Against the Fall of Night

There have been many memorable moments in my teaching career. A memorable moment never occurs just because of something I say but because of the impact it has on the audience. Without an impact, my words quickly fall back into the nothingness from which they come.

I distinctly remember a Saturday morning MBA class back in the fall of 2002. I was explaining Friedrich Hayek’s ideas on the rule of law. After interpreting Hayek’s ideas, I began to explain that the seed corn for respect for the rule of law must be stored during prosperous times. In other words, the metaphorical phrase “eating our seed corn” is applicable not only to physical assets and money, but also to ideas. During economic downturns, as the fear level goes up, the pressure on the rule of law often becomes great; it become difficult to keep intact respect for this important principle of a free and prosperous society. Of course, it doesn’t take too long until the Faustian bargain—trading the cultivation of long-term principles for short-term expediency—backfires.

I gave as an example the housing market. I explained why I thought housing was overpriced, and why we could expect to enter a manic phase of the market. This was in 2002; I was naïve and had no idea how overpriced the housing market was to become. I explained that because we were not storing the seed corn of respect for the rule of law, when the housing market did crumble, many would demand to be bailed out for their mistakes. To be sure, I didn’t anticipate that the banks would demand to be made whole for their costly errors. I was thinking more of homeowners who would claim that they which tricked into buying overpriced homes and would ask for government bailouts.

There was a bright and energetic woman sitting in the class. That day she played the part of Rick Santelli (the CNBC reporter who went off about homeowner bailouts on live television)—even before any of us heard of Rick Santelli. My version of what was to come resonated with her; she was outraged. “I’m going to be bailing out those who bought more housing than they can afford,” she emphatically exclaimed.

Both the student and I were innocent that day. Neither she nor I had any idea or how bad things would get. Meet Jim and Danielle Earl:

In 2001, Jim and Danielle Earl bought a home in California with a $500,000 mortgage. As housing prices began to rise, like many others, the Earls began to use their home as a cash cow. In 2005, they refinanced their home for $880,000.  By the time their house was foreclosed on, they owed over $1,000,000.

According to the Wall Street Journal: “ Investors…bought the house for $697,000 at a lender’s trustee sale and put $40,000 of work into a remodel, replacing carpeting and appliances, as well as upgrading the kitchen.” Investors then sold it to new buyers for $800,000.

Last week, just as the new owners were about to move in, the Earls, accompanied by their lawyer and a locksmith, broke into the home and moved back in. The police were there but stood down for the break-in.

In the Wall Street Journal, Michael T. Pines, the attorney for the Earls, is quoted as saying:

I’m trying to teach homeowners what their rights are. In my opinion, they are the legal owners of the property. All of these foreclosures, all of these evictions are grossly unlawful. All of the loans that are currently outstanding are grossly unlawful. Homeowners have a right to get their houses back because they were illegally stolen from them. I feel very confident in saying they have the legal right to do it.

In other words, Pines believes that not only are the foreclosures are illegal; but the mortgages are illegal too. Apparently, foreclosed homeowners should be given the homes free and clear of any financial obligations. Danielle Earl said, despite being over $880,000 in debt, “I don’t believe I owe anything at this point.”

Of course, not owing anything is the logical conclusion of placing a moratorium on foreclosures. A house is foreclosed on when the mortgage loan payments is not being made, usually the home owner has been delinquent for many months. The only possible way to still keep the delinquent homeowner in the house is to forgive or substantially write down the debt.

But why not write down or forgive the debt? Wouldn’t that be a good social policy? Wouldn’t that hasten an economic recovery?

There are many reasons that forgiving the debt is a bad policy. First, it will delay a housing recovery as housing prices are prevented from reaching a sustainable price level. Next, it will make it very difficult to sell foreclosed homes; new home buyers will find it impossible to obtain title insurance for such homes. Importantly, it creates a moral hazard for other homeowners to default on their loans.

But most importantly, it would further destroy respect for the rule of law. A vibrant economy depends on a vibrant middle class playing by the rules and believing that the rules are fair. Despite politicians continuing to claim that the banking sector bailouts were a necessary evil, there is still widespread disgust and anger; the general public feels they were forced to bail out the banking sector’s gross errors. The next wave of disgust and anger will occur as those who play by the rules watch those who don’t play by the rules reap large windfalls. Why should homeowners be rewarded when they bought houses they couldn’t afford and then took out home equity loans? Dangerous populist political movements will be born out of such disgust and anger.

In the former Soviet Union, where the rule of law was not respected, there used to be a maxim: “He who does not steal, steals from his family.” In other words, take every unfair advantage that you can get; since everyone else doing so, if you don’t, you are at a disadvantage.

In 2002, when I predicted that underwater homeowners would demand to be bailed out, I never foresaw that they would be breaking into homes with the police standing down. I never foresaw that they would demand that their mortgages be completely forgiven. Eight years of politicians and ordinary Americans working against the rule of law have made such nightmares possible.

The English poet A.E. Housman asked in his poem Smooth between Sea and Land:  “What shall I build or write against the fall of night?” When there is a sea change in collective attitudes about how society should be organized, the answer to the poet’s question is nothing. Nothing will change until individuals change their minds.

In his classic essay “Individualism: True and False,” Friedrich Hayek cautioned: “While it may not be difficult to destroy the spontaneous formations which are indispensable bases of a free civilization, it may be beyond our power deliberately to reconstruct such a civilization once these foundations are destroyed.” We can hope we change our minds before night falls.