rated securities because many investor types are only allowed to buy “AAA”. This is often a regulation at the government level, e.g. for state pension funds. (Free market?) 2. more importantly: because of capital requirements. Keeping a loan on your balance sheet causes the fedgov to charge you more “capital” than if you are able to securitize that loan and put it into a “vehicle”. These are insidery terms that I do not understand fully myself but the jist is: the federal government has regulations that, intentionally or not, give banks an incentive to turn loans into ‘securities’. (Much credit for making me aware of this to Arnold Kling.) So banks are just gaming the labyrinth of regulations that currently exist, best they can. They intentionally do X instead of Y not because X is inherently more profitable, but because a government regulation penalizes them and their ability to do business if they do Y. This is a free market?!?
Anyway, whatever the motive/incentives, once securitized, the loan pool becomes a bond and is traded on Wall Street. Here it becomes slice and diced, repackaged and resold, etc etc. Sexy! This is the part everyone seems to focus on when they talk about a “free market”, and this is the part whose failure is supposedly the death knell of same. Yes, there seems to be a “free market” in trading these products of huge amounts of government subsidy and regulation, in which those investment banks and hedge funds that are able to have better trading strategies (and of course more tricky slice ‘n dice strategies) are able to pocket profits from these government-subsidized products.
So my point was this. Suppose none of any of this existed and you wanted to set up a socialist program from scratch to fund housing in America. In the old-style USSR type system this might mean setting up a big government agency, with a giant budget, and then having the agency’s employees spend their days figuring out how to directly distribute the money/capital for people to buy homes. Or for builders to build them. Writing regulations and such, rules about who gets (qualifies for?) what homes where. Moving housing allocation from one district to another as overbuilding or underbuilding became evident. And so on. In the process they would surely amass a large amount of statistics, build models of income and employment and housing values, make projections of defaults and moves, reallocate funds/attention/capital/diktats from here to there, etc.
What many of those people would be doing with their days wouldn’t be all that different from what, say, mortgage-bond researchers at investment banks do with their days. And the net effect of their diktats would be similar to the net effect of what traders accomplish by selling bond A (say, a bond backed by too many Florida loans) and buying bond B (a bond backed by more diversified loans..). So if you wanted to build up this socialist program, and were creative and not too dogmatic about the egalitarian part of socialism, you might just wind up creating something like…..like what we have. Researchers, model-builders, and traders, all given personal incentives to allocate socialist distribution of housing more efficiently.
This led to my crazy hypothesis: our system for housing is, and has been for a long long time, a socialist one. There’s one key difference. Socialism has, notoriously, a “calculation problem” – under socialism the market is not free and so price discovery doesn’t take place. This is why you get bread lines on the one hand and overfilled warehouses full of shoes nobody wants on the other; the socialist bureaucrats, being so centralized, have an inherent difficulty in figuring out how and where to allocate resources.
So in the “capitalist” West, we’ve solved the socialist calculation problem, by letting Wall Street traders do it. And pocket a cut of the take. My theory, in short, is that the mortgage-bond market functions as the distribution/allocation system for what is an inherently socialist housing system.
Of course, we haven’t really solved the calculation problem, because as we have seen, Wall Street has done a notoriously bad job at pricing housing in the U.S. – overvaluing it by a huge amount in the past 20 years. That is after all why we now see the correction as a crash. But this gets to the heart of the matter; this bubble and crash, was it a failure of “capitalism” and the “free market”?
Or was it, instead, a failure of a socialist system piggybacking onto Wall Street (and the shadow financial system) as its distribution method? Because that, and not a “capitalist” “free market” is what we actually seem to have in practice. In some regards we have a socialism that is administered not by commissars who take bribes under the table but by financiers who take a huge cut out in the open; we have financial socialism.
This possibility is worth keeping in mind in the near future, because with the new administration taking office and a strengthened (D) majority, we are likely to be bombarded with political proposals for what will amount to yet more financial socialist proposals – proposals to achieve some socialist distribution, or end, by means of piggybacking off of (and in the process, enriching) the financial sector. “Cap and trade” proposals, e.g. capping ‘carbon’ output and then issuing tradeable ‘credits’, are the perfect example of this synergy between socialists and financiers; the latter are only too happy to have a new thing to trade (and pay themselves huge bonuses for trading) if only the former will write the onerous regulations that will make the creation of the artificially-spawned ‘assets’ necessary. There is no end to the pyramid schemes one can imagine by repeating this game over and over again – as long as enough people with capital to burn in the world are willing to play along. China was the mark when it came to U.S. housing bonds, now all we need to figure out is who’s got the spare cash to buy up ‘carbon credits’?
Meanwhile, don’t look now, but Obama won among the rich. Who’s the real party of the rich? Why are the rich so socialist nowadays anyway?
Because socialism pays. At least, it does the way we do it.
Where am I going with all this? Like I said: it’s just a crazy theory. I only half-believe it at the moment. But maybe the West won the Cold War not by resisting, fighting, and arguing against socialism; maybe we won it by figuring out a way to do it better and (for some of us, i.e. (D)s and (D)-supporters) to get rich in the process.
UPDATE: Good related post here.