How Capitalism Will Save Us

by Steve Forbes

  Fail to invest successfully or work productively and your net worth will quickly decline. People hold up free-spending Paris Hilton as an example of the selfishness and self-indulgence of wealth. What they don’t understand is that, unless she buckles down and actively builds up what she inherited she will become an example of downward mobility. One especially sad example is the once-mighty Astor fortune. At its height, the family wealth exceeded, relatively, that of Gates and Buffett put together. The Astors owned a big chunk of Manhattan. But as the family multiplied, their business acumen declined. The late Brooke Astor in fact took pride in giving away most of what remained of the fortune to a variety of charities, such as the New York Public Library. Since then, the family’s sad, scandalous story has become tabloid fodder: her son, eager for the remnants of this once-colossal fortune, was accused of abusing his aging and ailing mother, providing her with inadequate care, and forging changes to her will.

  The moral? Even the most seemingly massive, solidly based pools of wealth eventually evaporate. Entrepreneurial genes are rare indeed, and no family has a heredity claim on them.

  Bottom line: people get rich by working hard, innovating, and investing. The only ones who get rich at other people’s expense are bank robbers.

  Q AREN’T THE ABUSES OF SUBPRIME MORTGAGES THE PERFECT EXAMPLE OF HOW RICH PEOPLE MAKE FORTUNES ON THE BACKS OF THE POOR? IN THIS CASE, THEY REAPED PROFITS FROM PREDATORY LENDING AND MORTGAGE-BASED SECURITIES TRADES WHILE LOW-INCOME PEOPLE LOST THEIR HOMES.

  A SUBPRIME-MORTGAGE ABUSES PROLIFERATED AS A RESULT OF MARKET DISTORTIONS CREATED BY GOVERNMENT IN THE NAME OF HELPING POOR PEOPLE.

  During the 2008 financial meltdown—the stock market crash and credit crisis brought on by the collapse of the subprime-mortgage market—House of Representatives speaker Nancy Pelosi made an angry speech placing the blame for the disaster squarely on the shoulders of the rich: “On Wall Street people are flying high, they are making unconscionable amounts of money. They make a lot of money, they privatize the gain, the minute things go tough, they nationalize the risk. They get a golden parachute as they drive their firm into the ground, and the American people have to pick up the tab. Something is very, very wrong with this picture.”5

  Pelosi’s outburst on the eve of the first vote on Congress’s bank bailout was driven by election-year politics. Nonetheless, it reflected a view of free enterprise shared by critics and cynics on both left and right—that free markets essentially “privatize the profits, nationalize the losses.” To them, 2008’s financial Katrina was just one more example of the perils of capitalism, where people, propelled by greed, heedlessly and callously enrich themselves at the expense of others.

  Such an explanation may resonate with those who have seen too many Hollywood movies about corporate America, with cartoonish portrayals of demonic corporations and greedy Wall Street villains. But it bears no resemblance to what happened in the Real World.

  As we have pointed out, the most extreme economic downturns usually take place after government intervention ends up distorting markets. The subprime meltdown was not the result of runaway capitalism and the greedy machinations of “rich people.” It was the result of well-intentioned government interventions—including some intended to help poor people—that ended up wreaking havoc in the housing and financial markets.

  Most people fail to fully appreciate the roles of the two “government-sponsored enterprises” at the center of the debacle—Fannie Mae and Freddie Mac. We have discussed their activities in preceding chapters, and we will be returning to them again. We explained in chapter 1 that the mission carried out by Fannie and Freddie originated with government during the Depression. Fannie was a government agency created to boost the resources of banks to enable them to lend more and thus increase homeownership. Freddie Mac was a Fannie clone created in 1970. Alan Reynolds of the Cato Institute explains that the two corporations themselves did not provide mortgages:

  They just buy bundles of mortgages from lenders and swap them for mortgage-backed securities. They also invest in private mortgage-backed securities, paying for them by getting deeper in debt.6

  Fannie and Freddie fueled the trend toward securitization, the bundling of home loans into mortgage-backed securities that were bought and sold on Wall Street. In and of itself, securitization was a very positive financial innovation. The pool of money available for mortgages was now the entire financial system—instead of just local banks. Securitization spread the risk; if a mortgage went bad, one bank wouldn’t take the whole hit. The impact would be spread all over the country and throughout the world. Lower risks meant lower, more affordable mortgage rates. But unfortunately, like many essentially positive innovations, securitization could be misused and abused.

  We mentioned in chapter 2 that Freddie and Fannie began as federal agencies. They were later spun off by the government so that they could sell shares to the public and generate more mortgage money. But they weren’t truly privatized. Noted economist Alan Reynolds explains that Fannie and Freddie were vastly different from other private-sector corporations:

  They’re exempt from state and local taxes. And their required “core capital” (mainly stock) is merely 2.5 percent of assets, compared with a 6 to 8 percent norm for banks. As a result, their $5.3 trillion of debt is piled precariously atop a thin cushion of only $81 billion in core capital. It’s risky business. But who bears the risk? Fannie and Freddie pay an artificially low interest rate on their bonds because everyone assumes that, if it came to it, the U.S. Treasury would bail them out. The artificially fat spread between interest rates earned on mortgages and interest rates paid on bonds amounts to a big subsidy. That thwarts competition. It also undermines market discipline, because creditors have little incentive to monitor the firms’ borrowing and investments.7

  Fannie and Freddie had been created to serve as helpful resources in the housing market. Instead, the two giants virtually became the market. They recklessly expanded their indebtedness. Who cared? Uncle Sam stood behind them.

  During the administration of Bill Clinton, Fannie and Freddie became true behemoths. As Terry Jones recalled in Investor’s Business Daily in September 2008,

  [President] Clinton…extensively rewrote Fannie’s and Freddie’s rules. In so doing, he turned the two quasi-private, mortgage-funding firms into a semi-nationalized monopoly that dispensed cash to markets, made loans to large Democratic voting blocs and handed favors, jobs and money to political allies. This potent mix led inevitably to corruption and the Fannie-Freddie collapse.8

  By the mid-2000s, some people were warning of the enormous risk to the economy Fannie and Freddie had created. A report from the Heritage Foundation warned in 2005: “Fannie Mae and Freddie Mac have abused their generous federal privileges to the point that they now control as much as half of the nation’s residential mortgage market. Their commanding presence exposes U.S. financial markets to excessive risk and instability.”9

  Calls to rein in Fannie and Freddie went unheeded. Enriched by their government ties and special privileges, these government-sponsored monsters had enormous lobbying power. Between the late 1990s and 2008, the two spent some $200 million to buy political influence. Fannie and Freddie made themselves the most potent lobby in Washington—more powerful than any corporate interest from the private sector. Political contributions flowed everywhere. “Affordable housing” charities with ties to Fannie and Freddie had a presence in virtually every congressional district. Relatives of influential politicos could often find a cushy perch in these organizations.

  Fannie and Freddie were a favorite landing place for ex-officials and staffers from Congress seeking lucrative jobs after government careers. The hours were easy. And the pay was lavish. Fannie and Freddie soon had more million-dollar executives than virtually any company in America. In 2004, Fannie Mae’s then CEO Franklin Raines was seventy-seventh on Forbes list of most highly paid executives, with an annual compensation of $11.6 million.

  Fannie a
nd Freddie didn’t even have to make the financial disclosures required of every other publicly held company in America. This gravy train began to slow in 2004, when Raines and his executives were accused of manipulating Fannie’s books, overstating earnings and understating risk in an obvious ploy to inflate their bonuses. After an SEC review, Fannie had to cut its dividend to bolster its shaky finances. Raines and others were made to resign. Did they go to jail, as they would have in the private sector? Not a chance.

  While Fannie and Freddie were building their government-sponsored mortgage empires, Washington politicians were working to lower lending standards to homeowners. Lenders were pressed to abandon the standard they had developed based on decades of market experience, which had proved effective in filtering out too-risky borrowers—requiring homeowners to put 20 percent down. Why put 20 percent down? Why not 3 percent? That’s what Washington started to do in the 1970s. By the 2000s, President George W. Bush’s administration was urging lenders to write mortgages requiring no down payment.

  People who blame Wall Street for the subprime crisis conveniently forget that in the 1970s, banks were demonized for “redlining”—failing to lend to low-income neighborhoods. Congress, in 1977, during the Carter administration, responded by passing the Community Reinvestment Act, designed to pressure banks to make more loans. Banks could not get government approval to merge unless they had a CRA rating that showed they were in compliance with the law. Critics at the time warned that the act would lead to unsound lending and distort markets.

  The Community Reinvestment Act did not create today’s crisis, but it established a critical government priority that influenced lending for the ensuing decades, increasing pressure on banks to make loans they would not have made under normal circumstances. Thus, Uncle Sam institutionalized the very practices that are today labeled “predatory.”

  Government pressure on banks to lower lending standards and the creation of Fannie and Freddie were just two of the unfortunate interventions that helped inflate the subprime bubble. As we explained in chapter 2, misguided Federal Reserve policies of too much money and low interest rates also helped to fuel the lending mania.

  Clearly, no one in either government or the private sector could have foreseen that such a perfect storm could occur. There was plenty of blame to go around. But the Real World truth is that the subprime meltdown and its corruption was not caused by a private sector looking to get rich at the expense of the poor, but by government efforts to influence markets in the name of well-meaning social policies.

  REAL WORLD LESSON

  Private-sector “greed” is all too often blamed for calamitous market distortions engineered by government in the name of helping the poor.

  Q DON’T THE NUMBERS SHOW THAT THE POOR ARE SLIPPING WHILE THE RICH ARE GETTING RICHER?

  A NO. THE REAL WORLD TRUTH IS THAT OVER RECENT DECADES, ALL GROUPS HAVE GOTTEN RICHER.

  The era of 1982–2007 may well go down in history as a golden age of growth produced by a succession of promarket government reforms—most notably, the tax cuts of Ronald Reagan and George W. Bush, as well as the capital gains tax cut of Bill Clinton. A boom in high technology, finance, and other sectors created numerous newly rich individuals. This wealth was not at the expense of the poor. Everyone profited from millions of new jobs, products, and services.

  Yet even in good times, despite countless positive economic indicators, critics of capitalism insisted that the longest boom in the nation’s history benefited only “the rich,” while the poor lost ground.

  Exhibit A, some say, is the Gini coefficient, a government ratio measuring income distribution. In 2005 it reached its highest level ever according to the U.S. Census Bureau, 0.0462, reflecting a historic level of “income inequality,” an unprecedented gulf between rich and poor. Further proof, they say, is provided by Census Bureau statistics showing that the percentage of Americans living below the poverty line has remained virtually unchanged since the 1960s—around 12.5 percent.

  These numbers supposedly provide irrefutable evidence that the freemarket policies of the past three decades simply haven’t worked. In the words of Hillary Clinton, they’ve delivered “trickle-down economics without the trickle.”

  The problem is that many experts—on both ends of the political spectrum—say the government’s poverty numbers are frequently misrepresented. Some believe they’re just plain wrong.

  Let’s look at those income inequality numbers. Yes, there is a wider gulf between poor and rich incomes today than in years past. But it’s not because the poor are falling behind, but because more low-income people than ever are coming here.

  Between 500,000 and more than one million immigrants, many of them poor, are admitted to the United States each year. This does not include the one million to two million illegals who annually enter the United States. (Obviously, in times of recession, particularly a severe one, the number of newcomers temporarily declines.)

  According to Brink Lindsey of the Cato Institute, author of The Age of Abundance: How Prosperity Transformed America’s Politics and Culture, the portion of the total U.S. population born in foreign countries jumped from 5 percent in 1974 to 12 percent in 2004.10 Today’s top points of origin are not the European nations as they were in years past, but the world’s poorest countries, such as Mexico, Haiti, Cuba, the Dominican Republic, Nicaragua, and El Salvador, among others.

  Even the most mathematically challenged among us would acknowledge that the influx of so many tens of thousands of low-skilled, low-income people is going to widen the extremes of income in this country.

  This flood of immigrants raises the question, would so many be breaking their necks to come here—sometimes paying small fortunes to smugglers and risking their lives—if they believed the United States was a place where the poor got poorer? Media fantasies of American affluence are not the only thing drawing so many hundreds of thousands, legally and otherwise, to our shores and across our borders. They are motivated by the experiences of relatives, friends, and friends of friends who have conveyed an irresistible message: America is a place where you have a better chance to get ahead and even get rich.

  That’s what the income inequality numbers don’t show: income mobility, the movement between income levels in our economy. Few of us remain at the same income level throughout our lives. We move up and sometimes down depending on our age, our career advancement, and fluctuations in the economy.

  When you look at the statistics for income mobility, the numbers show that the poor are doing anything but standing still. America’s democratic capitalist society is more upwardly mobile than at any other time in history.

  According to a U.S. Treasury Department study of American taxpayers, about half of those in the lowest income group when filing their tax returns in 1996 moved into a higher income category by 2005. Twenty-five percent moved into a middle-or upper-income group, while more than 5 percent moved into the highest quintile.

  Diana Furchtgott-Roth, former chief economist at the U.S. Department of Labor, says that this upward mobility is reflected in a dramatic improvement in living standards among low-income people over the past two decades:

  In 1985, 38% of poor households owned a home—by 2005 it was 43%. And these homes were of better quality than the 1985 homes. In 1985, 17% of these homes had central air conditioning, and in 2005, 50% did. Fifty-six percent of homes owned by poor households had washing machines in 1985, and in 2005, it was 64%.11

  The Wall Street Journal observed that mobility runs in both directions. Among those with the very highest incomes in 1996—the top 1/100 of 1 percent—only 25 percent remained in the group in 2005.12

  Nor does greater income equality mean a fairer society. Journalist Hedrick Smith discovered this as a New York Times correspondent in the communist Russia of the 1970s. On paper, there may not have been income inequality. But there were still dramatic disparities:

  Money is a poor yardstick in Russia. Earnestly, I asked Intourist guides,
queried my Russian office interpreters, went to factories or engaged people in conversation in restaurants, inquiring how much they earned, how much they spent on food or rent, how much it cost to buy a car, trying to compare living standards. I busily went on making computations until Russian friends tipped me off that it was not money that really mattered but access or blat …influence or connections.13

  “Rich people” in the old Soviet Union may not have had American-style bank accounts. But they enjoyed special privileges off-limits to most Russians—like access to special stores with rare consumer goods, as well as the right to travel. Incomes in Russia may have been more equal. But there was less fairness: power and material wealth were concentrated in the hands of a tiny elite whose position was based on political favors and power.

  And what about that other oft-cited statistic—the 12.5 percent of Americans who have supposedly been stuck for decades at an income below the poverty line? In 2007, American Enterprise Institute analyst Douglas J. Besharov testified before the House of Representatives Ways and Means Committee that “many on the left as well as the right” believe the methodology used to produce that Census Bureau number is highly flawed and is very likely overstating the nation’s level of poverty.14

  The Census Bureau’s formula for calculating “income” understates things like self-employment income, which is not always reported. It also does not include numerous “in kind” benefits from government programs, such as food stamps and Medicaid. Nor does it encompass cash payments from government programs such as unemployment insurance and workers’ compensation. Besharov says that’s only the beginning of a dizzying list of flaws. Not all errors involve underreporting. But when they’re all tallied up, Besharov says the net effect is a dramatic understatement of real income.