Tuesday, October 6, 2009

Meddling with Prices: Subsidies

The government may provide a subsidy. The government takes tax money and uses it to pay part or all of the price of a good, and gives that good to some beneficiary. The good is both overproduced and overconsumed, but incentives to produce it efficiently or at increased quality are decreased. People don't care as much about these when they didn't themselves earn the money they are spending.

One of the most prominent examples these days is The Scooter Store. Tax money is diverted to scooters, increasing the seller's revenue while reducing or eliminating the buyer's cost. Consumers are more likely to buy, and not likely to hunt for bargains. Producers have an incentive to make more, but not to cut costs or prices. They both win, as do the government employees who administer the program. The losers are everyone who would have liked to use their tax money for something besides buying a scooter for somebody else, and anyone who competes with scooter manufacturers for land, employees, and raw materials.

Health care is rife with subsidies. This article by David Goldhill tells many of the ways that health care costs are diverted from people who get health care to others, and the problems this causes. When the customer isn't paying, he doesn't bother to look for a bargain. When the supplier knows he's going to get paid no matter what he does, he has no incentive to cut costs or improve quality. Mr. Goldhill's story about handwashing is a perfect example.

Another prominent example is postsecondary education (ie, at colleges and universities). As Pell grants and Stafford loans have increased, so too has tuition, ensuring that the market is always charged all that the family of the student can bear, PLUS any subsidies and financial aid they can acquire. And college students learn less and less about how to think and learn with each passing decade.

The housing crisis is also a case of subsidies causing problems. Fannie Mae and Freddy Mac are both federally subsidized companies that would promised to buy risky home mortgages from banks. Basically, they told the banks, "Make a loan to anybody who has a pulse and fills out an application. It doesn't matter if they've never paid off anything in their lives, or if the monthly payment would be twice their monthly income. If they don't pay it back, the government will buy the mortgage from you and collect the money from the borrowers." Artificially increased demand caused artificial increases in price. The artificial increases in price drew extra people into home construction. Most people who were getting the loans and knew they couldn't pay them off didn't care. They figured somebody else would come along before disaster struck and buy the home from them for enough to pay off the entire mortgage and put some money in their pockets besides.

Fannie Mae and Freddy Mac started running out of tax money to buy up bad loans, so they started selling their loans to investors and banks as "innovative mortgage-backed securities." They, and the banks, treated these MBS as part of their capital base. This meant that they could count them as part of their 3%-5% of assets that they actually have to keep on hand to pay depositors and creditors. The value of these things is hard to determine. What people are willing to pay for them at any moment may be a far, far cry from how much money they would bring in if you held on to them. The Federal Accounting Standards Board prefers that assets be valued at what people last paid for it.

How does this work? Imagine a mutual fund, whose primary asset is 10,000 mortgages, that the mutual fund company bought from Fannie Mae. Let's call it "Fannie's Upstanding Collection of Homeowners" and assign it the symbol, FUCHXX. They sell 10,000,000 shares of this agglomeration of mortgages. Your bank buys 10,000 shares of FUCHXX at $40. So they have $400,000 in FUCHXX. They count it as a $400,000 asset, even though they expect it to eventually pay them $800,000 in dividends. Then they loan out $8 million on the strength of that asset, most of which they borrowed.

News comes out that the default rate on Fannie Mae mortgages is absurdly high. Nobody is willing to buy anything based on them. FUCHXX drops to $8 a share. Your bank now has to count it as an $80,000 asset. This means it now has to either come up with another $320,000 in assets, or buy back $6.4 million in loans. Your bank is in big trouble.

That is about what happened to cause the banking crisis that launched the $700,000,000,000 Troubled Asset Recovery Program of President Bush, and the (far larger) "stimulus" package that was recently passed by the Democrat Party and President Obama. Neither of these does much to address the real problem: people were given mortgages they couldn't afford to pay off, and builders built far more houses than people would have bought if they had been limited to mortgages they could afford. The artificially high supply of mortgages is gone, leaving banks and taxpayers holding the bag. The money can't be made back by selling the houses, either. The artificially high demand for homes is gone too, leaving them worth much less than the defaulted mortgages for which they are collateral.

In this series:
Supply, Demand, and Price | Price Caps | Price Supports | Restricting Supply | Excises | Subsidies

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