Published on the site of the Financial Post (www.nationalpost.com), October 22, 2008, p. FP-15

 

No Free Financial Lunch
by
Pierre Lemieux

 

Former Liberal Finance Minister John Manley is all excited: he believes that the new government program to buy home mortgages from banks is a financial free lunch – even if he didn’t use this specific dithyramb in his comments to the Globe and Mail. The program has the Canada Mortgage and Housing Corporation (CMHC) purchase home mortgages from banks, starting with a chunk of $5-billion last Thursday and eventually going up to $25-billion and perhaps more. Since the state borrows at lower cost than private institutions, it can buy the mortgages at prices that profit both the banks and the taxpayers. The problem with this reasoning is that it proves too much. For then, why not make the state the only lender in the economy? The federal government could purchase all credit instruments from private financial institutions. The state would compete away all private lending institutions in the interest of all. The ultimate free financial lunch, indeed. We can see what’s wrong with this reasoning by going back to the basics. Ottawa buys mortgages for at least what they would sell for on the market. Otherwise, of course, the banks wouldn’t sell. Mr. Manley tells us that the banks asked Ottawa for the bargain. No surprise there: the free lunch is for them. But somebody will have to pay the bill. Given the new cash infusion, perhaps the banks will lend more, thereby boosting the money supply and generating inflation. But perhaps they won’t, and choose to stay in government securities. In the latter case, what happens is simply that the state lends money that was previously lent by private financial institutions. The taxpayers now shoulder the default risk that private investors and institutions were previously assuming. Indeed, it is because private lenders consider this risk too high that they happily dump their loans on the state. Since the state borrows at a lower interest rate, the risk is diminished, but not eliminated. By being forced to invest through the state, some taxpayers take more risk than they would want to. And the more the program expands, the higher the risk and the larger the number of cheated taxpayers. Why does the state pay less than private borrowers? Interest on government securities is lower because investors believe the risk premium is zero. The reason for this belief is simple: the state can always force the taxpayers to cough up the money. However, the default risk is nil only as long as taxpayers have enough money to pay or as long as they don’t revolt. This is why the yield on government securities is not lower in banana republics. The more the state evicts private lenders from the credit market, the higher the risk would become that it defaults on its debt obligations. The marginal interest rate on government securities would therefore rise, until the cost advantage of government lending has disappeared. Moreover, a government lending monopoly – the ultimate financial free lunch – would have an incentive to increase its interest margin by raising the rates at which it lends and decreasing the rate at which it remunerates savings. Competitive efficiency would be destroyed. And this is not counting the serious political problems that would follow from the state controlling all credit and, thus, all economic activity. Therefore, a government lending monopoly would not be a good idea. Taxpayers would have to shoulder higher risks and pay higher interest rates. And nearly everybody would lose from the abolition of competition and the increase in state power. Now, a small $25-billion purchase of mortgages (which are in fact already guaranteed by the state and only amount to 8% of all such guaranteed mortgages) will have similar consequences, only to a smaller degree. Either the program leads private lenders to increase their private loans by the same amount, and we get an increase in the money supply. Or private lenders stick to government securities, and we end up with an eviction of private lending by public lending. Because the amounts involved in the actual program are small and because the loans were already guaranteed by CMHC, however, the government’s borrowing cost will not be affected and the taxpayers will not immediately feel the pinch. Yet, $25-billion of the mortgage market will have been (more tightly) nationalized. And it will be very tempting for the government to continue eating into an apparent free lunch. The question is, are political and bureaucratic processes more efficient at allocating mortgages than the market? The American subprime crisis, which developed on a very socialized and politicized market, provides the answer. Ottawa should listen.