Tuesday, November 4, 2008

Financial Crisis and Lending to the Poor

Many teachers have shyed away from discussing the current financial problems in class. Part of the reason is that very few people truly understand it. Recently, I have learned that the halls of an agricultural economics department is the LAST place for good macroeconomics!

Another reason is that the subject is quite technical and mysterious. Discuss the financial crisis often involves discussing prices the common person is unfamiliar with (e.g. federal funds interest rate) and economic relationships the common person does not confront (e.g. the relationship between the fractional reserve system and the money supply).

Recently, however, I ran across a superb article that hurdles all of those esoteric barriers and gets right down to the real issue. The essay, What crisis? This is creative destruction, in Prospect Magazine notes that when firms are left alone, they figure out how to loan money to the poor. Just look at the splendid success of microloans in developing countries. I myself periodically lend money to MicroPlace.com. For example, I recently loaned $25 to four African women each, who used the money to start a soap business and an ice cream business. I will not earn much interest (3%, I think), but I will get my principal back and the interest.

In America, we have not left banks alone to determine how they should lend to the poor. Government decided to do it their own way with institutions such as Fannie Mae, Freddia Mac, and Farmer Mac. Government dictated how banks should deal with the poor, and government's incentives are different from business.

In a recent EconTalk podcast (Sept 29, 2008), economist Arnold Kling discusses how risky investors were making house loans to poor Americans. They did so knowing there was a significant risk of foreclosure, but that the potential return justified the risk. Politicians then pressured Fannie Mae into making the same loans, arguing that if Wall Street wizards were making mortgages to the poor, why couldn't Fannie Mae?

So in the end, Fannie Mae made business decisions not by business criteria, but political criteria. Politicians wanted to take credit for making housing available to the poor, but instead, have bankrupted the nation.

At the same time, my $100 loaned over the internet to four African women are doing great, because it was managed by businesses with the incentive to learn how to loan to the poor.

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