Aug 04 2008

Privatized Profit, Socialized Risk: the problem of public/private companies

Category: capitalism,corporations,corruption,economy,housing,Uncategorizedharmonicminer @ 11:28 am

Larry Summers on the underlying problem of joint private/public companies, and how they led to the current housing market crunch.

Here is a really good creative capitalism idea. All Americans benefit from increases in home ownership because of the values like hard work, community, and respect for property that ownership instills. Families want desperately to own their own homes and accumulate equity. Yet it is very hard for conventional banks that borrow money over the short term to lend over the kind of 30-year horizons that best help families buy houses.

How can the objective of ownership be best supported and how can the most adequate financing be assured? Voila, creative capitalism! How about chartering private companies as government sponsored enterprises with the mission of promoting home ownership affordability? Give them boards with some private representatives and some public representatives. Make clear that government stands behind their capital market innovations so they can borrow more cheaply and pass the savings on. Exempt them from the state local taxes that others pay. Give them specific objectives on affordability that they must meet. Rely on a special government regulator to assure that they balance their social responsibility with their drive to profit. Harness the profit motive to meet a social objective.

This is roughly the rationale behind Fannie Mae and Freddie Mac. I would submit that it is about as good or as bad as most creative capitalism ideas involving joint profit making and social objectives. But one hopes that we are now witnessing the end of this particular experiment in creative capitalism: the government is moving to pick up the pieces of the mess the GSEs have made and their shareholders are losing most of their money.

What went wrong? The illusion that the companies were doing virtuous work made it impossible to build a political case for serious regulation. When there were social failures the companies always blamed their need to perform for the shareholders. When there were business failures it was always the result of their social obligations. Government budget discipline was not appropriate because it was always emphasized that they were “private companies.” But market discipline was nearly nonexistent given the general perception — now validated — that their debt was government backed. Little wonder with gains privatized and losses socialized that the enterprises have gambled their way into financial catastrophe.

I wonder how general the lesson here might be. My fear is fairly general. Inherent in the multiple objectives urged for creative capitalists is a loss of accountability with respect to performance. The sense that the mission is virtuous is always a great club for beating down skeptics. When institutions have special responsibilities it is necessary that they be supported in competition to the detriment of market efficiency.

It is hard in this world to do well. It is hard to do good. When I hear a claim that an institution is going to do both, I reach for my wallet. You should too.

And even with all of this, it might have worked out far less disastrously without social/political pressure to loan to people who were poor credit risks. Similar problems have been observed in public/private partnerships like utitilities

UPDATE:  Governments will probably continue to try to repeal the laws of economics (with the best of intentions, and the worst of results) until, oh, the heat death of the universe.  Or the Second Coming.

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2 Responses to “Privatized Profit, Socialized Risk: the problem of public/private companies”

  1. harmonicminer » Why the Bubble Burst says:

    […] has been pointed out before, it ain’t rocket science, and here’s an unusually succinct statement of the problem. The bursting of the housing […]

  2. harmonicminer » Irrational choice theory says:

    […] UPDATE:  Privatized Profit, Socialized Risk discussed here. […]

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