Friday, July 25, 2008

Fragile by Design

Arnold Kling looks at Fannie Mae and Freddie Mac and discussed the fragile nature of their design.
This summer’s episode of the crisis in housing finance featured Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs). While it was often said that Fannie and Freddie were “too big to fail,” the real reason the government rescued the two mortgage giants is that their portfolios are too difficult to liquidate. Unlike Bear Stearns, the investment bank that collapsed suddenly earlier this year, Fannie and Freddie cannot be merged into other firms.

The GSE bailout exposed the fragility of our mortgage finance system. Years of government intervention have made the mortgage market heavily dependent on the GSEs. (As Treasury Secretary Hank Paulson has noted, in the first quarter of 2008 they funded 70 percent of all mortgage originations.) By the same token, the government policies that fostered this excessive concentration also made the GSEs highly susceptible to the sort of “run on the bank” that took place earlier this month.
Kling notes that Fannie and Freddie were designed to deal with catastrophic failures like the great depression, but are incredibly fragile when faced with something new.
Fragility is a common characteristic of centrally-planned systems. Designed to withstand historical shocks, they can fail catastrophically when faced with a new experience. The classic example is the Maginot Line, which was well-suited to the historical experience of World War I but unsuccessful when confronted with the Nazi blitzkrieg.

The opposite of a centrally-planned system is an emergent order, or what economist Friedrich Hayek termed a “spontaneous order.” A classic example would be the English language. No one designed the English language; it emerged and adapted over time. Language does not work well when it is designed top-down, as the failed example of Esperanto illustrates. Common law, which is built up over the years by precedent, is another example of an emergent order.
These are brilliant illustrations and I urge you to read the whole article.

No comments: