Crisis caused by income equality or government intervention?

There is a thought provoking interview with Raghuram Rajan in the December issue of Money magazine. Mr. Rajan is one of the few economists that warned our current financial crisis was coming and the article is primarily about Mr. Rajan’s theory that the current crisis is caused by income inequality:

“In the 1980s we saw a widening of income inequality. Typically the political reaction to that is to redistribute wealth. But in the ’80s and ’90s there was a sense that we’d had too much redistribution, too much welfare. So you had to find something else, and housing fit the bill for both political parties.

The Democrats thought it was wonderful to support home ownership for the poor, their natural constituents. The Republicans figured property owners would eventually vote Republican.”

Mr. Rajan then goes on to explain how the political issue of income inequality led the United States federal government to create the current crisis with their attempts to cure income inequality. I see a great deal of truth in what Mr. Rajan says but I would like to point out one crucial difference in how I view the problem.

It wasn’t income inequality that caused the current economic crisis. The direct cause of the crisis was the political response to income inequality. The difference is subtle but completely changes the diagnosis of the problem and if we misdiagnose the problem it is impossible to come up with the correct solution.

If income inequality is to blame for our current economic crisis then the federal government could prevent future crises by eliminating income inequality. In that case the the solution would be for the federal government to continue various forms of political intervention in the hope of solving income inequality. Of course Marxism and Socialism are two examples of such attempts and their results have been devastating.

On the other hand, if the current economic crisis was actually caused by clumsy political responses to income inequality we need to look for a different kind of solution. Maybe we could start by having politicans recite the Law of Unintended consequences: “An intervention in a complex system always creates unanticipated and often undesirable outcomes”. Then we could change the oath of office to “First, do no harm”. 

The interview with Mr. Rajan can be found online at CNNMoney.com

What most of us know that politicians don’t

Life is not fair.

It just isn’t.

Innocent children die every day. That isn’t fair. Hookers are caught with governors and get rich as the celebutante of the day. That isn’t fair. Hardworking people are layed off on Christmas Eve. That isn’t fair. Human beings don’t like unfairness but most of us realize that unfairness is indeed a fact of life. Why don’t politicians?

About thirty years ago President Jimmy Carter decided that it was unfair that everyone in the United States couldn’t own their own home so he decided that the government should fix the problem. The federal government encouraged banks to give mortgages to people that had never owned their own home before. How fair. In the 1990’s Janet Reno threatened banks that had not made enough loans in economically challenged areas. Banks made more loans in those areas and then sold them to investors with the understanding that the United States government would pick up the tab if the homeowners couldn’t pay.

Everybody was happy. People that historically could not afford homes bought houses. People that already owned homes bought newer and bigger houses. Then lenders came up with more “innovative” loans which could get more people in homes and let everyone buy bigger and better houses. People were full of glee as home prices continued to rise and more people owned homes. Life was more fair and politicians patted themselves on the back for the great thing they had done.

Then the people who could not have bought homes thirty years ago started to default on their mortgages. Uh-oh. Statistically it was inevitable. Banks knew thirty years ago that a certain percentage of these homeowners wouldn’t be able to afford their houses. That’s why the banks didn’t lend to them in the first place. But politicians had wanted life to be fair.

As more houses were foreclosed the flood of homes started lowering home values. People with high incomes found that they could not afford the “innovative” mortgages on their bigger and better homes. Uh-oh. More people lost their homes. The banks and investors couldn’t sell the homes they foreclosed. Banks and investors started going bankrupt and that brought us the economic crisis which faces the entire world right now.

There are roughly 220 million people in the United States that actually pay income taxes. The United States government has authorized spending of 700 billion dollars so far to fix the current economic crisis. By my feeble calculations that means that every U.S. taxpayer  is now on the hook for about $32,000 because politicians wanted life to be fair.

The funny thing is that in 1970 you could buy a really nice house for $32,000. It would have been cheaper if the United States government had just bought a nice house for every family that didn’t  have one.

Which brings me back to my original point. Life is not fair. It just isn’t.

We understand that. Why don’t politicians?