It seems that some people in Washington still don’t understand that businesses respond to incentives: when lawmakers change rules, people who operate businesses change their behavior. Consider the following set of events concerning the housing market bubble and the aftermath of its burst.

1. Partially because of the Community Reinvestment Act of 1977 and its subsequent revisions, partially because Fannie Mae and Freddie Mac were buying up tons of subprime mortgages so banks knew they could sell their loans to someone else and pocket the commissions, and partially because banks just wanted to make money on the booming housing market, many banks made loans to people who could not verify their income and probably had no business buying a house as a long-term investment.

2. The housing market tanked, these buyers could not sell their homes, and did not have the income to pay for them: foreclosures skyrocketed.

3. Banks become stuck with these properties and start taking huge losses on them. Many banks either go out of business or ask the federal government for bailout money because they just got in too far with these loans and were not diversified enough. Banks learned their lesson: tighten the standards you use for lending people money.

4. Congress hauls the heads of banks to a special session of the House Financial Services Committee on February 11 so they can publicly chastise these peoples for making loans they should not have made and paying for parties with taxpayer money (nevermind that all money spent by Congress is taxpayer money and they seem to have no problem wasting that…). “There is a great deal of anger in the country, much of it justified, about past practices,” said Barney Frank (D-Mass), the chairman of the HFSC. The moral of the story: banks should not have made these loans! Bad bankers! No soup for you!

5. The Obama administration and Congress announce they are seriously considering changing mortgage rules so that individual judges can change the terms of previously-issued contracts, violating the fundamental theory of contract law: that people have to know what to expect, or people will stop using contracts for long-term economic planning. The moral of the story: if a bank makes a loan with terms that a judge does not like, that judge will be able to change the terms and banks may find their loans actually costing them money instead of earning them profits. The plan is currently being debated in Congress.

6. Congress is now upset that banks are not making more loans with the money they have received from the federal government and the Federal Reserve Bank. At the HFSC meeting mentioned previously, Rep. Michael Capuano (D-Mass) demanded of the bankers: “Start loaning the money that we gave you. Get it on the street!”

Does nobody in Washington understand that their actions have consequences and, if they make policy changes or even annouce that they are thinking of making such changes, they must expect that people and businesses will respond accordingly? Is that concept really that difficult to comprehend? After being lambasted in the press and in Washington for making too many bad loans, banks reduced the number of loans and tightened credit standards. In fact, one might reasonably conclude that in light of the disastrous effect those loose credit standards eventually had on the economy, banks would have to be either stupid or irresponsible to not decrease the number of loans they make. But when they do the responsible thing, people in Congress get angry.

This whole situation reminds me of a great quote from Reagan: “If it moves, tax it. If it keeps moving, regulate it. If it stops moving, subsidize it.”

If the past is any indication of the future, I know what will happen next. Congress will make new laws requiring banks to loan out more of their money if they take TARP funds. Some banks will choose not to take TARP funds and instead will stop making loans. (American Express is now offering some customers a $300 check card if they will pay off their balance and walk away from AE — these customers are just too risky and AE wants to bribe them to go away.) Recognizing that fewer banks are taking TARP funds, Congress will impose even more regulations requiring all banks to make loans, whether they take TARP funds or not. Then in a few years when those loans go bad, Congress will bring these bank presidents back one more time so they can yell at them about how they should not have made those loans in the first place. The bankers will say they were just doing what they were told to do, but Chris Dodd and Barney Frank will get up on their big podiums and scoff at them anyway. Just wait and see.