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Russ Roberts argues that the differential in tax rates contributed to the housing boom. In 1997, a Republican Congress and Clinton enacted a law pushing capital gains taxes on real estate much lower (exempting people from paying capital gains taxes on the first $500,000 above the cost of the home realized from its sale), meaning that real estate became a better investment (tax-wise) than working, the stock market, etc.

It is all well and good but the crucial question is this:

"How could the recent residential mortgage-market meltdown, which the authors estimate will lead to credit losses of around $400 billion--less than 2 percent of the outstanding $22 trillion in U.S. equities--possibly have such large negative effects on economic activity in the United States? After all, a 2 percent decline in stock market prices sometimes happens on a daily basis and yet leads to hardly a ripple in the U.S. economy."

Governor Frederic S. Mishkin: On "Leveraged Losses: Lessons from the Mortgage Meltdown"

And by the way, Steven Horwitz, a year ago:

"There's a housing collapse? ;)

Seriously, I think the housing issues are being overblown because most of the media folks live in the areas where prices got bid up the most, hence are tending to fall the most. Out in the "rest of the country," prices never flew up so they aren't going down."

That imbalance itself could well be an injection effect, but if so, it hardly portends some sort of system-wide collapse."

Hey, I never said my batting average was 100%. :)

Add Rahm Emanuel (Dem-Illinois) to my list of politicians who I am not very fond of!!! I just heard him repeatedly claim that the current situation is a result of the failed free market ideology of the last 8 years, etc., etc.

Please pass Steve's original post to as many people as you can.


P.S.: Where do we have the system collapse? If we did nothing would be big losses take place -- of course; would unemployment probably move toward double-digits and inflation soar -- most likely; but will the US economy come to a screeching half --- NO. Let these firms fail, and let the market adjustments take place. It doesn't look like we are going to get a sane economic policy so all we have is the intellectual battle to wage, and we better be up to that challenge.

What is your take on this?:

"... financial markets often seem to be ineffective in predicting the onset of economic crises and indiscriminate in punishing risky firms after crises occur. Recent studies have shown that market discipline fluctuates in its intensity, with more relaxed monitoring in good times and more stringent oversight during periods of financial stress. The varying intensity of market discipline reflects the tendency of investors to act with excessive optimism during an expansionary “bubble” and to panic when the “bubble” bursts. For example, during the mid-1990's, financial institutions and other investors from developed nations disregarded potential warning signs and made huge investments in Latin America, Asia and Russia. However, when subsequent events revealed the full risks of those investments, investors engaged in frenzied “flights to safety” that had a devastating impact on developing economies.


Studies of recent banking crises in the United States and Latin America have shown that
investors and depositors (i) failed to restrain risk-taking by bank managers until a financial crisis revealed that some banks had already suffered severe harm, (ii) typically reacted to a crisis in the short term by punishing all banks exposed to the crisis, with only a limited degree of discrimination among banks with differing risk exposures, and (iii) applied a more effective and discriminating form of discipline only after the worst period of the crisis had passed."

Arthur E. Wilmarth, Jr.: Controlling Systemic Risk in an Era of Financial Consolidation (pg. 44, 46)

In other worlds, Christopher Ricciardi (former head of Merrill's structured credit business) could be right when he says:

"The true cause of the credit crisis has been the wholesale and irrational shutdown of the securitization market, and the lack of any reasonable, existing replacement for it. For over 30 years, the markets have relied on pooling loans together and repackaging them as income-generating securities – or securitization – for financing, with well over $1 trillion of new securitizations issued each year in recent years until the crisis began. Many types of loans essential to the day-to-day operation of a modern economy were financed this way – business loans, commercial equipment leases, residential and commercial mortgages, auto loans, student loans.

The securitization market worked exceptionally well for decades and was the financing tool of choice for large and small institutions alike. As investments, performance for securitized assets typically exceeded corporate and Treasury bond investments for decades.

Where securitization went wrong in recent years was with subprime mortgages. These securitizations performed disastrously, causing people to mistakenly question the practice of securitization itself.

Decades of historical data were ignored, with the subprime experience exclusively driving market perceptions: The entire securitization market was effectively shut down, and this explains the depth and persistence of the ongoing credit crisis."

Sound familiar? Keynesian "animal spirits" / herd instincts of investors?

I admire S. Horwitz' eloquent attempt to rebut the left within his own academic enclave. I hope his open letter is spread far and wide. Any effort to disentagle "capitalism" of the corporate variety from the free-market is welcomed. But I'm not sure it is wise to join with the left by characterizing corporations as "mean and nasty." Given the deep hostility that the left has against the "free market," this will only add fuel to the fire. When I was growing up in the 1970s I was fed a regular diet of anti-corporate/anti-capitalist propaganda through films and TV, which portrayed corporations and their leaders as greedy, rapacious, conspiratorial and murderous (perhaps some of this is true but I think significantly exaggerated). This negative portrayal continues and it is linked to the "free market." I think many on the left would be hard pressed to trust the "competitive" forces of the market to mitigate the real and alleged evil doings of corporations. Although S. Horwitz stressed the importance of competition and the fact that free-market economists are critical of corporations who feed at the public trough, he should go farther to stress that free-market economists are not shils for corporations but without adding to the very negative stereotype that already exists. Perhaps he could make a firmer distinction between those corporate leaders who acted out of greed and those honest market players who merely joined a feeding frenzy fed by artificially lowered interest rates and bad policy. He could mention that CATO -- surely synonymous with "free-market" capitalism in the left's view? -- warned against a potential Freddie/Fannie bailout. He could also mention that many leading libertarians like M. Rothbard have constantly assailed the corporate state and its minions.

Hi Austrian Economists,

I sent you an email a while ago but never received a response; can you please email me so we can discuss my proposal?


The tone of this letter indicates to me that it is targeted towards the lay-liberal. If that is the case, maybe post this at the Daily KOS, or other popular liberal sites?

One thing that I think may be missing is the distinction between deregulating and moving towards a free market. David Friedman points out that once government has entered the game, it can do something like privatize gains and socialize losses (e.g., the GSEs). In that case, the system will work better if it is regulated to make the socialized losses less clostly (e.g., by requiring 20% down payment requirements, for example), and removing this regulation may actually make the market more coercive (and therefore less free) than it would otherwise be.

IMO this is an important point, because many liberals assume that deregulating always moves us closer to a free market, while the opposite can easily be true.

Fantastic letter Steve

Outstanding letter Professor Horwitz. It blends the historical narrative approach of Rothbard with a careful eye on public opinion a la Hayek (and Caplan!).

I am a soldier in the fight for more LEFT-leaning libertarians!


Excellent Steve, thank you! You've done a real service for the rest of us.


Horwitz´s letter is OK, but it´s by no means "outstanding", "excellent", or "fantastic"! It is pretty much delusional to seek causes of the current financial crisis only (or primarily) in the area of housing and mortgage regulations.

In my view, the institutional framework of financial markets and the failure of corporate governance and proper risk management is far more important.

Being a "free market guy" myself and "fellow traveler" of austrian economics, I am deeply troubled by the lack of insight which is displayed on this blog with respect to the current financial mess (the exception being Frederic Sautet).

In any event, it is pretty much clear how much fragile our financial markets and banking have become ("house of cards"). So the question is: what kind of institutional reform is needed in order to make financial markets and banking more robust?

Good job, Steve. We'll be a long time sorting out what happened, but I expect your letter will hold up very well indeed over time. Matěj Šuster (who seems to be some sort of functionary at an otherwise impressive Czech think tank) seems to think he's gotten one up on you by quoting your earlier sanguine comment on housing. Pete sketches an answer to that silliness. Even if we say you missed that one, it only goes to underline the fact that these things are clear only ex post. We need the entrepreneurial market process to guide us into the future. That decentralized selection process works infinitely better than any expert or group of experts precisely because the future must be *constructed* and cannot be *calculated*.

These are serious times; we need serious discussion.

Yep, we need serious discussion. But do we get one here? Compare Boettke´s and Horwitz´s posts (in re "financial crisis") with i. e. Tyler Cowen´s posts on Marginal Revolution or Arnold Kling´s posts on Econlog and you´ll see the difference.

Who are the ones who try to seriously figure out what went wrong and what to do? Kling and Cowen! Horwitz and Boettke just keep repeating a few pretty general points again and again, i.e. "we-do-not-have-free-markets-so-free-market-could-not-possibly-have-failed". :o) This is all well and good and I agree with this point, but it´s not good enough.

Firstly, what exactly is a "free market"? Give me some definiton, please! Does it include i. e. 100 % reserve banking (Rothbard, De Soto, Hülsmann, etc.)? In particular, what kind of institutional framework is needed in oreder to establish a free FINANCIAL market (i. e. which regulations should be repealed)?

PS: I am pretty much a hard core libertarian. It´s just that I find those particular Boettke´s and Horwitz´s posts disappointing. It´s not a voice of reason, but rather a voice of emotions and fear.

Well Matej, Greg Mankiw seems to think Steve's letter to the left is worth reading:

I think Boettke and Horwitz both go far, far deeper than you allow. Leaving that aside, however, I would note that it is showing no want of seriousness to emphasize the basic points.

It's my understanding that the derivative markets are unregulated. It also appears that investments in derivatives are crashing. In fact the derivative markets appear to be at the heart of the crises, but you make no mention of the derivative markets in your letter.

Why is that?

I also note that Warren Buffet refused to let his insurance company invest in the derivative markets because he called them a financial time bomb.

If Warren Buffet could resist the siren call of the government interventions, why couldn't the rest of the corporate world?

I don't know, but I think you should go back and rethink some of your arguments.

Roger Koppl:
With all due respect to Mankiw, we simply must do better. At present, it is imperative to offer unbiased and sound economic analysis. Unfortunately, Horwitz´s letter is too much one-sided and some of his claims are misguided.

Here is a more serious and credible analysis:

"There are both old and new components in the origins of the subprime shock. The primary novelty is the central role of “agency problems” in asset management.

In previous real estate-related financial shocks, government financial subsidies for bearing risk seem to have been key triggering factors, along with accommodative monetary policy, and government subsidies played key roles in the most severe real estate-related financial crises. While the subsidisation of borrowing also played a role in the current US housing cycle, the subprime boom and bust occurred LARGELY OUTSIDE the realm of GOVERNMENT-sponsored programmes.

Investors in subprime-related financial claims made ex ante unwise investments, which seem to be best understood as the result of a conflict of interest between asset managers and their clients. In that sense, sponsors of subprime securitisations and the rating agencies – whose unrealistic assumptions about subprime risk were known to investors prior to the run up in subprime investments – were providing the market with investments that asset managers demanded in spite of the obvious understatements of risk in those investments.

The subprime debacle is best understood as the result of a particular confluence of circumstances in which longstanding incentive problems combined with unusual historical circumstances. The longstanding problems were (1) asset management agency problems of institutional investors and (2) government distortions in real estate finance that encouraged borrowers to accept high leverage when it was offered. But these problems by themselves do not explain the timing or severity of the subprime debacle. The specific historical circumstances of (1) loose monetary policy, which generated a global savings glut, and (2) the historical accident of a very low loss rate during the early history of subprime mortgage foreclosures in 2001-2002 were crucial in triggering extreme excessive risk taking by institutional investors. The savings glut provided an influx of investable funds, and the historically low loss rate gave incentive-conflicted asset managers, rating agencies, and securitisation sponsors a basis of “plausible deniability” on which to base unreasonably low projections of default risk."

Charles W. Calomiris: "The subprime turmoil: What’s old, what’s new, and what’s next",

Highly recommended!

Well, Matej, I'll leave it for other readers of this blog to judge whether Calomiris tells so much better -- or so different! -- a story than Horwitz in his open letter. I gather from the bits in CAPS that you think those words make a big difference. Again, I'll leave it to other readers of this blog to judge.

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