Monday, June 08, 2009

Was it Government failure that caused the crisis?

Fourteen economists connected with the right-wing think tank called the Institute of Economic Affairs in London published, in the Daily Telegraph, one of the largest-cirulation UK newspapers, an advertisement on the 12th of May this year.

This asserted that it was not a failure of markets, but rather a failure of government, that caused the crisis.

I did not comment on the matter then because I thought I had already covered the question of the origins of the crisis sufficiently.

However, as someone I respect asks me to comment directly on the advertisement and the study to which it refers ("Verdict on the Crash", available at:, here goes.

Do let us note is that the fourteen are eminent economists from across the developed world:
- Dr James Alexander, Head of Equity Research, M&G
- Prof Michael Beenstock, Professor of Economics, Hebrew University of Jerusalem
- Prof Philip Booth, Professor of Insurance & Risk Management, Cass Business School
- Dr Eamonn Butler, Director, Adam Smith Institute
- Prof Tim Congdon, Founder, Lombard Street Research
- Prof Laurence Copeland, Professor of Finance, Cardiff Business School
- Prof Kevin Dowd, Professor of Financial Risk Management, Nottingham University Business School
- Dr John Greenwood, Chief Economist, Invesco
- Dr Samuel Gregg, Research Director, Acton Institute
- Prof John Kay, St John’s College, Oxford
- Prof David Llewellyn, Professor of Money and Banking, Loughborough University
- Prof Alan Morrison, Professor of Finance, University of Oxford
- Prof D R Myddelton, Emeritus Professor of Finance and Accounting, Cranfield University, and
- Prof Geoffrey Wood, Professor of Economics, Cass Business School.

They summarise their findings in more or less the following words (with my comments in brackets immediately after)

● Central banks created a monetary bubble that fed an asset price boom and distorted the pricing of risk (the 14 do not ask, and therefore do not answer, what caused central banks to "create" such a bubble)

● US government policy encouraged high-risk lending through support for Fannie Mae and Freddie Mac and through the Community Reinvestment Act and related regulations (clearly, the 14 think that the government should have no such acts and regulations – and that is certainly one point of view, but it is a point of view that is politically untenable – economists sometimes live in a rarefied world divorced from real life)

● Regulators and central bankers failed to use their considerable powers to stop risks building up in the financial system and an extension of regulation will not make a future crash less likely (again, the 14 fail to ask WHY regulators and central bankers did not use the powers they had and indeed abandoned the duties and responsibilities they had, and why those whose job it was to keep an eye on regulators and central banks failed to notice this and failed to call them to account)

● Much existing banking regulation exacerbated the crisis and reduced the effectiveness of market monitoring of banks. The FSA, in the UK, has failed in its statutory duty to "maintain market confidence" (so we need better regulation, not the absence of regulation)

● Tax and regulatory systems encourage complex and opaque methods of increasing gearing in the financial system (so the 14 do agree that tax and regulatory systems should discourage such methods and such gearing/ leveraging?)

● Financial institutions that have made mistakes have lost the majority of their value; on the other hand, regulators are being rewarded for failure by an extension of their size and powers (the first is a moot point, the second is valid – and I agree with them that this is neither proper nor just)
● Evidence suggests that serious systemic problems have not arisen amongst unregulated institutions (well, if unregulated institutions were simply enabling regulated institutions to play, much as a pimp does in the case of a prostitute, it is not the pimp who gets infected with HIV but the customer).

The conclusion of the 14 is that "no significant changes are needed to the regulatory environment surrounding hedge funds, short-selling, offshore banks, private equity or tax havens".

This is breathtakingly bold, but only what you would expect from a right-wing think tank.

They claim that what is needed, instead, is a "revolution in financial regulation", and the consider that the following sorts of things constitute that "revolution" (again, my comments are in brackets):

● Making bank depositors prior creditors (I agree). This will provide better incentives for prudent behaviour and make a call on deposit insurance funds less likely (I doubt that this would always be the result, but let that pass).

● Provisions to ensure an orderly winding up, recapitalisation or sale of systemic financial institutions in difficulty. Banks must be allowed to fail. (In theory, they are already "allowed to fail". In practice, governments have not felt able to let them fail. Where economics clashes with politics, remember, politics will usually win).

● Enhancing market disclosure by ensuring that banks report relevant information to shareholders (that IS a matter of making the regulation tighter or more efficient or more effective – choose your own language)

● Central banks should make "proper use" of lender-of-last-resort facilities to deal with illiquid banks (isn't this precisely what has been done?)

● Central banks should monitor he growth of broad money together with the build-up of wider inflationary risks (they probably do this already; even where they do not, it was not the absence of the information that was the problem, it was a systematic and consistent avoidance of attention to the information that was shouting for their attention).

In brief, IEA is a free market think tank – and of course therefore still thinks in old categories of market versus government, with a commitment to trying to roll back the government.

Actually, I have huge sympathy with this point of view in discussing NATIONAL economies (most governments around the world are, if not made up of rogues, thieves and murderers, at the very least more interested in lining their own pockets than they are in doing anything substantial for their countries).

However, as far as I can see framing the GLOBAL discussion in terms of "free markets" versus "non-free markets" is fundamentally misconceived:
1. There is in reality no such thing as a "pure free market"; moreover, there cannot be such a thing as a "pure free market" because that would be a free for all, which would soon establish the might of some dominant mafia or clique.
2. What we have are markets with less or more government intervention, and the question is: what is the right kind and level of government intervention for what stage of economic development or what phase of the economic cycle or degree of integration in the global economy?
3. There is huge confusion because of the terms used in the debate, such as "government". There are 3 branches of "government" that are relevant to the discussion: the executive wing (that actually implements rules, regulations, procedures, and so on), the legislature (which makes the rules) and the judiciary (which is there to decide whether the rules are being kept – and, to a certain extent, whether the rules are right).
4. When we talk of "government intervention", we usually refer to the executive branch of the government.
5. Regarding the level of "executive government"INTERVENTION, I don't think there is much left to debate: in general, there is agreement that, after a certain level of minimum development has been reached by a country, the less "executive government" INTERVENTION there is, the better
6. However, the level of "executive government" INTERVENTION is an entirely different question from the following, which is the key question: what are the right rules for a global free market to operate in a way that is just and responsible? That is a matter for the legislature and for the judiciary.
7. It is the legislature and the judiciary that have the job of creating the playing field within which business should pursue success, as well as the rules (good governance, transparency and accountability) by which the game is played. If countries have level playing fields with the right rules, they enable society (investors, managers, workers, suppliers and the public) to be confident that business (and every other area of national life) are being run in a trustworthy way. THAT is what makes for long-term success, not "free markets", not executive over-activity (which results in bribery and nepotism), and not even legislative and judicial over-activity (which can result, as in Russia, in the abuse of these to dispossess investors). So you can certainly have too much government, just as you can have too much "market freedom". What is critical, however, is "a space for business in which the rules are clearly defined, in which society nurtures virtue, with resulting responsible behaviour in relation to shareholders and other stakeholders in businesses, as well as in relation to the environment". At present, as the current crisis shows, we have neither society able to nurture virtue, nor governments laying down or implementing appropriate rules, nor business executives behaving with due consideration for anything beyond their own pockets (for that matter, we don't have consumers behaving with responsibility either).

In other words, we have a society-wide malaise, and neither legislative fiat nor "free markets" are going to sort cure that. What would cure that would be a spiritual and ethical resurgence which results in the transformation of markets as well as the transformation of politics and and the transformation of government. Sphere: Related Content

No comments: