What happened — further reflections

         Wall Street did screw up royally, and needed government’s help. The problem was a triple whammy: many big financial institutions underestimated the risks in mortgage-based securities should house prices fall, compounded by a perverse incentive for banks to make mortgage loans disregarding ability to pay (another case of unforeseen consequences), and by a credit bubble fueled by low interest rates, which promoted financing by borrowing rather than selling shares (a good thing as long as a firm makes money, but dangerous otherwise). Capitalism was a victim of its success: huge wealth had been generated, sloshing around in search of investments, and Wall Street was (overly) creative in responding.

            The actual mortgage related losses were not that huge, but triggered a crisis of confidence that spiraled out of control and paralyzed the credit system, which in turn prompted a panicked financial selling frenzy. Thus the problem wasn’t so much the system as the psychology of its human participants. Of course, any system worth its salt must allow for that. But this was a one-off, a unique event, like a once-per-century storm. No system could ever be impervious to such storms.

            Blame has been put on deregulation, or government regulatory failure. There was some fraud, that should have been stopped. However, beyond that, it is far from clear what regulation could, or should, actually have done that would have prevented the smash-up. It would have required government second-guessing business and investment decisions by private firms using their own money. Some of those decisions proved disastrous, but why expect government to make better ones with other people’s money? And if you do blame government for the situation, what that really shows is just how difficult it is for government to navigate in today’s exceedingly complex financial landscape.

            This is all about how credit and capital get distributed throughout the economy. Government-run systems, like the USSR’s, did that poorly. Our freer system, with moneyholders possessing the flexibility to invest based on finding promising opportunities has, in recent decades, midwifed fantastic economic growth—even considering the 2008 setback. There isn’t any viable alternative system.

            This is not to say “the market is always right,” or is the answer for every societal concern. Life isn’t that simple. For example, we all know about “the tragedy of the commons”—if everyone can graze sheep on common land, it soon will be grassless. And if every fisherman maximizes his catch, fish populations implode. But note that in such situations, where someone can get something for nothing, that isn’t really market economics. Hence the term “market failure” is often used. In market economics, you have to pay for what you get, there are no free lunches; and if government must step in to close the buffet, that doesn’t violate free market principles, it protects them.

            Thus, the idea of “unfettered” free markets, with no government role, is a false straw man. No defender of capitalism advocates that. We do need government, to act as referee, and to intervene to keep markets open, competitive, and genuinely free. That’s what “unfettered markets” should really mean.

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2 Responses to “What happened — further reflections”

  1. Richard Says:

    “However, beyond that, it is far from clear what regulation could, or should, actually have done that would have prevented the smash-up”.

    But isn’t that too something of a strawman: the largest investment banks were leveraged–by administrative fiat–far beyond the previously acceptable 12:1 and way up to the ranges of 30:1.

    The only difference between properly funded insurance reserves and a Ponzi scheme is a rigorous actuarial review, one that considers systemic risk as well as individual risk. For that reason most insurance providers do not insure more than a few percent of large structures: the rest is reinsured out. And some risks are so massive that there must be government underwriting–consider the FDIC, or terrorism risks, or the huge government guarantees in the early years of airlines that permitted expansion.

    Surely less leverage (larger reserves) coupled with a proper view of the systemic risks involved would have diminished the current crisis greatly.

  2. Mike Says:

    The idea that regulation couldn’t help prevent or reduce the severity of the current crisis is preposterous.

    As the commenter above observed, merely requiring sane leverage ratios and prudent reserve requirement would’ve done much to stanch the bleeding.

    Funny how we did fine for over 60 years, but when regulations were loosened or discarded, we have a huge calamity.

    Coincidence? Right, sure.

    FSR COMMENT: The above two comments reflect a mystical belief in the wisdom and perspicacity of government regulation. If government could actually, in the real world, do the job that well, I’d be all for it. But, having spent my own 26-year career in government regulation (!) I do not have such faith. In fact, government shares some of the blame here because government does not and cannot possess the omniscient wisdom the commentators seem to think it ought to have deployed. The truth is that over the previous several decades, the financial markets were handmaidens to boffo worldwide economic growth not because they were sufficiently regulated, but rather because they were left sufficiently free to do their thing. In the context of that monumental long-term track record, what happened lately is a mere blip.
    As a past career government regulator, I have come to the belief that government regulation has a built-in tendency to do the wrong thing, and to do more harm than good.

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