WHAT DO ethanol and the subprime mortgage meltdown have in common?The answer is the Law of Unintended Consequences. In the case of ethanol Jacoby argues,
Take ethanol, the much-hyped biofuel made (primarily) from corn. Ethanol has been touted as a weapon in the fashionable crusade against climate change, because when mixed with gasoline, it modestly reduces emissions of carbon dioxide. Reasoning that if a little ethanol is good, a lot must be better, Congress and the Bush administration recently mandated a sextupling of ethanol production, from the 6 billion gallons produced last year to 36 billion by 2022.Jacoby goes on to note that
But now comes word that expanding ethanol use is likely to mean not less CO2 in the atmosphere, but more. Instead of reducing greenhouse gas emissions from gasoline by 20 percent - the estimate Congress relied on in requiring the huge increase in production - ethanol use will cause such emissions to nearly double over the next 30 years.
The subprime mortgage collapse is another tale of unintended consequences.In this case the problem is the 1977 Community Reinvestment Act.
The crisis has its roots in the Community Reinvestment Act of 1977, a Carter-era law that purported to prevent "redlining" - denying mortgages to black borrowers - by pressuring banks to make home loans in "low- and moderate-income neighborhoods." Under the act, banks were to be graded on their attentiveness to the "credit needs" of "predominantly minority neighborhoods." The higher a bank's rating, the more likely that regulators would say yes when the bank sought to open a new branch or undertake a merger or acquisition.The backers of both these pieces of legislation I'm sure had good intentions, but the outcomes are bad. Why? There seem to be many examples of such outcomes, too many for it to be just bad luck. Political markets do not seem to punish inefficiency in the way we would expect economic markets to do. The incentives that politicians face are just don't seem to be right. But the incentives for politicians ultimately come from the voters. So if voters don't like the outcomes do they only have themselves to blame? Or is it that politicians are captured by special interest groups? But if they are, why? Why can't voters see the dangers of such capture and punish those politicians who act for interest groups. Is it that asymmetric information means there are rents associated with economic policy and the politicians are better informed about them than the voters. Voters will be unsure of the distribution of these rents, because they lack the necessary information. This gives politicians room to use these rents to their own personal advantage without the voters knowing, so they can not be punished. Or is it that the rational voter is just a myth?
But to earn high ratings, banks were forced to make increasingly risky loans to borrowers who wouldn't qualify for a mortgage under normal standards of creditworthiness. The Community Reinvestment Act, made even more stringent during the Clinton administration, trapped lenders in a Catch-22.
"If they comply," wrote Loyola College economist Thomas DiLorenzo, "they know they will have to suffer from more loan defaults. If they don't comply, they face financial penalties . . . which can cost a large corporation like Bank of America billions of dollars."
Banks nationwide thus ended up making more and more subprime loans and agreeing to dangerously lax underwriting standards - no down payment, no verification of income, interest-only payment plans, weak credit history. If they tried to compensate for the higher risks they were taking by charging higher interest rates, they were accused of unfairly steering borrowers into "predatory" loans they couldn't afford.
(HT: Greg Mankiw)