For the past couple of weeks stories of the demise of Fannie Mae and Freddie Mac have filled the front pages of newspapers and the Internet. There are a number of explanations as to what brought about their collapse, but a simple one is the people who received the rewards of the returns on the institutions’ investments were not the same as those who assumed the risks. In other words, decisions were made based on what would bring about the highest returns, without regard to the corresponding risks.
Years ago Nobel Prize winning economist Harry Markowitz wrote that an efficient portfolio is one which “offers the highest expected return for any given degree of risk, or that has the lowest degree of risk for any given expected return.” In other words, one needs to weigh the risks with the rewards when making a financial (or in fact any type of) decision.
When the perceived risk of something is zero, a person will make decisions that will bring the highest reward. The problem with any Government Sponsored Enterprise (GSE), which Fannie Mae and Freddie Mac fall under, is government separates rewards and risks and those responsible for making decisions are ignorant of any associated risks. Ideally the federal government should get out of the business of supporting quasi-private organizations because any government involvement implies government intervention when things go wrong.
A look at Senator Obama’s economic plan is filled with recommendations which would increase the federal government’s involvement in public/private investments and enterprises. Some include:
- The creation of an Advance Manufacturing Fund.
- The creation of a Manufacturing Extension Fund.
- Investments in “clean energy projects.”
- Creation of a Renewable Portfolio Standard.
- National Infrastructure Reinvestment Bank.
- Investment in the “sciences.”
- Creation of a National Network of Public-Private Business Incubators.
All of these suggestions involve government agents—either elected, bureaucratic or both—who would make decisions on where to invest public funds. Since these funds are not theirs to begin with, they are less likely to take into account risk. In addition, there will be political pressures to provide money to selected groups who have influence rather than what makes the soundest financial sense.
For the economy to make prudent decisions, the rewards and risks must be felt by the actual decision-makers. When you split the two you end up with outcomes like that of Fannie Mae and Freddie Mac, where the stockholders and board of directors make out with millions of dollars and the taxpayers are the ones who foot the bill. The economic plans envisioned by Senator Obama would only increase the amount of tax-payer financed boondoggles.