‘The Most Egregious Culprits: Fannie and Freddie’

Published November 24, 2010

In recent years, “Wall Street” has become the accepted sound bite for the cause of the debt crisis.  During the ensuing panic, this theme sold well in the United States, both on Capital Hill as well as on Main Street.  So did the so-called lack of regulation—a “politically correct” answer for all the problems.  Don’t get me wrong, this is not an attempt to absolve Wall Street, the banks, or the private sector from blame.  Sadly, there was much at fault with greed playing a major role in what happened.  Wall Street institutions in their rush for greater immediate returns irrespective of consequential long-term risks, were guilty of irresponsible behavior and in some cases malfeasance.  They deserved to be punished.

However, the anti-Wall Street theme resulted in an unwarranted and unceasing barrage by appointed and elected officials against American business in general.  It generated an all-out legislative and regulatory agenda to fix the perceived problem.  Unfortunately, corrective measures undertaken under panicked conditions are always dangerous and often counter- productive.  Sometimes they result in unforeseen consequences.  The collective blame on Wall Street, the banks, U.S. business was translated by some as a failure of the free market ideal.  This was a blatantly false and dangerous premise.  Worse, it represents a message that is roundly applauded by every enemy of liberty on the planet.  It brought to mind the warning by economist Milton Friedman: “The challenge for my generation was to provide an intellectual defense of liberty. The challenge for your generation is to keep it.”

Wall Street as the main villain completely ignores the most egregious culprits of the financial collapse: two Government Sponsored Enterprises, Fannie Mae and Freddie Mac.  These two GSEs were on an affordable-housing mission becoming the largest buyers of sub-prime mortgages between 2004 and 2007.  It was a mission encouraged by elected and appointed federal officials who presented themselves as champions of affordable housing.  According to the former Fannie Mae Chief of Credit Officer, as of mid-2008, more than 70 percent in high-risk mortgages were accounted for by the federal government in one way or another with nearly two-thirds of that held by Fannie and Freddie.  The Wall Street Journal called it, “One of the great political scandals of our age.” And as far as regulatory authority, there were plenty of rules on the books to prevent much of the private sector’s wrong doing.  But instead of demanding strict adherence, government assisted the private sector’s risk-taking appetite by keeping interest rates historically low and opening the spigot for increased leverage that served to accentuate the dangers in the marketplace.  Thus, in my opinion, the financial reforms recently adopted, to a large degree, represent a grave misdirect which might do harm to the essence of America’s  success story.  I can only hope that the flaws in this legislation will be corrected in the days ahead.

The American Free Market ideal—symbolized by its national emblem, the bald eagle, a rare and precious bird—was born in the Declaration of Independence at the precise moment in 1776 when Thomas Jefferson and his cadre of revolutionaries declared the entitlement of some self-evident truths among which are life, liberty and the pursuit of happiness.  During the two plus centuries that followed the adoption of this principle by a people of immigrant ancestry and a multi-cultural heritage, it produced an unprecedented result:  It became a lightning rod for ideas.  It created a crucible for innovation.  It became the decisive driver of progress in science, technology, and economic development.  It was the fundamental ideal that brought this nation to the pinnacle of success.  Oh, and one more thing, it changed the course of civilization.   

To understand how and why this outcome transpired one must recognize that the American free market ideal is not simply an economic principle giving an individual the right to produce goods and services without coercion or government intervention.  As economist Friedrich Hayek explained, it is a social philosophy encompassing ethics, moral values, jurisprudence, ideas, and a way of life.  The American free market ideal from its inception unleashed the most powerful economic and political influence, first on the U.S., and ultimately on the rest of the world.  At its core is Liberty, the right to act pursuant to one’s judgment; the right to examine ideas; the right to experiment and explore; the right of private property.  It prized competition.  It didn’t take long before the world recognized the value of this ideal.  In France the comparable, “Liberte, Egalite, Fraternite,” was adopted.  In the Constitutions of Canada, Australia, and New Zealand, peace, order and good government.  In Japan, its 1947 Constitution included life, liberty and property.  Similar references can be found throughout numerous nations in the world.  

Indeed, here in China, in the late 1970s, the great Deng Xiaoping, regarded as the primary architect of modern China and its dramatic economic reform, espoused a philosophy that in many ways echoed the American free market ideal.  The crux of Deng Xiaoping’s philosophy was based on pragmatism and embodied in his dictum to seek truth from facts.  The criteria for success, he believed, are determined by common sense and flexibility rather than by ideology.  He dramatized this philosophy by insisting, “No matter if it is a white cat or a black cat; as long as it can catch mice, it is a good cat.”  And Deng did not just focus on the economy.  Deng identified other areas where changes had to be made for China to become a world power: There was the need to revamp the educational system, especially universities and research institutes; lawyers had to be trained in the intricacies of commercial and corporate law; there was need for an expanded judicial system; more Chinese had to be permitted to study overseas, and more foreign students and tourists to come to China.
Since the adoption of Deng Xiaoping’s vision of common sense economics, China pursued a pragmatic path towards a market-driven economy.  The results have been nothing short of astounding and are reminiscent of the early economic successes occasioned in the United States.  China’s economy during the past 30 years has changed from a centrally planned system that was largely closed to international trade to a more market-oriented economy that has a rapidly growing private sector and is a major player in the global economy.  Reforms started with the phasing out of collectivized agriculture, and expanded to include the gradual liberalization of prices, fiscal decentralization, increased autonomy for state enterprises, the foundation of a diversified banking system, the development of stock and futures markets, the rapid growth of the non-state sector, and the opening to foreign trade and investment.  Deng Xiaoping’s ideology lifted more people out of poverty than did the efforts of any other world leader, anytime, anywhere.

To one degree or another, the facets of the free market ideal were adopted by nearly every nation on the planet and served to effect world populations in every aspect of their lives.  Its beauty lies in its inherent ability to unshackle human energies whether in science, medicine, technology, agriculture, space exploration, transportation, health, or education.  The ideal also promotes cooperation between nations of the world.  The Wall Street Journal recently noted that the Chilean miners owe their lives to the free market ideal.  It was free market applications that resulted in the development of the Center Rock Drill in the U.S., coupled with innovations from Germany, Japan, South Korea, and of course Chile to combine and achieve the miracle.  This example is reminiscent of the “Free to Choose” TV series several decades back, when Milton Friedman explained to the whole world the basic principles underlying the free market by examining the make-up of a lead pencil and the variety of global participants it took to build it. 

America had the first mover advantage.  According to Encyclopedia Britannica, of the 159 great inventions of the 20th Century, 110 were invented in the U.S.  That is nearly seventy percent.  Most profoundly, the revolutionary changes the world experienced during the last three decades of the previous century were the result of free market applications primarily built on American innovations.  This technological tsunami—the so-called information revolution—empowered the people on this planet to have instant informational flows in total disregard of internal prohibitions or national boundaries.  It offered everyone a stark, uncompromising comparison of standards of living, economic freedoms, and the value of liberty.  It proved to be the common denominator for the dramatic upheavals ever experienced in the annals of mankind.  In what seemed like a made for TV video, we were ring-side spectators at a global rebellion when in less than an eye-blink the Berlin Wall fell, Germany was unified, Apartheid ended, Eastern Europe was liberated, the Cold War ceased, and a doctrine that impaired the freedom of three generations, wrecked the economies of scores of nations, and misdirected the destiny of the entire planet for seven decades, was decisively repudiated.  How quickly we forget.

Many nations participated in engendering these global changes, however, it was a singular triumph of the free market ideal and a clear example of its impact on civilization.  And it was equally a triumph of Wall Street.  In truth, without American business know-how, its ability to attract investments, its system of capital formation, its willingness to assume risk, and its vast financial resources, the result might not have been possible.  Make no mistake, the Internet, Google, Microsoft, Apple, Amazon and a host of other enterprises based on amazing innovations for advancing information and knowledge to the world’s populations are primarily consequences of the free market ideal.  And, yes, they represent achievements chiefly underwritten by American business and Wall Street. 

It is no secret that those same free market dynamics served to overpower the forces of tyranny in two World Wars.  Most important, America has never hesitated to explain the virtues of its free market ideal and never kept secret its components and features.  While knowing that in doing so it was creating its own competitors, America never wavered in its fundamental mission   to spread its know-how to every corner of civilization, teaching and encouraging people to follow.  And with great success!  Inevitably, the world caught on and caught up.  The world of today is a hugely different place than it was, say, a century ago.  Not simply because of major advances in science and technology although that is its most obvious and tangible difference, but because those very advances are a direct product of the free market ideal that swept across every nook and cranny of this planet.  Standards of living have broadly improved, life expectancy has greatly expanded, and the quality of life for much of civilization is vastly enriched. 

Thus, as we respond to the causes of the recent meltdown, as we reform the rules relating to financial markets, as we harmonize international rules and procedures, we must be ever so careful that this rare and precious bird—the free market ideal—remains unharmed.

Leo Melamed is a writer, lecturer, and founder of the Chicago Mercantile Exchange, creator of the financial futures market, and Chairman Emeritus of CME Group. He delivered these remarks Nov. 9 at the International Financial Forum 2010 in Beijing, China. Used with permission.