Up Front

Improving the Federal Government’s Performance as a Lender

Douglas J. Elliott

Few people give much thought to the fact that the U.S. federal government is a huge financial institution, in addition to its other roles. At its recent peak during the financial crisis, the government controlled programs to lend or guarantee almost $10 trillion to the private sector, roughly two-thirds of the size of America’s annual economic output. Even now, the total is over $7 trillion, approximately equal to the outstanding loans in the entire U.S. banking system.

About $5 trillion of this sum relates to Fannie Mae and Freddie Mac, which the federal government is likely to eventually relinquish control of, although my bet is that it retains a substantial portion of the risk until the underlying mortgages are paid off over time. However, even the traditional programs that have been around for half a century, like FHA mortgages and student loans, represent a surprising $2 trillion of credit.

Despite a fundamental American idea that the government “stays out of business,” there is very little chance that we will pull back substantially from offering mortgages, helping students borrow to attend college, making loans to small businesses, and aiding farmers in obtaining credit. In some cases there are good policy arguments for the government’s role and in all cases there are very strong political reasons. Do not expect a major pullback from the traditional programs if the Republicans take full charge in Washington in 2012. These programs seldom shrink no matter which party is in power, because they are largely aimed at core voter blocs that can determine elections.

Politics does not always make bad policy; some of these programs are clearly good for the country. Federal credit programs can fill the gap when there are substantial benefits to society as a whole from the activity being financed or when institutional structures in the banking sector are not well-suited to meeting the credit needs. Student loans probably represent the clearest example. The private sector credit providers are simply not geared to make very long-term personal loans, with no collateral, to teenagers whose ability to repay will depend heavily on life decisions and job prospects that are very hard to forecast. (They can lend based on guarantees from creditworthy parents, but the students for whom loans will make the most difference do not tend to have such parents.) Yet there is a strong benefit for our nation and its economy in having a college-educated workforce, leading the government to play a legitimate, useful role.

Unfortunately, the evidence suggests that taxpayers do not get as much “bang for the buck” as they could from the federal credit programs. The most comprehensive studies conclude that the programs taken as a whole are significantly too costly compared to the benefits they provide. A number of smaller studies show results that range from relatively neutral to quite negative in their cost/benefit assessments.

What can we do to improve the return on our investment in the federal credit programs? I have ten suggestions, which are fleshed out in my new book, Uncle Sam in Pinstripes: Evaluating the Federal Credit Programs.

  1. Target borrowers more carefully
  2. Take more account of the relative risk of different loans
  3. Use the same budget rules for all federal credit programs
  4. Use risk-based discount rates for federal budget purposes
  5. Avoid having the Fed run credit programs, to the extent possible
  6. Formalize the process of initiating new credit programs
  7. Create a federal bank to administer all credit programs
  8. Focus more on optimizing the allocation of money between programs
  9. Spread “best practices” more effectively
  10. Improve the compensation and training of federal financial workers

These recommendations would put the credit programs on a sounder business basis without sacrificing the benefits for society provided by federal credit support. If taxpayers are going to own a giant bank, we should ensure it is run as effectively as possible.