The recent collapse of financial giants Lehman and AIG have led to new calls for regulation. Nobel Prize winning economist Joseph Stiglitz has proposed a six point plan to deal with the current financial situation. He believes that the government needs to “correct the incentives for executives” by requiring that bonuses be paid on five year returns, rather than on annual returns. We need a “financial products safety commission”. We need a “financial systems stability commission” to overview the entire financial system. We need to impose regulations like “speed bumps” to limit excessive lending. We need regulation to limit predatory lending. Finally, we need better competition laws. Firms that are “too big to fail” ought to be broken up.
Absent from this list are any calls for reforming the Federal agencies that currently exist. Professor Stiglitz insists that “financial institutions are at the center of blame”. Stiglitz does admit that the Fed mismanaged policy, but makes no mention of other authorities. The Federal Reserve created this problem with “a flood of liquidity” that caused a “housing bubble” and low household savings. These are interesting observations. The idea that inflationary monetary policy should cause an investment boom in housing and dearth of household savings (i.e. a consumption boom) that leads to a crash is highly consistent with the explanation of business cycles that earned Friedrich Hayek his Nobel Prize in economics. Professor Stiglitz is hinting at Austrian Business Cycle Theory.
Unfortunately, professor Stiglitz has learned the wrong lessons from this experience. He has jumped to the conclusion that private markets and “lax regulation” are to blame. While it is surely the case that private investors and CEO’s have committed errors, it could hardly be the case that Federal Regulators are blameless. At a minimum, Federal authorities failed to prevent the current crisis. Professor Stiglitz does note that “the ingenuity of those in financial markets means that regulations will be circumvented. Indeed, he admits that past regulations came to be ineffective, and uses this as an excuse for more regulation. This supports the theory of regulation advanced by Ludwig von Mises in his 1940 book on Interventionism. Regulations lead to unforeseen and unintended consequences that require more regulation, if we insist upon governmental controls instead of regulation by true competition.
The current crisis should be viewed as a failure of several large organizations, only some of which are private. The difference between private failure and public failure is that, as Milton Friedman put it, “If you start a program that is a failure and you are in the private market, the only way you can keep it going is by digging into your own pocket. That is your bottom line. However, if you are in the government, you have another recourse. With perfectly good intentions and good will nobody likes to say “I was wrong” you can say, “Oh, the only reason it is a failure is because we haven’t done enough”. This crisis is shutting down some private firms, like AIG, yet culpable public sector organizations will continue their operations, perhaps without any reforms at all. We may also get more of these public regulatory organizations. This is the true failure of a system, failure to reform itself. Capitalism reforms itself through bankruptcy, but government has no such automatic mechanism for change and reform. ON the contrary, public institutions use crises as justifications for their expansion, even where these public institutions are at least partly to blame for the crisis in question. We can, however, learn from the recent crisis by putting it in the proper perspective. Mises and Hayek arrived at the right answers largely because they thought about capitalism and government in evolutionary terms. We can arrive at the rights answers to the problems of our time by thinking about them in the same way.
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Maybe we need a commission for protection from loony economists (e.g. Stiglitz)…
Except for Austrian School economists, very few economists, financial commentators, and members of the public assign the root cause of the current financial crisis where it belongs, i.e., at the Federal Reserve System. In the early 2000s, the Fed created enormous quantities of loanable funds literally out of thin air and succeeded in driving short-term interest rates to 1%, a level that had not existed for decades. Importantly, these loanable funds did not arise from real savings.
The current situation in the mortgage securities market and its impacts on other parts of the financial system would not have occurred, at least at anywhere close to the existing magnitude, if the FED had not created the loanable funds. This newly created “liquidity†had to be loaned somewhere, and this time, for a variety of reasons, found its way into mortgage loans of terrible credit quality.
The current financial gyrations by the Feds are the logical outcome of years of statolatry. The entire nation believes that the federal government has god-like powers. They believe it can end poverty, crime, disease and all financial problems. Americans are learning how impotent their god is, but instead of accepting that fact, they insist that the state they worship could accomplish all of those feats if only we gave it more money or more power to regulate out lives.
The Old Testament prophets used to chide Israel for mining gold with their hands, fashioning an idol from the gold, then worshipping the idol and pretending it was alive with supernatural powers. How different are Americans when they fashion a government with their own hands, fill its positions with human beings just like them, and then attribute to that government god-like powers?
The self-correcting mechanism of bankruptcy that you write about sends a lot of innocent people to the poor house, doesn’t it? As long as executives at the top are able to negotiate contracts that protect them from the extraordinary hardships that their bad decisions shower on the people below, as long as top management lives in a riskless world — they exit bankruptcy with millions — why should they care if their business ideas are essentially high risk and, ultimately, predatory? There will always be those at the top who could care less about the pain they inflict on others.
L. Mukey, bankruptcy is terrible and within the destruction multiple lessons are often learned and missed. As investors become more adept at analyzing companies they are able to invest in companies which follow procedures that support long term success. This would likely include restrictions on executives to ensure ‘skin in the game.’ The argument of harming the innocent misses the point of market mechanisms.
Rubbish. Their decisions are bad mostly for their employers, the shareholders of the firm. Hence if the shareholders want to see an influx of money, they have every incentive to rid themselves of worthless executives. At worst, other employees will need to find new work. As will fired executives. So yeah, the existence of people willing to try lose their employers’ money will continue, only they will suffer for it in the absence of bail outs…
Leslie: “The self-correcting mechanism of bankruptcy that you write about sends a lot of innocent people to the poor house, doesn’t it?”
It depends on who you think are innocent. Middle-class investors get hurt because they trust the state and coporations too much. If they were less trusting, they wouldn’t get hurt so much.
The only innocents I can see are the working poor who lose their jobs because of recessions. Our current financial system was specifically designed to transfer wealth from the working poor to wealthy bankers. The poor will suffer whether we allow troubled banks to fail or bail them out because we the feds don’t have the power to defy economic law forever. At some point someone has to pay and it’s usually the poor.
“At worst, other employees will need to find new work. As will fired executives. So yeah, the existence of people willing to try lose their employers’ money will continue, only they will suffer for it in the absence of bail outs…”
Many tens of thousands needing to find new work at the same time, the stockholders screwed, the top execs floating away with their golden parachutes. Incentives to replace the bad guys? Based on what information? Up until July of 2008 most of the information available, including from Greenspan who was supposed to know (Krugman notwithstanding), supported the expansion of the housing market. For every article that sounding a warning, there were hundreds that extolled the virtues of spreading out the risks through structured vehicles. The sophisticated, educated shareholder (much less the average shareholder) has no clue which economic theory works or doesn’t — evidenced by the fact that so many of the world’s so called best and brightest bought the derivatives that are now destroying them. Pension funds, private funds, state funds … they have never reigned in executive pay in any effective manner. The system begs to be abused and there are always those miscreants (and some well-meaning bone-heads) that are happy to oblige. In the end, they don’t suffer. They have their millions. The people who suffer are those against whom the deck is heavily stacked.
With programmed trading, mathematical models, game theory and reckless ambition, the markets have become a gaming casino in which card counters and players with loaded dice are welcomed to the table. For some powerful hedge funds, it’s not a question of production or investing, but skimming. The markets have become incredibly distorted by people who only deal in abstractions.
Right, so you’re complaining about the Fed’s policies impact on these individuals. But the author never said that bankruptcy is self-correcting when the Fed distorts the market…
Fundamentalist,
Agreed. And I’m not saying investors should be absolved from their responsibility to do rigorous due diligence. I am saying that in a marketplace where big money corrupts politics, where Kudlowesque free market ideologues (like Phil Gramm) unleash unscrupulous opportunists into the market, some carefully thought out regulation might be in order. We Americans learned some hard lessons during the Depression. How quickly we forgot…
Leslie,
Bankruptcy is quite bad compared to an ideal situation. Innocent people do incur losses. However, we all recognize risks from being employed in certian industries. Also, the alternative of a system that does not shut down inefficient organizations is far worse. General economic progress requires some localized short term personal losses. That is reality.
Giving a liver transplant to an alcoholic?
(This may be an appropriate metaphor?)
Leslie: “We Americans learned some hard lessons during the Depression. How quickly we forgot…”
The free market is very stable. State intervention, especially in the form of creating fiat money and controlling the money supply, destabilizes it. That should have been the lesson of the Depression.
We could create enough regulation to eliminate the excesses of state intervention in the market place, but it’s much simpler to have the state nationalize businesses. Regulation is nothing but bureaucrats telling business owners how to run their businesses. If the bureaucrats are so smart, at least smarter than the business owners, then maybe the state should just take over businesses and run them directly. That might sound like a good idea. I don’t think the USSR or Communist China experienced business cycles. I know for a fact they never experienced “irrational exuberance.”
But there is a downside: regulation destroys wealth. It’s not true that we can regulate away the business cycles that regulation causes and still increase wealth. That’s probably the biggest lie that few people are addressing in this whole debate. I was listening to O’Reilly last night and he had two of his financial producers on with him. They were all mad at the SEC and other regulators for letting this crisis happen. But what they don’t understand is that if we had the regulation necessary to stop such crises, we would all grow gradually poorer, as did the USSR and China under communism.
The formula for wealth goes like this: free markets create wealth. State intervention destabilizes markets and reduces wealth creation. Enough regulation can restore stability at the cost of destroying wealth.
Leslie – Most of the problems of executives abusing the system comes from the massive expansion of the money supply orchestrated by the Federal Reserve.
Per Austrian Business Cycle Theory, and common sense observation of past cycles, large credit expansions lead to large stock booms and illusory profits (profits that are largely reduced or entirely eliminated once the downturn sets in) – these are the two primary methods of executive compensation – one based on short term profits, one levered through options to the prices of the company’s stock.
Take away the artificial short term profits and the artificial stock market boom by eliminating the Federal Reserve and fractional reserve banking (either through law, or more preferably through complete freedom with zero government intervention in money and banking, which would lead to the same thing), and executives would make a whole lot less money and would mostly deserve what they make.
The system is horribly messed up, to the disadvantage of the little guy. This is what most mainstream ‘freemarketers’ fail to realize.
You’re right that given the current system such regulation is better than nothing (at least in the short term, as regulation leads to greater regulation and state power which leads to poverty), but we should be attacking the heart of the problem and not it’s many monstrous limbs.
No reform and no “fix” of the current problems will do anything to prevent later financial catastrophe. At most, they will prevent most of the same sort of excesses from occurring in the same way in the future. But the system itself is one of “built-in” catastrophe waiting to happen. The likeliest scenario is one in which the patches assure that the next crisis is, though different in cause, even larger than those past. The rule is: the better is the fix, the longer will be the interim before the next crisis AND the larger the subsequent one shall be.
The actual root of the problem is the idea–widely accepted by the vast majority in this and every other place on Earth–that the political authority has any role whatever to play in defining what is and is not money or in the determination of the proper quantity of money or its “value,” or in the legitimacy
of whatever rates of interest on obligations arise between contracting parties.
Exchange of many sorts is the principal activity through which humans seek the individual satisfactions which comprise their fullfilment in living; every single coercive interference with such process–beyond that necessary to assure its peaceful continuation–is a diminution of the totality of the satisfactions achieved by the whole of humanity and engenders opposing reactions, each of which plays its part in the production of loss, waste, and, ultimately, the resort to violent action as
a rational program for melioration.
None of the core problems shall be addressed; it is unlikely they will even be recognized or mentioned in discussion among those with any connection to the “levers of power.” “The people” are utterly incognizant of the principles involved: not one in a million in the ‘developed” nations has even a clue where lie the roots of the recurrent crises.
That the founders of the nation were essentially ignorant of such matters is clearly to be seen in the Constitution itself: in the power enunciated in one amendment to regulate trade of certain types and, in another, to define what is money and determine the value thereof. These are basic and politically irremediable obstacles and have counterparts (or worse) in the systems of every single existing nation.
The world-embracing system as currently existing has only a single possible outcome: worldwide panic on such scale that most of the world’s population that is not rural , agrarian, and relatively isolated will perish, either from starvation and deprivation brought on by worldwide monetary collapse or in paroxysms of violence in attempt to survive through predation on one another. I have no idea who will survive or where–just that it will be a world of material conditions approaching those a thousand years in the past in the most undeveloped regions. It’s not what I want and I don’t expect it will happen in my lifetime (though it might certainly in the lifetime of some now living). The only thing of which I’m certain–is that it’s certain.
The evolution of exchange and civilization are not merely linked and congruent; they are simply one and the same thing. Tyrants did not usurp the money-function from the people among whom it originated; rather, people, ignorant then (even as now) of economics and inclined lazily toward simplicity, demanded that those who administered the law should make exchange even easier than it was–by regulation of the weights and finenesses of precious coinage, by decreeing convertibility of token coinage, by establishing the prevalent coinage as “legal tender,” with penalties invoked for those impertinent enough to refuse it when offered.
Thus was force introduced into otherwise voluntary acts of cooperation. And though but slight was the force and infrequent the occasion of its application, yet the seed–everywhere, eventually–was sown for the thoroughgoing control of authority over the fundamental medium of exchange. Everything else follows, not according to a schedule, of course, but with the same “cause and effect’ relationship as characterize any economic (or indeed, natural) phenomena.
Von Mises could see the same future but he couldn’t see how it could be prevented–other than to return to a less-corrupted version of the recent past (the Gold Standard), hoping, I suppose, for a reprise of a “loop” of history: that in which the standard was instituted and then became corrupted. With luck, perhaps the successful period might be lengthened and the loop replayed endlessly and, thus, greater havoc averted. But history doesn’t repeat itself (as he himself observed, if it repeated, it wouldn’t be history–it’d be a natural science). For one thing, the population of the world is vastly greater and substantially more interdependent. No city of 200,000 or more–anywhere in the world–could survive the lack of food and fuel coincident with monetary collapse for more than a few weeks.at most. Whole nations are dependent on imported foods, fuel, and other raw materials. But from where shall come such stuff when none are able to pay with anything that may be recognized as of further exchangeability? People “do what’s necessary” and can manage many transactions through barter or on other basis; such shifts cannot provide for all, though, and it is to be expected that, with monetary collapse shall occur great breakdown in “law and order,” much of such presence being required just to supervise the orderly-as-possible rationing of what most need foe survival in the immediate aftermath.
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