Part III - Defending the Government by Misunderstanding Economic Fundamentals
The fundamental flaw in Paul Krugman's defense of the government in the housing bubble is he attempts to draw a distinction between the losses suffered by Fannie and Freddie on their conforming loans, and the losses suffered by the private mortgage companies on their loan portfolios. What Krugman - and HUD Secretary Donovan for that matter - are saying is the reckless business practices of one market participant can't affect the profitability or soundness of other companies competing in that same market.
Even by the standards of what passes for economic thought these days it is a pretty silly argument. Moreover, even by the standards for economic insight that Ivy League economics professors, the New York Times and housing secretaries are known for, it is also an argument that betrays a massive misunderstanding of how markets work. Essentially, the defenders of the GSEs are claiming that the actions of the most dominant company in a market can't affect the profitability of other companies in that same market. A review of both the airline industry and the market for long-distances telephone service in the late 1990's will show how silly this argument is.
There is a saying in the airline industry attributed to Gordon Bethune, former chairman of Continental Airlines. It states, "You are only as smart as your dumbest competitor." For discussion purposes, assume you operate an airline and a competitor starts to offer flights between New York and Los Angeles for $75. The average airline passenger won't draw a distinction between carriers in terms of service. If one carrier is offering lower fares between the same cities, then the average airline passenger will almost always fly on the airline offering lower fares. With so much of your costs fixed and tied up in salaries and aircraft, you will be forced to compete with these lower prices. Your cost structure may not allow you to meet your competitor's fares, but you will have to reduce your fares to compete.
This simple dynamic explains the boom and bust cycle the airline industry is known for. The entrant of a single competitor dedicated to lowering prices to increase market share will change the business conditions for all the airlines it competes with. Consequently, for most airlines the most widely traveled route is the one in and out of bankruptcy court! There is a saying in the investment community that states, "If the Wright brothers had any idea of how much money would be lost by airline companies, they never would have invented the airplane."
Another example of how the incompetence of one company can impact the profitability of an entire industry is provided by WorldCom during the tech bubble. WorldCom competed in an industry that doesn't even exist today - long-distance telephone service. Nevertheless, during the 1990s it was a huge industry, and among the players in it besides WorldCom were AT&T and Sprint. WorldCom began to offer very low rates for long-distance service. Like the airline industry, the companies in the long-distance market could not distinguish themselves in any way other than price.
Once WorldCom lowered its prices other long-distance companies had to as well. At the risk of introducing the fallacy of the false-choice, it is not a stretch to say that the only alternative for the other long-distance companies was to keep their long-distance rates and lose most of their customers in the process. It turned out WorldCom was a complete fraud and not even a legitimate company. Because they weren't a Wall Street bank, WorldCom's CEO, Bernie Ebbers, was sent to jail for fraud. WorldCom eventually collapsed in a massive scandal of accounting fraud and executive corruption - not altogether unlike the collapse of Fannie Mae and Freddie Mac. Before it collapsed however, WorldCom forced other market participants to match its prices, and, in doing so, didn't just destroy itself but poleaxed an entire industry!
The dynamics in the mortgage industry were no different than the theoretical discussion of the airline industry or what happened in the long-distance market with WorldCom. In fact, Fannie Mae and Freddie Mac actually combine the attributes of our dumb competitor in the airline industry, and those of the fraudulent WorldCom in the market for long-distance phone service. What made Fannie and Freddie so dumb was their pursuit of a non-economic objective - furthering the government's central plan for housing. Of course, the best evidence of the non-economic objective are the massive losses they suffered on the mortgages they - futilely - issued to expand homeownership. Of course, Fannie's record for accounting fraud and the cozy relationship both GSEs enjoyed with congress makes them virtually indistinguishable from WorldCom in terms of corruption.
The argument made by the Paul Krugman's and Shaun Donovan's of the world that the incompetence of one company in a market - much less the most dominant company in a market - can't ultimately impact the profitability of other companies in that market is absolutely ludicrous. Krugman's argument also proves that economics - unlike real sciences like medicine, physics or engineering - is not immune from taking massive steps backwards. It is also an argument that finds particularly fertile ground in the minds of people with no real-world business experience. In Paul Krugman's case the ignorance this lack of practical, real-world business experience - not counting his service to Enron as a consultant anyway - is exacerbated by the political prism through which he views everything. (1)
As evidence of the fact that political considerations are constantly bubbling underneath the thin veneer which passes for his academic rigor is the close Krugman makes to his defense of Fannie and Freddie in the housing bubble. In closing what he believes is an ironclad tight case proving that Fannie and Freddie had nothing to do with the housing bubble, he dismisses as sheer folly the notion that Barney Frank could have had anything to do with the housing bubble either. Krugman states,
"Of course, I imagine this post, like everything else, will fail to penetrate the cone of silence. It's convenient to believe that somehow this is all Barney Frank's fault." (2)
Barney Frank exercised an enormous role in advancing the housing bubble. Arguably, he was the biggest defender of the GSEs in congress. He fought OFHEO when that office uncovered the accounting fraud that led to the resignation of Franklin Raines. (See Franklin Raines on the Dunce list.) Later, and well after the housing bubble started to collapse, Frank completely dismissed the likelihood of a housing bubble even existing. Here is Barney Frank on the floor of congress on June 27, 2005 vowing to pursue the very policies that had by then placed the US economy in a precarious position where a catastrophic financial collapse was inevitable.
"This is a very important resolution - particularly at this time - because we have, I think, an excessive degree of concern right now about homeownership and its role in the economy....Homes that are occupied may see an ebb and flow in prices, the price at a certain percentage level, but you are not going to see the collapse that you see when people talk about a bubble. So those of us on our committee in particular will continue to push for homeownership."
There is nothing untoward about describing Barney Frank's role in the housing bubble as "massive." It is a conclusion that any fair-minded person would concede is compelled by the facts. The fact that someone in a position of media authority like Krugman could take such transparently bogus positions on such an important topic begs a larger question. How could this possibly be - particularly when Krugman's fallacies revolve around the most significant economic crisis since the 1930s? It is here that the contemporary notion of fake news comes to the fore.
In particular, it would appear that many elements of the mainstream or "legacy" media have a vested interest in not pursuing aspects of the financial crisis to their logical conclusion. Not only does legacy media have a reflexive response to protect an "activist" government, many elements of the media have become inextricably linked with the people they are responsible for reporting on and being skeptical of. For example, CNN's Chris Cuomo is the brother of HUD's Andrew Cuomo, while NBC's and MSNBC's Andrea Mitchell is married to Alan Greenspan. Kathleen Brown, the sister of current California governor Jerry Brown, was on Countrywide's board during some of the housing market's wildest excesses. Fortunately - for her - she is married to Van Gordon Sauter, the former head of CBS news. In the same way that the government's role in bringing about the housing crisis was transparently obvious, so is legacy media's role in the generation of "fake news," particularly when the definition of "fake news" includes what isn't reported, and not just what is reported.
September 9, 2018
1. Bethany McLean and Peter Elkind, The Smartest Guys in the Room - the Amazing Rize and Scandalous Fall of Enron, (10th Anniversary Edition), Penguin Group, New York, 2004, p. 240 Of all the ruinous investments and squandering of real capital that led to Enron's high profile bankruptcy, in the first rank must stand paying Paul Krugman $50,000 to meet with Enron's CEO, Ken Lay, twice a year. Apparently the point of these meetings was for Enron to benefit from all of Krugman's "insights."
2. Paul Krugman, "The Conscience of a Liberal: Things Everyone in Chicago Knows," June 03, 2010, https://krugman.blogs.nytimes.com/2010/06/03/things-everyone-in-chicago-knows/