Lou Dobbs spends most of his television appearances voicing anger and outrage over illegal immigration and the demise of the middle class. It takes a rare sort of guest to make him appear the stoic, but Rep. Barney Frank (D., Mass.), chairman of the House Banking Committee, managed to do so on Wednesday. As he shouted down a calm, deliberative Dobbs and accused the host of “interrupting” him for trying to engage him in a conversation, Frank laid the blame for the current financial crisis on the philosophy of limited government. “Here is the problem, a lack of regulation going back to Ronald Reagan allowed the private sector to make the mistakes that put us in this situation,” he shouted. The problem, he went on, was Reagan’s contention that “government is dumb and markets are smart.” Regulation and oversight were not such priorities for Frank in 2003. That was when Republicans in Congress began examining a $10.6 billion accounting fraud at Fannie Mae — a fraud that helped top executives there to collect $245 million in performance bonuses over five years. As Fannie Mae was a Democratic stronghold, full of Clinton hands like Franklin Raines and Jamie Gorelick, Frank and other Democrats in 2003 reacted to the accusations by circling the wagons and attempting to discredit the regulators. In one hearing on the accounting fraud, Rep. William Lacy Clay (D., Mo.) went so far as to say, “This hearing is about the political lynching of Franklin Raines.” Frank was nearly as bold: “These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” Frank told the New York Times then. “The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” Frank’s first statement was clearly wrong — the GSEs were facing a financial crisis. But his second statement was correct, and so is a modified version of its contrapositive: The more we saw in terms of “affordable housing,” the greater the problems became. In the election-year rush to place partisan blame for the current situation, it is lost on many that both parties failed. Both promoted Fannie and Freddie as organizations that could make a constructive government intervention in the economy — this, and not some mythical deregulation, caused our current mess. Whether you want to call it Bill Clinton’s third way or George W. Bush’s compassionate conservatism, the GSE-driven inflation of the mortgage market has backfired on everyone. Far from being free-market entities, the GSEs were creatures of government whose special privileges allowed them to dominate the secondary mortgage market. They were exempt from state and local taxes, permitted to operate with far less capital on hand than comparable institutions, and legally exempted from filing reports with the Securities and Exchange Commission. Fannie and Freddie also had a combined $4.5 billion line of credit from the United States Treasury.

In addition to these advantages, their privately held debt enjoyed a special status in the financial world that had nothing to do with market forces at all. Federal bank regulators, who require depository institutions to hold a certain amount of “tier 1” capital for rainy days, permitted banks to hold Fannie and Freddie debt for this purpose in place of such less profitable instruments as cash and government bonds. In 2004, the FDIC reported with great concern that its member institutions were holding more than $1 trillion in GSE-related securities, and goes without mentioning the securities held by Bear Stearns or the credit default swaps that AIG sold to protect their holders from losses. All of this contributed to the accurate perception that Fannie and Freddie were so big the government would not let them fail — a guarantee once dismissed by Barney Frank as imaginary, but which has in fact proven true.

From this position of government-created competitive advantage, the GSEs drove the secondary mortgage market with their well-meaning but fatal 1999 policy of expanding homeownership to the un-creditworthy .

When things go wrong in the market, politicians predictably call for greater regulation, as though it is always an improvement. Perhaps they ought to call for less economic manipulation by entities like Fannie and Freddie. Given their central role in precipitating the nation’s current financial crisis, it is worth noting that since 1992, there has existed an entire government agency — the Office of Federal Housing Enterprise Oversight (OFHEO) — whose sole purpose was to regulate Freddie and Fannie. Despite this, each company managed to cover up major accounting irregularities for years, and finally to collapse into the government’s arms begging for help.

One could argue that, thanks to Barney Frank and the politics of the Fannie Mae accounting scandal earlier this decade, such extensive regulation went for naught. But better to learn the underlying lesson about whether government can outsmart markets, and just where the road leads that is paved by well-intentioned government planners.

— David Freddoso is an NRO staff reporter.