Gurus: Blame The Gub’ment?

A controversial economist says government attempts to increase home ownership are at the root of the sub-prime mortgage mess.

John R. Lott, a senior research scientist at the University of Maryland, is one of America's most controversial economists. Lott is best known for his comprehensive study of the effects of gun ownership on crime. After doing a statistical analysis on crime statistics and gun ownership data in every county in the United States from 1977 to 1994, Lott concluded: “More Guns, Less Crime,” which is also the title of a book published in 1998 by the University of Chicago Press. Naturally, opponents lined up to criticize his methods. Anti-gun activists even posed as him on the internet to embarrass him. Newsweek, in a 2001 profile, derisively called him the “gun crowd's guru,” and flatly described him as a pariah in academic circles — a brilliant if complicated economist who couldn't keep a university job for long.

But the ill effects of gun control are not even his most controversial research subject. He has conducted research that argues that affirmative action in police departments leads to higher crime rates; that women's suffrage led to a massive increase in the amount of non-military government spending beginning in the 1920s; government licensing of doctors and lawyers amounts to illegal restraint of trade; and that secret ballots reduce voting participation. For this and other work, Nobel Laureate Milton Friedman said that, “John Lott has few equals as a perceptive analyst of controversial public policy issues.”

In short, Lott is a good read and, to this reviewer, persuasive. But for those who are not of a free-market leaning, his conclusions can be polarizing. It was his assertion that abortion increased violent crime in the 1970s that helped stoke a colossal row with Steven Levitt, the author of Freakonomics. And their disagreements resulted in Lott filing a defamation suit against Levitt; the suit was dismissed, but Lott is appealing. Indeed, Lott's most recent book, Freedomnomics: Why The Free Market Works And Other Half-Baked Theories Don't (Regnery Publishing, 2007), is, in some ways, an assault on what Lott considers to be the faulty logic behind Freakonomics, still a best seller and still on every airport kiosk shelf, even years after its first printing. On the dust jacket for Freedomnomics, Lott concludes, “The controversial assertions made in the trendy book Freakonomics are almost entirely wrong.” The book misleads the public and fuels unreasonable suspicion of corporations and the free market, Lott avers. As for the current mortgage meltdown? You guessed it, it's partly the government's fault.

Registered Rep.: There is all this talk about so-called excess profits being made by petroleum companies. Didn't we learn from the 1970s that windfall profit taxes are a bad idea?

JOHN LOTT: The reason why the price of oil is so high right now is that people demand more of the products than we have available. The question is: How do you solve that? I think probably the best way to solve that is to give people the incentive to go and produce more, provide more for people. The more profits people think that they can make, the faster they're going to provide that service for other people. The threat of windfall profit taxes diminishes the return for people going out and doing it.

It's not like we have a lot more monopoly power over the price of oil in the market compared to a year or two years ago. And a lot of people like to think that there's some nefarious cabal or something determining oil prices. But …

RR: OPEC obviously affects the price of oil, but otherwise it's too big of a market to be manipulated.

JL: Right. Just listen to the discussion had by politicians. People seem to think that American oil companies are doing something nefarious to cause the prices to go up. But it's pretty clear when you look at the data: It's the world price of oil that's determining the gas prices. And if you look at gas over the last two years, five years, 10 years or whatever, you see gas prices go up and down based on the worldwide price for oil.

RR: The point of your latest book is that markets work.

JL: To me economics boils down to a pretty basic idea — if something's more costly, people do less of it. Put another way, the greater the return that you get from something, the more you're going to do it. And that simple idea, I think, really explains a lot of the world's behavior, a lot of things that businesses do and a lot of human activities — from crime to why out-of-wedlock births increased during the 1970s. So, I think people often view economics as being much narrower than that, but I think economics is a part of everyday life in many different ways.

RR: In your book you talk about some of the problems that governments create when they try to regulate things or set prices. Government, however well meaning, can make so-called market failures even worse. Should the government save Freddie Mac and Fannie Mae? What is your take on what Paulson and the Treasury are doing?

JL: The irony is how so much government policy got us in the situations we're in right now in terms of the housing market.

RR: Really?

JL: Yes, in the 1990s there was a huge amount of pressure on banks and lending institutions to change the rules that they used for lending money. There was a study done by the Boston Fed in the early 1990s that claimed that there was discrimination in the mortgage market. In 1992, the Fed said, and I quote, “discrimination may be observed when a lender's underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower–income minority applicants.” It created a manual for mortgage lenders.

So what is on the list of Fed's “outdated criteria”? Such discriminatory factors as the borrower's credit history, income verification and the size of the mortgage payment relative to income. The report said, “Lack of credit history should not be seen as a negative factor.” It suggested that people with past credit problems should be reviewed for extenuating circumstances. So the Fed basically demanded that banks lower their lending standards.

It turns out afterwards that it was one of these bizarre situations where the study that the Fed had done was based upon some faulty data. There had been some typos in the data. So you had somebody who got turned down for buying a $60,000 house where the claim was that his net worth was $10 million. And, in fact, his net worth was probably $1,000.

But anyway, once those observations were cleaned up it turned out that that wasn't the type of discrimination that was going on. The problem was that the study was used to go and pressure the banks — through rules that are put out by the Federal Reserve — to stop take into account individual income, or ability to repay.

RR: Come on.

JL: I wrote a piece on this a while ago. Indeed, two academics — Professors Ted Day and Stan Liebowitz at the University of Texas at Dallas — criticized the Fed policy back in 1998, warning, “After the warm and fuzzy glow of ‘flexible underwriting standards’ has worn off, we may discover that they are nothing more than standards that lead to bad loans … these policies will have done a disservice to their putative beneficiaries if … they are dispossessed from their homes.” True.

The real irony is that earlier you had the federal government pushing lending institutions to make loans that they didn't want to make to the risky borrowers. And now the government wants stricter loan requirements. So it's kind of like the federal government has gone from one extreme to the other.

And by tightening loan requirements now, of course, that feeds into this whole problem, because that means people are not going to be able to buy houses that otherwise they would have been able to buy in a normal market. And that causes prices of houses to go down more than they otherwise would have gone down.

RR: So, let me guess, you were critical of the Bear Stearns bailout.

JL: Yeah, well, I guess my concern is that you want people to bear the risks that they take. And we've probably gotten to a point in this country where people just assume the federal government is going to come and bail banks out, or individuals with too much mortgage. So, you end up with problems like we had.

RR: So what's the answer?

JL: I think the answer is just trying to rely on private insurance mechanisms as much as possible. At the very least if they're going to insist on the government providing this type of insurance, you should at least try to have the government price the insurance as a private company would do it.

RR: But then going back to the financial services institutions, you had those so-called monoline insurance companies that would insure as a hedge for some of these securities that these firms were investing in. And that didn't work out so great either.

JL: I'm not going to say that people don't make mistakes on these types of things. Sure, they make mistakes; information is not perfect out there. The question is, do people at least have an incentive to bear the costs of the risks they take?

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