Credit Crisis not a market failure
If someone else has already pointed this out, please let me know. I have yet to see anyone anywhere make this point.
A lot of people are claiming the current credit crisis as a failure of the free market system.
Now, whatever your stance on the capitalist system is — good, bad, flawed, or perfect, right now that doesn’t matter. This post is here to make one point: the global financial sector does not operate as a free market.
How so?
The banking system operates under the direct support of the government. The US Federal Reserve, just like every other central bank, controls interest rates. Not only does the interest rate act as a price control mechanism, the capital flows & liquidity that are provided to the banking system act as a government subsidy. Without this level of government intervention there would be no business model.
Additionally, there is no historical basis for the long term stability of banking. Again and again government agencies are required to bail out banks, dating back hundreds of years. Nassim Nicholas Taleb pointed this out in his very, very timely 2007 book, The Black Swan.
Why does the banking system continually fail? Leverage. When you have no leverage riding out difficult times is achievable. The model of fractional reserve banking mandates the use of leverage. What kind of profits would banks earn if they could only lend out $1 for every $1 of deposits?
As I’ve said elsewhere, I think we may be facing a full blown end to a credit super cycle. It may happen rapidly, or it may be stretched out over the course of 10 years. I don’t know. With low overhead and nearly unlimited flexibility I am very happy to be in the business I am in. You should be too.
Oh I’ve been pointing this out. Fannie & Freddie are at the eye of this storm and they couldn’t exist with their 50:1 leverage without the government.
Additionally, the government since 1977 has been arm twisting banks into lowering lending standards to get more lower income people into housing. It was a good intention, but it paved the road to hell.
In 2005 there was a bill put forth by Chuck Hagel, cosponsored by 3 other republicans, including John McCain calling for more regulation on fannie & freddie. It was blocked by democrats in a pure party-line vote because, in the words of Barney Frank (who should be imfamous because of this) “Fannie & Freddie have no problems, and if we add regulations we may limit the access of affordable housing to the poor and minorities.”
John McCain gave a speech warning this could happen in 2005. Bush mentioned it in numerous State of the Union speeches. Ron Paul gave it a big speech in 2003. Democrats repeatedly blocked it.
I hate Obama’s most recent campaign ad. He sets up a strawman saying “For 8 years we’ve had an administration with an anything goes regulatory attitude.” Which is BS, the alarm was raised by the administration and other Republicans.
So no, this isn’t a failure of capitalism. This is a failure of socialism. This is a failure of government tinkering with markets in the guise of social engineering. This is a failure of having two bloated poorly run government sponsored behemoths who would buy any loan a bank would write, and so banks would write any loan they could.
What really grinds my gears though, is the unrepetent blaming of capitalism and capitalism policies and Republicans by the Democrats. We need a 911 Commission type investigation into this, but we won’t get it, because Pelosi and Reid will not authorize it, because they know where it will lead.
Comment by Chris — September 30, 2008 @ 7:20 am
McCain / Bush support the war, you have no argument.
Comment by Tob — September 30, 2008 @ 12:46 pm
Ignoring the fact that the vote to authorize the Iraq War was near unanimous (meaning most the Democrats voted for it as well). And ignoring the fact that Obama voted against the surge, which is the thing that has enabled us to start pulling troops out (and which he admits has succeeded beyond our wildest dreams).
I really doubt whether or not to invade Iraq is a decision the next president will have to make. Until we invent time travel anyways. Gotta get on that.
Comment by Chris — September 30, 2008 @ 1:03 pm
I’m in complete agreement with you Chris.
I just hope someone comes out publicly and says the banking system is not part of the free market. I’m not sure Ron Paul has stated this.
To be fair, every market has regulations and government influence. The banking system, however, exists in its present form only through the power of government.
Comment by Andrew — September 30, 2008 @ 1:20 pm
Lots of issues here Andrew. I think fractional reserve banking will always be with us. It’s just a natural consequence of banking. Without fractional reserve, banks would have a hard time earning money without what most people would consider usurious rates.
One of the main problems in addition to Fannie and Freddie are the co-conspirators of de facto banks that are not regulated as banks in addition to opaque markets for the latest securities innovations. So I think this whole mess was caused by multiple points of failure in the system.
Here is my view on the market though. I won’t call it a market failure because there is no rule or law of nature that markets are stable in any way. Markets always have solutions, its just that WE might not always like the solutions. Markets are capable of consuming themselves or destroying one industry only to replace them with another. A mass extinction in an ecosystem can be brought about by market forces.
Lately, I hear a lot of people deride this bailout as socialism. Well that may be so, but we live within the garden of society and unless we want to live out in the free market jungle then these are the things we have to do. Well we’ve actually had a lot of intervention even before this bailout, but without this kind of intervention, the banking system would be nuked and take a decade to regrow. I know this view is not popular amongst many economists and I’m all for markets, but I think free market adherents are comparable to religious fanatics in their uncompromising views.
OK, there is no way I’ll be able to flesh out the entirety of my thinking here, so I’ll just leave it at that and say I always enjoy your posts relating to economics.
Comment by Marc — October 4, 2008 @ 2:59 am
I think you are right that fractional reserve banking will be sticking around.
It seems that there are different views on the “free market” and what it really means. Larry Kudlow on CNBC seems to think that “free market capitalism” is the best system ever and that the US government needed to save it last week.
Comment by Andrew — October 6, 2008 @ 1:33 am
The Federal Reserve is not part of the government. Is a private institution. Get your facts straight. The lend the money to the government, they don’t care about you or the people of the United States.
Comment by Mike — October 7, 2008 @ 10:26 pm
Yes, we are certainly lucky to be in the industry we are in. But, as with all businesses in some way they are linked by credit. Weather it be an affiliate network offering credit to an advertiser for 15 days after the publisher has been paid to simply using credit to supplement expenses until payments are made.
Without credit things could be really bumpy.
Comment by Amped Media — October 27, 2008 @ 2:53 pm