Today’s government-bungled finances echo economist’s warning of 65 years ago


Standard & Poor’s recent decision to downgrade the credit rating of the United States government from AAA to AA+ contributed to the biggest drop of the Dow Jones Industrial Average since December 2008. Gross national debt is at $14.5 trillion. Unemployment is 9.1 percent. And the government-owned Freddie Mac mortgage finance entity is asking for another $1.5 billion from taxpayers. According to Reuters, “Freddie Mac has drawn $65.2 billion from the government [read: taxpayers] since it was taken over at the height of the financial crisis in September of 2008.”

Clearly, federal bureaucrats from decades past until the present have failed as stewards of the taxes they take from the world’s greatest source of wealth: the private citizens of the United States. Though the questions and recriminations are innumerable as to the causes and possible solutions, this post addresses just one: Why shouldn’t government get involved in lending money? The federal government’s role as lender and banker has contributed substantially to the current fiasco. Is this a role government should play?

For the answer, we turn to economist Henry Hazlitt and his 1946 classic Economics in One Lesson. For anyone wanting to understand the basics of economics, this is an essential read. Below are excerpts providing an answer to our question:

There is a decisive difference between the loans supplied by private lenders and the loans supplied by a government agency. Each private lender risks his own funds. When people risk their own funds they are usually careful in their investigations to determine the adequacy of the assets pledged and the business acumen and honesty of the borrower.

If the government operated by the same strict standards, there would be no good argument for its entering the field at all. Why do precisely what private agencies already do? But the government almost invariably operates by different standards. The whole argument for its entering the lending business, in fact, is that it will make loans to people who could not get them from private lenders. This is only another way of saying that the government lenders will take risks with other people’s money (the taxpayers’) that private lenders will not take with their own money.

…What is really being lent is not money, which is merely the medium of exchange, but capital. What is really being lent, say, is the farm or the tractor itself. Now the number of farms in existence is limited, and so is the production of tractors. The farm or tractor that is lent to A cannot be lent to B. The real question is, therefore, whether A or B shall get the farm.

Hazlitt goes on to show that the decision about who should get the farm is based on credit. Hazlitt explains that credit is not something a banker gives to a person, but rather it is something that person already has. He or she has it because they have marketable assets, character, or a proven record.

Now it is to A, let us say, who has credit, that the banker would make his loan. But the government goes into the lending business in a charitable frame of mind because, as we say, it is worried about B. B cannot get a mortgage or other loans from private lenders because he does not have credit with them. He has no savings; he has no impressive record as a good farmer; he is perhaps at the moment on relief. Why not, say the advocates of government credit, make him a useful and productive member of society by lending him enough for a farm and a mule or tractor and setting him up in business?

Perhaps in an individual case it may work out all right. But it is obvious that in general the people selected by these government standards will be poorer risks than the people selected by private standards. More money will be lost by loans to them. There will be a much higher percentage of failures among them. They will be less efficient. More resources will be wasted by them. Yet the recipients of government credit will get their farms and tractors at the expense of those who otherwise would have been the recipients of private credit. Because B has a farm, A will be deprived of a farm. A may be squeezed out either because interest rates have gone up as a result of the government operations, or because farm prices have been forced up as a result of them, or because there is no other farm to be had in his neighborhood. In any case, the net result of government credit has not been to increase the amount of wealth produced by the community but to reduce it, because the available real capital (consisting of actual farms, tractors, etc.) has been placed in the hands of the less efficient borrowers rather than in the hands of the more efficient and trustworthy.

So, we see how government loans can distort the free market to reduce overall wealth, but what if government does not offer loans and chooses only to guarantee them? Hazlitt also answers this question, and in a way that is eerily prophetic in respect to today’s economic environment:

The case against government-guaranteed loans and mortgages to private businesses and persons is almost as strong as, though less obvious than, the case against direct government loans and mortgages. The advocates of government-guaranteed mortgages also forget that what is being lent is ultimately real capital, which is limited in supply, and that they are helping identified B at the expense of some unidentified A. Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to “buy” houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief in the long run they do not increase overall national production but encourage malinvestment.

The federal government has gradually worked its way into the U.S. housing market and other markets, and now Americans are paying for it.  And government lending happens not only on the federal level but on the state and local level, as we reported in June.

[pullquote]Government does not create wealth, it only destroys it or moves it around.[/pullquote]All of this reminds us that government does not create wealth, it only destroys it or moves it around. Here is a final quote from Hazlitt in this regard, including a nugget relevant to our current national debt situation:

The government never lends or gives anything to business that it does not take away from business. One often hears New Dealers and other statists boast about the way government “bailed business out” with the Reconstruction Finance Corporation, the Home Owners Loan Corporation and other government agencies in 1932 and later. But the government can give no financial help to business that it does not first or finally take from business. The government’s funds all come from taxes. Even the much vaunted “government credit” rests on the assumption that its loans will ultimately be repaid out of the proceeds of taxes. When the government makes loans or subsidies to business, what it does is to tax successful private business in order to support unsuccessful private business. Under certain emergency circumstances there may be a plausible argument for this, the merits of which we need not examine here. But in the long run it does not sound like a paying proposition from the standpoint of the country as a whole. And experience has shown that it isn’t.