How Capitalism Will Save Us (8 page)

Scores of other examples are provided by the electronics industry. A few years ago flat-screen TVs cost ten thousand dollars or more. Now you can get many for under five thousand dollars.

What happens when companies aren’t allowed to generate profits? No barometer exists to adjust supply to meet demand. Politicians like to think that punishing profits serves the public interest. But the Real World economic truth is that it does the opposite. You end up with shortages of essential products—and sometimes surpluses of things no one wants.

Many people today are too young to remember what happened after President Richard Nixon imposed controls on the price of oil in the 1970s. Immediate shortages of gasoline resulted, which led to gas lines. People had to fill up on given days, depending on whether they had odd- or even-numbered license plates.

Taxing profits to punish “greedy” companies doesn’t work, either. That’s because profit is a key source of the investment capital companies use to expand operations, innovate, and create jobs.

In the case of oil companies, taxes on profits destroy capital that would otherwise go toward exploration and new oil production. In 1980 President Jimmy Carter enacted the Windfall Profit Tax to punish supposedly avaricious oil companies. What happened? Domestic production plunged. With oil companies producing less, the levy generated far less for Uncle Sam than proponents had predicted. The Windfall Profit Tax was widely considered a disappointment and was eventually repealed.

Decades later, when gasoline prices skyrocketed from 2004 to mid-2008, there were no gas lines. Why? Because there were none of the kind of profit-punishing price controls imposed by President Nixon in the 1970s—something antiprofit protesters have failed to notice.

As for drugs, a major reason newly developed medications are more expensive in the United States is not because of “gouging.” It’s because drug makers charge more in this country to recover the costs of selling to Canada and European nations whose state-run heath-care systems keep drug prices artificially low.

So what do Canadians and Europeans get for their “fairer” drug prices? As we will explore in
chapter 7
, they get fewer new medicines and treatment with older, frequently less effective drugs.

Critics say profit is merely a bribe to get businesspeople to provide products and services. Actually, profit is essential to achieving innovation and a higher standard of living.

The late renowned management guru Peter Drucker repeatedly emphasized this key, oft-ignored point: without profits, there is no capital to build the advances of the future. If you don’t have profit, you don’t get change.

Profit is not only moral. It’s essential to a healthy economy. What’s immoral is not allowing people to make it.

I
t’s a question often raised by free-market critics: how can capitalism be a moral system when low-income people are so often harmed by the fluctuations of “unfettered” markets?

For many, the subprime-mortgage debacle provided the most painful example in years of this moral pitfall of capitalism. According to the popular narrative, “predatory” lenders trapped low-income borrowers with lenient subprime loans. Ridiculous introductory terms seduced thousands of unsuspecting homeowners into signing on the dotted line—only to be slammed later with higher interest rates.

The result: hundreds of thousands of subprime borrowers went into default. Bad subprime loans were blamed for a 53 percent rise in delinquencies and foreclosure proceedings on 1.5 million homes in 2007, a situation that only got worse in 2008.

Media reports about the crisis highlighted heartbreaking personal stories of poor people facing the loss of their homes. During her presidential primary campaign, Hillary Clinton called for curbs on “abuses” by “unscrupulous brokers.” Her Democratic rival John Edwards compared the mortgage market to “the wild, wild West.”

Of course, poor people were hardly the only ones hurt. The crisis ripped through the economy. Several major lenders, such as New Century Financial and American Home Mortgage, were forced into bankruptcy. Even the largest mortgage company, Countrywide Financial Corporation, was laid low. It was ultimately sold to Bank of America at the fire-sale price of about five dollars per share—a stark contrast to its forty-three-dollar-a share price in 2006, before the bubble burst.

The financial crisis has been a global disaster, but the collapse and economic devastation were not the fault of “unfettered markets.” It was a classic case of what economists refer to as “moral hazard,” the damage that occurs when government artificially protects people from the consequences of their high-risk behavior.

Cato Institute senior fellow Gerald P. O’Driscoll explains:

In the case of the subprime crisis, overly low interest rates and an overabundant money supply, combined with well-intentioned though misguided policy, encouraged lenders to engage in risky behavior. They made ill-advised loans that they wouldn’t have made under normal circumstances to too many unqualified borrowers, ultimately causing a collapse.

It all began several years back after the dot-com bust of 2000 and 2001. Seeking to boost the economy, the Federal Reserve Bank made two critical mistakes. First, it kept interest rates too low for too long. Second, it started printing more money, triggering an inflation in home values.

Suddenly the market was on steroids. Prices kept rising with no end in sight. These upwardly spiraling prices—rather than “greed”—were one reason that lenders lowered their standards. People figured,
So what if you weren’t really qualified to receive a loan?
There was a way out: you could sell your house for more money or refinance later.

Inflating the bubble still further were the government-created mortgage giants, Fannie Mae and its cousin, Freddie Mac. We go into additional detail about these two giants in later chapters. President Franklin Roosevelt set up Fannie Mae during the Great Depression to indirectly boost a flagging housing market. Freddie Mac, a Fannie Mae clone, was launched in 1970. Fannie and Freddie were eventually spun off by the government, selling shares and becoming enormous publicly held corporations. Their mission is to indirectly help the housing market by buying mortgages from banks, bundling them into packages to be sold to investors. The idea was to generate money for banks that would increase mortgage lending and help more Americans achieve the dream of owning their homes.

Fannie’s and Freddie’s money comes from selling their own bonds, as well as stock, to investors. However, the two companies owe their enormous size—as well as their immense political and market power—to their ties to government. They had emergency lines of credit with the U.S. Treasury Department. Investors thereby believed that the companies were implicitly backed by the government. As we mentioned in the introduction to this book, they are larger than any private-sector competitors.

The impact of these enormous corporations on the housing market cannot be overstated. Fannie and Freddie were responsible for some $1.6
trillion
worth of less-than-prime mortgages by 2008 from banks and mortgage brokers, packaging them as securities and selling them to investors.

With money flooding the market, some lenders didn’t bother documenting whether borrowers had any real income. These were dubbed “no doc” loans. Anyone breathing seemed to be able to obtain a mortgage. Sometimes no down payment was required.

Contrary to the impression conveyed by politicians like Congressman Barney Frank and Senator Christopher Dodd, most lenders were more careless than predatory, making loans with free-flowing capital in a market that seemed certain to keep going up.

The end result was a classic bubble of gargantuan dimensions. Then
the Fed started to raise interest rates between 2005 and 2006. Everyone had previously assumed that subprime home buyers could always get a new mortgage with a new teaser rate when the teaser of an existing mortgage expired. But now those ultralow teaser rates would have to go up. Even if a home buyer got a new teaser rate, it was going to be higher than the old one. The market for home mortgages began to cool.

The whole thing crashed in the summer of 2007. Subprime borrowers—particularly speculators or “flippers”—faced increased monthly payments and could not refinance or sell. They were stuck.

Ironically, some of the same people who today criticize subprime lenders condemned banks in the 1970s for
not
lending to low-income communities. Back then, the practice was demonized as “redlining.” The outcry resulted in the 1977 Community Reinvestment Act, which required banks to offer credit to their entire market area and not just wealthier neighborhoods. Until recently, anti-redlining sentiment persisted. It has been credited by many with helping to create an atmosphere that only further encouraged subprime lenders. Moreover, the Department of Housing and Urban Development urged lenders to provide loans requiring no down payment for low-income people right up to the bust.