What is the proper role for the government in the financial system, and in housing finance, in particular? This is among the “essentially contestable questions”--those which may be debated for decades and centuries without clear resolution.

Resident Fellow Alex J. Pollock

The two dominant theories are respectively derived from two great political economists: Adam Smith and John Maynard Keynes.

In The Wealth of Nations, published in the famous year 1776, Smith set the lasting intellectual framework for thinking about the productive power of competitive private markets, which has transformed the world. In this view, government intervention is particularly prone to creating monopolies and special privileges, which generate undeserved monopoly profits (economic rents), constrain competition, and reduce productivity. It thus results in less wealth being created for the society and ordinary people are made worse off.

Keynes, writing amidst the world financial collapse and economic crisis of the 1930s, came to the opposite view: that state intervention was both necessary and beneficial to address problems which markets could not solve on their own. When financial behavior is dominated by fear and extreme uncertainty, only the compact power of the state, with its sovereign authority to compel, tax and borrow, is available to move things forward.

Considering at length this debate of ideas and prescriptions for political economy, the noted economic historian, Charles Kindleberger, asked, “So should we follow Smith or Keynes?” He concluded that the only possible rational answer is: “Both, depending on the circumstances.”  In other words, the answer is different at different times.

A Proposal

Kindleberger was the author (among many other works) of Manias, Panics and Crashes, a wide ranging history of the financial busts which follow booms, first published in 1978, and prescient about the financial crises of the following generation. A fifth edition of this book, updated by Robert Z. Aliber, has brought the story up to our more recent dot-com mania and subsequent scandals, to which the same fundamental patterns continue to apply.

Kindleberger, surveying several centuries of financial history, observed that financial crises and scandals occur, on average, about once every ten years. This matches my own experience in banking and finance, which began during the “credit crunch”of 1969, then the collapse of the Penn Central Railroad and the U.S. commercial paper market in the next year, and various other memorable busts since. The most senior representative to the 2006 World Congress of Housing Finance, Howard Sexton, Chairman of the Southern Cross Building Society, New Zealand since the 1960s, has told me that once every ten years matches his experience, too. It seems to take financial actors less than a decade to forget the lessons their predecessors painfully learned.

This pattern gives rise to my proposal for balancing between Smith and Keynes, which expands upon Kindleberger’s insight of “Both, depending on the circumstances,” by quantifying how much we should have of each.  Since crises and scandals occur about 10% of the time, the proposed mix is as follows:

Pollock Proposal

Adam Smith :  90%, for normal times

J.M. Keynes:  10%, for times of crisis.

In normal times, we want the economic efficiency, innovation, productivity and resulting economic well-being of ordinary people created by competitive private markets.  But when the financial system hits its periodic crises, the intervention and coordination of the state can be helpful.  This intervention should, however, be temporary. If prolonged, it will tend to monopoly, bureaucracy, less innovation, and less growth. In the extreme, it will become socialist stagnation.

So the Keynesian actions should be temporary. We should have the 90% Smith, 10% Keynes mix, with the state interventions withdrawn after the crisis is over.

This is the Cincinnatian Doctrine, modeled after the Roman hero Cincinnatus, who flourished in the fifth century B.C.  Cincinnatus became Dictator of Rome, being “called from the plough to save the state.” In the classic Roman Republic, the dictatorship was a temporary office, which the holder was expected to resign after the crisis was addressed. Cincinnatus did--and went back to his farm.

Cincinnatus was a model for the American founding fathers and for George Washington, in particular. Washington became the “Modern Cinicinnatus” for saving his country twice, once as General and once as President, and returning to his farm each time. When he probably could have become King of America after the Revolution, he resigned his command instead.  Upon hearing this, George III famously remarked, “If this be true, he is the greatest man of the age!”

But those who attain political and economic power do not often have the virtue of Cincinnatus or Washington. The key problem with this doctrine is therefore: how to get the intervention to withdraw when its time has passed? When monopoly profits, market power, and the bureaucratic interests of government agencies become imbedded in the financial system, how do we return to the proper Smithian competition for the next 90% of the time?

The American GSEs as an Example

Consider as notable examples of this problem the American Housing “Government-Sponsored Enterprises” (the “GSEs”), a $ 5 trillion sector of the U.S. housing finance system.

Each of the GSEs was created as a response to particular circumstances of a real or perceived crisis in housing finance, in the following years:

Fannie Mae                               1938

Federal Home Loan Banks    1932

Freddie Mac                              1970

The existence of each GSE reflected some specific historical moment. Each GSE got government sponsorship with special benefits, privileges and advantages for its shareholders, because it addressed pressing problems for politicians at the time. Every GSE represents a deal made with the government to trade privileges for helping with such problems in line with the Keynesian theory.

It would be astonishing if the circumstances of the time did not change dramatically in the course of several decades--as of course they have. Fannie was created solely to buy FHA-insured mortgages, a function it no longer performs. The Federal Home Loan Banks were created to focus entirely on small, local, mutual savings associations, but their principal customers are now giant interstate banks. Freddie was created to solve the shortage of mortgage credit caused by interest rate ceilings on deposits, but these ceilings were ended two decades ago. In short, none of the circumstances which prompted the creation of any of the GSEs still exists. The original deals are all passe’, indeed completely irrelevant.

But these government interventions have not been withdrawn, and all the GSEs are still here, having developed in ways never intended or foreseen by their designers. They are all huge issuers of debt with the implicit guaranty of the government, of enormous size, financial influence and political importance, and enjoy billions of dollars of economic rents (monopoly profits). They are now very hard to control, the accounting scandals of Fannie and Freddie of recent years notwithstanding.

GSEs are the marriage of government privileges and private benefits, created in crisis for purposes now outmoded. Unlike other marriages, they should always end in divorce--in other words, the Cincinnatian Doctrine should be applied. But how?

Applying the Cincinnatian Doctrine to the GSEs

The following steps should be taken to move the GSEs in a Cincinnatian direction:

• First of all, abolish their perpetual charters and replace them with limited-life charters of ten years duration. Giving the GSEs perpetual charters was a major mistake. With a limited-life charter, there is at least a regular chance to reconsider the deal with the government and take account of the inevitably changed circumstances.
  
• Foster competition among and for GSEs in all sensible ways. Competition will curtail their market power and economic rents, and increase the probability of ultimate privatization.
  
• Apply the logic that GSEs are in reality joint ventures in partnership with the capital of the government. As former Congressman J. J. Pickle of Texas observed about them, “The risk is 99% public and the profit is 100% private.” If this formula were corrected and the profit were divided according to the risk bearing, it would increase the motivation of the GSE managers to pursue privatization.
  
• Clearly target privatization as the goal, once the original crisis has passed.
  
• Insure that all future interventions, in response to the crises of the future, have limited-life charters or sunset provisions.

In short, unlike Cincinnatus, GSEs and other state interventions will not voluntarily go back to private life. They need to be forced.

Summary

We may summarize the Cincinnatian Doctrine as the following cycle:

...and so on ad infinitum

Alex J. Pollock is a resident fellow at AEI.