Who Guards the Guardians? How the United States Government Caused a Worldwide Economic Crisis By Jeffrey Borrowdale



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Who Guards the Guardians? How the United States Government Caused a Worldwide Economic Crisis

By Jeffrey Borrowdale
In a fiercely partisan speech which led to the narrow failure of the first bailout bill, House Speaker Nancy Pelosi blamed our current financial crisis on Republican support for unfettered capitalism
They claim to be free-market advocates, when it’s really an anything goes mentality. No regulation, no supervision, no discipline…in this unbridled form, as encouraged and supported by the Republicans — some Republicans, not all — it has created not jobs, not capital, it has created chaos.1
Was this a market failure, caused by Republican deregulation, or the result of government intervention, and market distortions caused by programs and policies of primarily Democratic politicians?

Fannie Mae was created in 1938 as a New Deal program to help lower income Americans buy homes. It did so by creating a national mortgage market, so that borrowers weren't restricted by the credit policies of their regional banks. President Johnson made Fannie Mae into a Government Sponsored Enterprise (GSE), allowing it to function as a market entity but with the backing and oversight of the Federal Government. Following this were a series of Democrat-backed anti-discrimination measures all aimed at pressuring banks to make loans to poor and minority borrowers with questionable credit worthiness.2 Despite these measures, and the fact that the government had even created another GSE, Freddie Mac, to "compete" with Fannie, Democrats argued that borrowers were still held hostage to local demographics and that racial and ethnic prejudices were keeping otherwise qualified borrowers from getting loans. So, President Carter and a Democrat majority Congress passed the Community Reinvestment Act of 1977 (CRA) requiring federal regulators "to assess an institution's record of helping to meet the credit needs of the local communities in which the institution is chartered, consistent with the safe and sound operation of the institution."3 In practice, this meant banks receiving FDIC insurance in areas near poor, minority populations were strong-armed into loans to high-risk borrowers or faced restrictions on mergers and acquisitions. Then, in 1989 the Home Mortgage Public Disclosure Act was amended to force banks to collect and publish racial data,4 allowing political pressure groups like ACORN to sue banks for not making enough CRA mandated loans.5 6 7 8

The paradoxically named Federal Housing Enterprises Financial Safety and Soundness Act of 1992 "imposed housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas" on Fannie Mae and Freddie Mac.9 That same year the Federal Reserve Bank of Boston published a manual to help banks to comply with these regulations. "Closing the Gap: A Guide to Equal Opportunities Lending" advised against adherence to "outdated" traditional criteria such as a mortgage payment as a proportion of income, down payment amount or credit history. It suggested participation in a credit counseling program might be an adequate proof of credit worthiness and reminded banks that unemployment, welfare and disability benefits are accepted as income by Fannie and Freddie.10 In 1995, the Clinton Administration amended the CRA to authorize subprime loans to risky borrowers, while at the same time rewriting the CRA compliance rules, making it so difficult for banks to comply that with new "diversity" requirements that they were forced to make unwise loans based solely on race.11 In his last year in office, Clinton, through the Department of Housing and Urban Development, mandated that Fannie Mae dedicate 50% of its business to "low and moderate income families."12 Throughout the 90s the Federal Reserve System, another GSE which works closely with the Treasury Department to set monetary policy, kept interest rates absurdly low, further inflating the housing bubble.

Enter the market. In1997 First Union Capital and Bear Sterns began a public offering of Mortgage Backed Securities (MBS) derived from these government mandated risky loans.13 Because Fannie and Freddie had the implicit backing of the Federal Government, these securities had a AAA rating as well as a high rate of return and were thus bought en masse by big fund managers of retirement accounts, investment banks and insurance firms, as well as many foreign investors. Just as important, this flooded the housing market with a virtually unlimited amount of capital. All banks had to do was find the borrowers, process the paperwork and resell the loans to Fannie and Freddie, making a handsome profit in origination fees. No credit? No income? No down payment? No problem! Uncle Sam wants you to have a home loan! Banks like Countrywide and IndyMac started making "ninja" (No Income, No Assets) loans and low/no document loans to anyone, including illegal aliens;14 Fannie and Freddie bought them all. With people who previously could never afford homes or qualify for loans began buying homes, the housing boom began in earnest. Because of Federal Reserve had set interest rates so low, borrowing was cheap. Increased demand drove prices up, encouraging people to buy investment properties and flip houses for quick profits, especially in attractive areas like Southern California and the Florida coast. Lenders also began applying the lax standards of their low-income loans to middle and upper-class house-flippers and investors. Many of these risky loans had adjustable rates, were interest-only or had introductory teaser rates. When unsustainably low rates rose, teasers expired and gas prices skyrocketed, defaults began. Housing prices began declining in over-valued markets, and borrowers found themselves owing more on houses than they were worth. Those who had put nothing down, simply walked away from the loans. Foreclosures further fueled price drops, sending cascading effects into the MBS and derivatives markets, with the shockwaves reverberating to overseas investors and global financial markets.

The chief catalyst of this government-created crisis wasn't deregulation of markets championed by Republicans,15 but rather resistance of government oversight of GSEs by Democrats.16 Bush and Congressional Republicans lobbied for additional oversight from 2002 to 2007, with Senator McCain co-sponsoring a key reform bill.17 All efforts were rebuffed by Democrats with party-line votes.18 It's no coincidence that Democrats, who started these programs, defended them, and that those who chaired banking and finance committees and obstructed were the chief recipients of lobbyist money from Fannie and Freddie.19 And it's not surprising that calls for oversight by Republicans met with charges of racism.20

While the details of this market crisis are complex, the fundamentals are simple. This financial wildfire was sparked by the Federal Government keeping interest rates artificially low, coercing and enticing banks into making "affirmative action" loans, then buying and reselling them to investors. Resulting lower credit standards and capital flood created an artificial housing bubble, which, when it burst, sent cascading effects into financial markets. As GSEs, Fannie and Freddie took risks no private institution would take, and because of their GSE status investors saw them as a low risk. Democrats resisted oversight because they created and believed in these institutions, because these loans went to their key constituencies and because of lobbyist contributions. The Bush Administration's only role in the crisis is in not replacing long-time Federal Reserve Chairman Alan Greenspan, and allowing him to flood the housing market with cheap money, fueling the speculative housing bubble.

The market has built-in corrective mechanisms of risk-aversion, loss-aversion and failure. But, if instead of trusting markets, we trust politicians to guard economy, it begs the question, "Who guards the guardians?"21
ENDNOTES
1 Nancy Pelosi, C-SPAN, September 29, 2008, 12:21pm ET http://www.youtube.com/watch?v=ey3ZlsmIkz42 The Fair Housing Act (1968), The Equal Credit Opportunity Act (1974) and the Home Mortgage Disclosure Act (1975) http://www.federalreserve.gov/newsevents/testimony/braunstein20080213a.htm

3 Title 12: Banks and Banking, Part 345—Community Reinvestment http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=44059fe1dfc00c61e5a82d909ebafac0&rgn=div8&view=text&node=12:4.0.1.2.33.1.3.1&idno=12

4 Federal Deposit Insurance Corporation Press Release, March 31, 2005: Frequently Asked Questions About the New HDMA Data - 1. What is the Home Mortgage Disclosure Act (HDMA)?

http://www.fdic.gov/news/news/press/2005/pr3005a.html

5 Thomas J. DiLorenzo, "The Government-Created Subprime Mortgage Meltdown"



http://www.lewrockwell.com/dilorenzo/dilorenzo125.html

6 Stan Leibowitz, "The Real Scandal: How Feds Invited The Mortgage MESS", New York Post http://www.nypost.com/seven/02052008/postopinion/opedcolumnists/the_real_scandal_243911.htm?page=0

7 Stanley Kurtz, "O's Dangerous Pals: Barack's 'Organizer' Buds Pushed For Bad Mortgages" September 29, 2008, Posted: 3:53 AM ET.

http://www.nypost.com/seven/09292008/postopinion/opedcolumnists/os_dangerous_pals_131216.htm?page=0

8 In 1994, a young Barack Obama sued Citibank for failing to give loans to minority applicants. Citibank settled out of court in 1998 for an undisclosed amount. http://www.mediacircus.com/2008/10/obama-sued-citibank-under-cra-to-force-it-to-make-bad-loans/

9 About Fannie Mae: Our Charter – The Federal Housing Enterprises Financial Safety and Soundness Act of 1992. Last Revised: March 6, 2008. http://www.fanniemae.com/aboutfm/charter.jhtml

10 The Federal Reserve Bank of Boston, Closing the Gap: A Guide to Equal Opportunities Lending, Last Updated 4/92. http://www.bos.frb.org/commdev/commaff/closingt.pdf

11 Terry Jones, "How A Clinton-Era Rule Rewrite Made Subprime Crisis Inevitable"

Investor's Business Daily, Posted Wednesday, September 24, 2008 4:30 PM PT http://www.ibdeditorials.com/IBDArticles.aspx?id=307149667289804

12 "Fannie Mae Increases CRA Options," ABA Banking Journal, November 2000. http://findarticles.com/p/articles/mi_hb6632/is_200011/ai_n26424963?tag=rel.res1

13 Wachovia Press Release, October 20, 1997, "Unique Transaction To Benefit Underserved Housing Market" http://www.wachovia.com/inside/page/textonly/0,,134_307%5E306,00.html

14 Chris Isidore , "'Liar Loans': Mortgage Woes Beyond Subprime: Loans where borrowers gave little proof of income could be the next threat to the troubled real estate market - and the economy," CNN Money, March 19 2007: 5:01 PM EDT



http://money.cnn.com/2007/03/19/news/economy/next_subprime/index.htm

15 The Graham-Leach-Bliley Act of 1999, rather than being a cause of the meltdown, helped markets cope with it. The act, supported by Larry Summers, Robert Rubin, John Sweeney and Harry Reid, among others, repeal parts of the Glass-Steagall Act of 1933, which separated commercial and investment banking. This allowed investment firms Bear Stearns and Merill Lynch to be absorbed into more soundly capitalized J.P. Morgan/Chase and Bank of America respectively. See "Dispelling The 'Deregulation' Myth," Investor's Business Daily, Posted Friday, September 19, 2008 4:20 PM PT http://www.liveleak.com/view?i=966_1222076584

16 In 2002, the housing boom was the one bright spot in an otherwise dark economy, still reeling from the dot-com bust and the 9/11 attacks, so Democrats were reluctant to acknowledge the danger. Wall Street Journal editor Paul Gigot, who reports being savaged by Fannie and Freddie allies, quips about his paper's February editorial of that year, "Fannie Mae Enron?" that his only regret was the question mark. http://online.wsj.com/public/article_print/SB121677050160675397.html

Observe the important distinction between regulation of markets by government, and oversight of government-chartered entities. I am against the former but strongly in favor of the latter. If we are to have such organizations, they must be watched very closely. It should be noted that Ron Paul warned of just such a GSE-based economic meltdown in 2003 and introduced the Free Housing Market Enhancement Act, which would have completely averted the crisis by repealing the authority given to the Federal Reserve to purchase GSE debt. http://www.lewrockwell.com/paul/paul128.html

17 "Mr. President, this week Fannie Mae's regulator reported that the company's quarterly reports of profit growth over the past few years were 'illusions deliberately and systematically created' by the company's senior management, which resulted in a $10.6 billion accounting scandal. The Office of Federal Housing Enterprise Oversight's report goes on to say that Fannie Mae employees deliberately and intentionally manipulated financial reports to hit earnings targets in order to trigger bonuses for senior executives. In the case of Franklin Raines, Fannie Mae's former chief executive officer, OFHEO's report shows that over half of Mr. Raines' compensation for the 6 years through 2003 was directly tied to meeting earnings targets. The report of financial misconduct at Fannie Mae echoes the deeply troubling $5 billion profit restatement at Freddie Mac.

The OFHEO report also states that Fannie Mae used its political power to lobby Congress in an effort to interfere with the regulator's examination of the company's accounting problems. This report comes some weeks after Freddie Mac paid a record $3.8 million fine in a settlement with the Federal Election Commission and restated lobbying disclosure reports from 2004 to 2005. These are entities that have demonstrated over and over again that they are deeply in need of reform.

For years I have been concerned about the regulatory structure that governs Fannie Mae and Freddie Mac--known as Government-sponsored entities [sic] or GSEs--and the sheer magnitude of these companies and the role they play in the housing market. OFHEO's report this week does nothing to ease these concerns. In fact, the report does quite the contrary. OFHEO's report solidifies my view that the GSEs need to be reformed without delay.

I join as a cosponsor of the Federal Housing Enterprise Regulatory Reform Act of 2005, S. 190, to underscore my support for quick passage of GSE regulatory reform legislation. If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole.

I urge my colleagues to support swift action on this GSE reform legislation." – Sen. John McCain, United States Senate, May 25, 2006, Section 16. http://www.govtrack.us/congress/record.xpd?id=109-s20060525-16&bill=s109-190

During the Vice Presidential Debate, Joe Biden deliberately mislead the audience, claiming that McCain was surprised by the mortgage crisis while Barack Obama sent a letter of warning to Treasury Secretary Paulson and Fed Chairman Bernake in 2007. However, scrutiny of Obama's letter shows that while it warns of immanent foreclosures, it focuses on "predatory lending," calling for a summit aimed at preserving the status quo, keeping people in their homes, and providing more credit counseling for wayward borrowers; it contains no warning of a catastrophic impending financial crisis based on massive foreclosures, as did Senator McCain's speech. http://obama.senate.gov/press/070322-obama_urges_ber/

18 Al Hubbard and Noam Neusner, "Where Was Sen. Dodd? Playing the Blame Game On Fannie and Freddie," Friday, September 12, 2008; Page A15. http://www.washingtonpost.com/wp-dyn/content/article/2008/09/11/AR2008091102841.html

19 http://www.opensecrets.org/news/2008/09/update-fannie-mae-and-freddie.html

20 In late 2004 an Office of Federal Housing Enterprise Oversight (OFEO) report showed the serious trouble Fannie and Freddie were in, and Democrats, especially black Democrats Maxine Waters, Gregory Meeks, and Artur Davis vociferously defended the Fannie, its minority loans and its African-American chairman, Franklin Raines, resisting new regulation. Rep. Lacy Clay referred to the criticism of Chairman Raines a "political lynching." http://www.youtube.com/watch?v=_MGT_cSi7Rs

21 This quote, often misattributed to Plato, is from Juvenal's Satire and concerns a husband's dilemma about his unfaithful wife, but has an obvious political analog: "I know the plan that my friends always advise me to adopt: "Lock her up, imprison her!" But who will guard the guardians? They keep quiet about the girl's secrets and get her as their payment; everyone hushes it up." --Juvenal, Oxoniensis 29-33, E.O. Winstedt 1899, "A Bodleian MS of Juvenal", Classical Review 13: 201–205


THE GREAT ECONOMIC DEBATE OF THE TWENTIETH CENTURY

Steve Forbes


The great economic debate of the twentieth century was between collectivists and free-marketers. In one sense, the free-marketers won: When the Berlin Wall fell in 1989, it was widely acknowledged that Soviet socialism had been a catastrophic, not to say murderous, failure. But in another sense, the debate continues. Democratic capitalism still has not vanquished the idea of collectivism. Far from it.

At the beginning of the last century, free markets seemed to be on the ascendancy everywhere. But two events gave collectivism its lease on life. The first was World War I. In addition to the slaughter - and to breeding the ideologies of communism, state fascism, Nazism, and even the Islamic fascism we are battling today - World War I served as an intoxicating drug to those in the West who believed that a handful of people in government could manage affairs better than the messy way in which free peoples tend to do so. Massive increases in government powers, coupled with massive increases in taxation, gave many the idea that you can achieve massive increases in production by commandeering the financial resources of society.

The second event that served as a boon to collectivism was the Great Depression, which was widely seen as a free-market failure. This view was false. Misguided government policies were at fault – the Smoot-Hawley Tariff, for instance, which dried up the flow of capital in and out of the country. If you track the stock market crash of 1929, it parallels the course of this tariff bill through Congress. When Smoot-Hawley arose in the fall of 1929, the markets fell; when it looked like the tariff bill was sidetracked in late 1929, the markets revived (the Dow Jones went up 50 percent from its lows in November); in the spring of 1930 it was signed into law, and the rest is history. There were other factors at work in the Great Depression, of course, such as President Hoover’s gigantic tax increases of 1931. But despite the fact that these also involved bad policies, the lesson taken away by many was that economies will implode unless the government manages them. John Maynard Keynes, the intellectual guiding light behind New Deal economics, believed that an economy was like a machine: If you put doses of money into it or pull money out at the right times, he thought, you can achieve an equilibrium. This idea that government can drive an economy has had baleful consequences.

Other leading economists at the time, such as Joseph Schumpeter, recognized that an economy is an aggregate of disparate activities – thus that the idea of achieving equilibrium, while it makes for a neat theory, is nonsense in the real world. A vibrant economy is full of constant disequilibria: New enterprises rise up, old ones decline, etc. Snapshots of such economies mean very little. In the real world, therefore, free markets operate rationally and efficiently in a way that government regulators simply can’t. Here in America we came to this realization at the end of the 1970s. Following World War II, we largely bought into the idea that government must play an active role to prevent the economy from going off the cliff. But in the late 1970s, the devastation of inflation and high taxes brought about a reassessment. With the election of Ronald Reagan, the U.S. took a step back from Keynesian economies. Since then, as Western Europe has stagnated-creating, for instance, only a fraction of the private sector jobs that the U.S. has created-our country has undergone an economic revival.

Nonetheless, democratic capitalism often still seems on the defensive. Why?
IS DEMOCRATIC CAPITALISM GOOD?

One of the great vulnerabilities of capitalism is the perception that it is somehow less than moral, if not positively amoral. A common view of business was depicted in the movie Wall Street, in which Michael Douglas’s character made famous the phrase, “Greed is good.” Capitalism is widely seen as promoting selfishness. We tolerate it because it gives us jobs and prosperity, but many look on this as a Faustian bargain. Charity and capitalism are seen as polar opposites. Thus there’s a phrase that’s often used today - I myself use it from time to time without thinking - which is “giving back.” If you’ve succeeded in business, it’s counted a good thing if you “give back” to the community. And charity is, of course, a good thing. The problem with this phrase is its implication that by succeeding, we have taken something that wasn’t ours. The same idea is summed up in the cynical saying. “Behind every great fortune lies a great crime.” This way of thinking about democratic capitalism is wrong.

In fact, philanthropy and capitalism are two sides of the same coin. To succeed in business in a free-market economy, one must meet the needs and wants of others. Even someone who makes babies cry is not going to succeed unless he or she provides a product or service that people want. This system weaves intricate webs of cooperation that we don’t even think about. Take a restaurant: Someone who opens a restaurant assumes that farmers will provide the food and that someone else will process and package it and that someone else will deliver it, having been supplied the fuel to do so by yet someone else, etc. These marvelous webs of cooperation happen every day throughout a free economy. No one is commanding it. It occurs spontaneously in a way that economists like Schumpeter understood.

Free markets also force people to look to the future and take risks. Misers do not found companies like Microsoft. Nor should we look on it as immoral for people to work for the betterment of themselves and their families. We are all born with God-given talents, and it is right to develop them to the fullest. The great virtue of democratic capitalism is that it guarantees that as we develop our talents, we’re contributing to the public good. Statistics show that the U.S. is both the most commercial nation and the most philanthropic nation in human history. And this is no paradox. The two go hand-in-hand.

Another vulnerability of democratic capitalism is that although it leads to progress and to an increase in our societal standard of living, progress is usually disruptive. This allows collectivists to play on people’s natural fear of change. We saw this with the rise of industrialism in the 19th century. We had paintings and writings depicting a pastoral agricultural past. Then railroads came along to disrupt the canals, and cars came along to disrupt the railroads. Buggy-whip makers and blacksmiths were done for. One can imagine what 60 Minutes would have been investigating 100 years ago: the poor blacksmiths being put out of work by Henry Ford. Likewise, when TV came along in the late 1940s and early 1950s, most movie theaters in the country went broke. Now the internet is disrupting newspapers and Craig’s List is disrupting classified advertising. Disruptions are inevitable in a free-market system. The political challenge is to allow these disruptions to take place - they are ultimately constructive, after all - rather than reacting in a way that stymies progress.

In recent decades, collectivists have also hijacked the cause of environmentalism to promote their agenda. I’m not talking about the desire to have clean water; we’re all in favor of that. Or clean air; one of the great things we’ve done in the last century is getting lead out of the air. Saving tigers and elephants is also a good thing. I’m talking about those who use the mantra of environmentalism to try to control the economy the way the old-time socialists wanted to, breathing hellfire and damnation on those who don’t subscribe to their new, post-Christian religion. The fact is, if our goal is to improve the environment, increasing government regulation and destroying manufacturing is counterproductive. Affluence is the friend, not the enemy, of the environment. As people become better off, they want a higher quality of life, including environmental improvements. And new technology drives such improvements. Consider the east coast of the U.S. Even though its population has more than doubled - in some areas, it’s tripled - and even though there are more developments, malls, and urban sprawl, there are more trees today than there were 80 years ago. Why? Because of technology that allows us to grow more food on less land. Technology is a friend of the environment.


ADDITIONAL COLLECTIVIST MYTHS

Let me mention three additional myths that are used to promote collectivism. One is the idea that demand is the key to economic growth. Economists often talk about means to increase “aggregate demand,” as if that would ensure that the economy will grow. Following Keynes, they assume that the economy is like a machine. But again, the economy is an aggregate of tens of millions of people, millions of businesses, millions of technologies. We don’t know how it interacts on a day-to-day basis. We don’t know what’s going to work or not work. Who could have conceived of eBay ten to twelve years age? But today, 400,000 people make their livings on eBay. When Google was launched, there were ten other search engines. Who would have thought another one was needed? Isn’t that how you get so-called “bubbles”? But Google found a way to do it better and ended up on top. Innovation is the key. Whether it’s railroads, cars, computers, the Internet, or iPods, risk-taking is messy. It is often irrational, and seemingly wasteful. But it’s the only way to determine what works best and what doesn’t.

Another collectivist myth concerns trade. If I were dictator of the world - even though I believe in the First Amendment - I would ban trade numbers, especially merchandise trade numbers. They just lead to mischief. We are given the impression that a trade surplus is like a profit and a trade deficit is like a loss. But trade is not a transaction between countries. It takes place between parties. For example, Forbes magazine buys paper. For all of the 88 years that we’ve been in existence, we’ve run a trade deficit with our paper suppliers. If you look just at the trade deficit, you might think we are doing poorly. But if you look at the two parties involved, that turns out to be an illusion. The paper supplier thinks he is going to make money selling his paper. We think we’re going to make money by taking the paper and putting print on it, with value added. So it’s a mutually profitable transaction, even if it looks like a trade deficit. Or consider a book printed in Taiwan. Looking at the trade number alone, it appears there is a two dollar trade deficit with Taiwan. Yet the book comes back here and retails for $24.95. The value added is in the U.S. The author gets a cut, the publisher gets a cut, booksellers get a cut, distributors get a cut, and remainder stores get a cut. Something similar happened with iPods: A lot of its parts are made overseas, but where is most of its value added? Here in the United States. North America has had a merchandise trade deficit for 350 out of the last 400 years, and we have done very well, thank you.

The final myth I’ll mention concerns budget deficits. Milton Friedman said several years ago that if he had a choice between a federal budget of $1 trillion that was in the red and a federal budget of $2 trillion that was balanced, he would take the former. Deficits, in and of themselves, are not evil. Deficits must be put into context, because Washington’s inability to curb spending is often used as an excuse to raise taxes.


PRINCIPLES OF PROSPERITY

Now let me turn to five basic principles of economic growth. First and foremost is the rule of law: Without individual equality before the law, entrepreneurs cannot challenge already existing businesses. Alliances between the latter and government regulators who place barriers before entrepreneurs must be guarded against.

The second essential principle is property rights. We take it for granted in this country that if you buy a piece of property, everyone acknowledges that you own it. Most countries don’t have that kind of uniform property system. A few years ago, Hernando DeSoto, a great economist from Peru, saw that in countries like his, although there is entrepreneurial activity, there isn’t the corresponding prosperity found in the U.S. And he wondered why. In his recent book – The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else - one of the key factors he cites is the absence in so many other countries of a legal foundation for property rights. In Brazil’s shanty towns, an individual may know that he owns the house in which he lives, and his neighbors may know it, but the fact is not recognized elsewhere.

Mr. Desoto was asked by the Egyptian government a few years ago to determine who owns the businesses and residences in Egypt. His finding was that 88 percent of businesses in Egypt are illegal. Why is that? Here in the U.S., it is possible to set up a business legally in a matter of days. In Egypt, it takes a couple of years. It requires going through numerous bureaucracies, doling out numerous bribes, etc. So it makes sense to proceed “informally.” On the other hand, running a business outside the law limits its growth. Most “informal” enterprises never grow beyond the level of family enterprises, because if they get too big, they might attract the attention of the tax collector. DeSoto’s group also reported that 92 percent of Egyptian housing is illegal. People living in residences may have deeds; but only a few miles away, those deeds are not recognized. In Egypt, as in so many other places, there is no uniform system of establishing and protecting property rights. As a result, four billion people around the world own $9 trillion of assets that amount to dead capital.

What do I mean by “dead capital”? Remember that here in the U.S., the most important source of capital for new ventures is not Wall Street, the local banker or the venture capitalist. It is the mortgage market. People either increase their mortgage or take out a second mortgage in order to start businesses. That is not possible in countries like Egypt. Understanding this was the key to Japan’s post-World War II economic boom. General MacArthur reformed a feudalistic property system, in which the peasants had only an informal system of property exchange, into a system with formalized property rights. Immediately, the Japanese economy took off. The importance of property rights is not sufficiently recognized by those of us who take them for granted.

The third principle of economic prosperity is low taxes. Taxes are not just a means of raising revenue for the government. They are also a price. Income taxes are a price paid for working; taxes on profits are the price paid for being successful in business; taxes on capital gains are the price paid for taking risks. In light of this, the importance of low taxes is easy to see: When you lower the price of good things - things like work, success and risk-taking - you tend to get more of them. Raise the price of these good things and you get less. In 2003, we lowered tax rates in the U.S. and the economy started to grow again. As we’ve seen time and again, tax cuts do not mean a loss of tax revenue. By increasing incentives, the government comes out ahead. Washington’s revenues in the last fiscal year were up 15 percent - $100 billion above expectations. Washington’s problem is not revenue, but spending.

The fourth principle I would mention is making it simpler to launch legal businesses. Getting bureaucracy out of the way will inject a new vibrancy into the economy. The fifth and final principle is free trade. Expanding markets and creating greater opportunity for trade benefits us all.

In closing, I will remind you of a point I made earlier: The reason that the great economic debate continues into the 21st century, despite the proven superiority of free markets in terms of delivering prosperity, is because of the misperceptions that keep democratic capitalism from capturing the moral high ground. Dispelling these misperceptions should be our priority as we carry on that debate in the years ahead.


Excerpted from a speech delivered at Hillsdale College on January 29, 2006
Steve Forbes is president and CEO of Forbes, Inc., and editor-in-chief of Forbes magazine. In 1985, President Reagan named him chairman of the Board for International Broadcasting, where he oversaw the operation of Radio Free Europe and Radio Liberty. He was reappointed to this post by President George H. W. Bush and served until 1993. Mr. Forbes graduated in 1966 from Brooks School in North Andover, Massachusetts, and received a B.A. in history from Princeton University in 1970. He serves on the boards of the Ronald Reagan Presidential Foundation, the Heritage Foundation and the Foundation for the Defense for Democracies. His most recent book is Flat Tax revolution: Using a Postcard to Abolish the IRS.
A TAXING PARABLE

Bill Burrows


Let's put tax cuts in terms everyone can understand. Suppose that every day, ten people go out for dinner. The bill for all ten comes to $100. If they paid their bill the way we pay our taxes, it would go something like this:

* The first four people

(the poorest) would pay nothing.

* The fifth would pay $1.

* The sixth would pay $3.

* The seventh $7.

* The eighth $12.

* The ninth $18.

* The tenth person (the richest)

would pay $59.

So, that's what they decided to do. The ten people at dinner in the restaurant every day and seemed quite happy with the arrangement, until one day, the owner threw them a curve.

"Since you are all such good customers," he said, "I'm going to reduce the cost of your daily meal by $20."

So, now dinner for the ten only cost $80. The group still wanted to pay their bill the way we pay our taxes.

So, the first four people were unaffected. They would still eat for free. But what about the other six, the paying customers? How could they divvy up the $20 windfall so that everyone would get a 'fair share'?

The six people realized that $20 divided by six is $3.33. But if they subtracted that from everybody's share, then the fifth person and the sixth person would each end up being 'PAID' to eat their meal.
And so:

* The fifth person, like the first four, now paid nothing (100% savings).


* The sixth now paid $2 instead of $3 (33% savings).

* The seventh now paid $5 instead of $7 (28% savings).

* The eighth now paid $9 instead of $12 (25% savings).

* The ninth now paid $14 instead of $18 (22% savings).

* The tenth now paid $49 instead of $59 (16% savings).

Each of the six was better off than before. And the first four continued to eat for free. But once outside the restaurant, the people began to compare their savings.


"I only got a dollar out of the $20," declared the sixth person. He pointed to the tenth person "but he got $10!"

"Yeah, that's right," exclaimed the fifth person. "I only saved a dollar, too. It's unfair that he got ten times more than me!"



"That's true!!" shouted the seventh person. "Why should he get $10 back when I got only $2? The wealthy get all the breaks!"
"Wait a minute," yelled the first four people in unison. "We didn't get anything at all. The system exploits the poor!"

The nine people surrounded the tenth and beat him up. The next night the tenth person didn't show up for dinner, so the nine sat down and ate without him. But when it came time to pay the bill, they discovered something important. They didn't have enough money between all of them for even half of the bill! And that, boys and girls, journalists and college professors, is how our highly progressive tax system works. The people who pay the highest taxes get a larger benefit from a tax reduction. Tax them too much, attack them for being wealthy, and as many may not show up at the table anymore. There are lots of good restaurants in Europe and the Caribbean.

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