Fannie Mae and Freddie Mac as Capital Distortion Machines

By Anthony Randazzo & Adam Millsap

Fannie Mae and Freddie Mac's recent return to nominal profitability - at least as measured using questionable accounting methods but still leaving taxpayers $60 billion in the hole from the five year GSE bailout - has cast a shadow on the structural danger the government-sponsored enterprises pose to the economy. While the billions used to bail out the failed mortgage finance giants were an unacceptable cost to taxpayers, some of whom were concurrently being forced out of homes for similar insolvency issues, the greatest damage Fannie and Freddie have caused is in the form of immeasurable malinvestment of dollars over the past eighty years that has on the margin starved capital hungry businesses. The result is a level of homeownership beyond what the market would have reached on its own, skewing long-term economic growth trends and perhaps even contributing to today's high unemployment.

The link between homeownership and unemployment is a long debated issue in economic policy circles, but is particularly relevant to today's faux-recovery in housing and weak labor market. To wit, a recent paper sponsored by the Peterson Institute has been getting some press lately for its claim that too much homeownership may actually lead to increased unemployment and dampen new business creation. In "Does High Home-Ownership Impair the Labor Market?" authors David Blanchflower and Andrew Oswald argue that high levels of homeownership impose a negative externality on the surrounding area, which has the effect of increasing future unemployment. The same negative effects of homeownership rates show up when correlated with new business creation.

The paper does not identify a definitive causation link between homeownership and unemployment. However, the authors' strongest contention is that traffic congestion and the resulting longer commuting times found in areas of high homeownership, perhaps due to the reluctance of homeowners to move to obtain new employment, creates an unpriced external cost that lowers the rate of employment. A second explanation suggested by the authors is that homeowners push for zoning limits in a "not in my backyard" strategy to keep businesses from forming nearby. Accordingly, fewer new firms mean less employment opportunities and higher rates of unemployment.

Of greater importance, homeownership limits the mobility of the labor force because it can be challenging to sell one's home and move to places where jobs are most plentiful. The fact that labor immobility can contribute to unemployment at some level has been documented in multiple studies over the past few decades. One such well cited study by economists Richard K. Green and Patric H. Hendershott ("Home Ownership and Unemployment in the U.S.") found that the negative effect of homeownership on labor mobility and unemployment is strongest for middle-aged adults in the U.S.

However, there is a broader link that can be found between homeownership and today's continued high unemployment numbers if we look to the Austrian theory of malinvestment. The 1930s saw the creation of Fannie Mae and the Federal Housing Administration explicitly to encourage investors to put more capital into financing mortgages and lower the costs of homeownership. This means that more capital is used to finance mortgages than otherwise would be in the absence of a subsidy. Market pricing would allocate that capital to other endeavors and enterprises based on risk assessments and the potential for return on investment.

Scarce resources mean that any investment in housing is investment that cannot be employed in businesses. There are certainly good reasons for households to buy homes and for investors to finance mortgages. However, the unintended consequence of subsidizing home ownership is decreasing business investment. If an individual purchases a home because its price has been lowered by a federal subsidy, or an investor shifts capital into mortgage finance because of guarantees from Fannie and Freddie, then homeownership is being pursued contrary to how the market would otherwise direct that money, perhaps at the cost of job creation.

Businesses need capital both to start up and expand. Any policy that distorts the capital market in favor of home ownership over business investment is going to see more of the former and less of the latter. In a time of high unemployment the last thing we need is the government subsidizing housing at the expense of business creation. (At the same time, tax policies that incentivize business investment over other uses of capital are equally harmful to long-term economic growth.)

It is important to recognize that subsidizing one thing in favor of another will eventually lead to problems, even if on the surface the subsidies appear to be helpful. Correcting the problem of malinvestment is as easy as simply allowing the market to work. Housing reform that eliminates boondoggles Fannie Mae and Freddie Mac, rolls back the mortgage interest deduction, and shrinks government mortgage guarantees by the FHA would go a long way toward solving the current distortionary problems in the capital market.

Reform focused on reducing the role of government in mortgage finance would probably lead to lower rates of homeownership, but as Branchflower and Oswald show, this may not be a bad thing. For too long this country has maintained policies that subsidize homeownership as part of the American Dream. It is time that we recognize the shortcomings of those policies and accept that they're doing more harm than good.

Anthony Randazzo is director of economic research at Reason Foundation where Adam Millsap is a summer policy intern.
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