Interest group politics make it difficult to reform the welfare state or the pressure for egalitarian outcomes. Here are some examples. In the 1980s, it became clear that many savings and loan associations would fail. Deposit guarantees protected depositors, but failure imposed losses on taxpayers. The U.S. Congress acted to hide the problem, but some managements understood that delay created opportunities to take risky gambles that would restore the value of equity if the investment paid off. Since equity was low or negative, the cost of additional losses would be borne by taxpayers. Some took the gamble. Taxpayers’ losses reached $150 billion.
A few years later, President Clinton appointed Jim Johnson to head the Federal National Mortgage Association, FNMA. FNMA began in 1937 as a purchaser and occasional seller of outstanding mortgages to smooth fluctuations in mortgage rates and create a more liquid market. Later, the Federal Home Loan Bank Board created a separate organization, FHLMC, (Freddie Mac) to buy and sell mortgages also.
Jim Johnson had been a campaign manager in Walter Mondale’s 1984 presidential campaign. He was well connected politically and wanted to make housing ownership more egalitarian. He saw an opportunity to expand FNMA’s operations while offering opportunity to low income home buyers.
The political appeal of expanding home ownership was popular. To facilitate this program, the government agencies lowered down payments and eventually offered to buy sub-prime mortgages that had no down payment to borrowers that had no credit history.
Selling sub-prime mortgages to the two government sponsored buyers, FNMA and FHLMC, was a very profitable business. Some mortgage lenders actively worked to issue such mortgages that could be resold profitably. Major banks did the same. An international agreement required the banks to hold larger reserves behind mortgages in their portfolios. The banks circumvented the costly regulation by chartering subsidiaries that held the mortgages but evaded the requirement.
Regulators did not object.
A few voices that pointed to the risk of defaults and losses were ignored or dismissed. Congressman Barney Frank was chairman of the House Committee that had oversight responsibility. He urged expansion of the program. President George Bush viewed the programs as part of his “ownership” program. He did not ask: What did the homebuyers own? Many made no down payments; they “owned” an option to gain home equity if home prices rose, but they also owned the prospect of loss if home prices fell.
Contrary to repeated forecasts that home prices would not fall throughout the country, the unexpected happened. The social welfare experiment in expanding home ownership to minorities and low-income families failed in a wave of mortgage defaults and foreclosed houses.
In January 2009, the Obama administration inherited the housing and financial failures. Their program design called for a massive increase in government spending and temporary tax reductions.
Professor Lawrence Summers, head of the new president’s economic staff, said that the program should be targeted and temporary. Bad advice! Decades of economic research showed that temporary tax reduction and spending increases get very little response.
Congress developed the program details. Their interest as always was in distributing financial support to their political supporters, so the supposed economic stimulus became an example of welfare state redistribution. For example, money was spent to help states avoid laying off teachers. When the funding was not renewed, lay offs resumed. What was achieved?
A principal weakness of the program was its short-term focus. A large stock of unsold houses and projected defaults on mortgages implied the recession would be deep and long lasting. Properly designed policy changes would have avoided targeted and temporary changes and offered permanent incentives for investment. A better policy would have increased incentives for investment and adopted rules for future fiscal and monetary policies.
The social welfare state empowers interest groups that demand support from their political allies.
Their main concern is benefits to them and their members. They oppose efforts to reduce spending on their benefits. Fire and police unions receive such large pension and health care benefits that state and local governments are forced to reduce spending on such basic functions of government as police or fire protection. At the federal level, spending for pensions and health care forces reductions in spending for defense against terrorism.
Every knowledgeable observer agrees that projected growth of federal government spending is unsustainable. Still, the federal government does not propose reductions. Any solution that reduces spending acts like a tax levied against particular groups – the retired and their families, the teachers union, or some other organized group. Greece, Italy and Spain waited for the crisis to force sudden changes that could have been phased in gradually and less painfully. Must the United States repeat their error?
Similar problems threaten the survival of the European Union. As in the United States, voters agreed to increase spending on redistribution for pensions, health care, and the unemployed, but few vote to pay for the benefits. Budget deficits increase until they are unsustainable and markets are unwilling to finance them.
The political system cannot agree on a program. Short-term palliatives prevent an immediate crisis, but the problems remain. Uncertainty rises, so investment falls. The debtors urge the creditor countries to pay more and to forgive debts. The creditors demand reforms that open markets, reduce the power of labor monopolies, raise retirement ages, sell state industries, and reduces transfer payments. Each of these affects a powerful interest group. And it reduces the welfare states.

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