Who Can Fix This?

The financial sector in the US is suffering through a crisis that we have not seen in my life-time.  Who is to blame?  And  who can fix it?

On the morning talk shows -- CNN, Fox, ABC, CBS, and NBC --- this is subject of conversation.  But I have not heard one word of sense uttered.  Mitt Romney gave us this general rule for bailouts --- when the failiing of the firms will hurt taxpayers more than the cost of the bailout we should bail the firm out. And he added that when we not only bail them out, but the government takes ownership of part of the firm when it turns around government can earn a profit.  Bill Richardson just keeps insisting that hope and change includes higher taxes and more regulation.

F. A. Hayek once remarked that the unfortunate fate of the economist was to be called upon more than any other scientists for his opinion on public policy only to have that advice dismissed almost as soon as it is uttered.*  If an economist of the skill of F. A. Hayek had his words dismissed, then it should be no surprise when those who are his less skilled followers don't even get an initial hearing among the power elite.  But part of that reason is that the message that Hayek and pre-Keynesian economists offered was one that challenged the presumption that whoever the President was could be in control of a complex economic system.  An individual or a party (either one) cannot fix our economic problems.

Instead, government must instead get out of the way of market adjustments.  Government is NOT a corrective.  More often than not, it is the source (as in this case) of our economic difficulties.  No bailouts, eliminate regulations, certainly no nationalizations, no priming of the pump with easy money, just allow firms to be weeded out that made imprudent decisions, allow capital to be reallocated, and permit prices to adjust to the new market realities.  David Hume argued that the foundation of society was stability of possession, transference by consent and the keeping of promises.  It is easy to see why violating those priinciples of social interaction would result in chaos --- e.g., 'societies' governed by predation, stealing, and betrayal do not even warrant the label society.  But the persistent and consistent application of Hume's principles is also hard for people to follow.  So rather than a policy regime of well defined and enforced property rights, the allocation of resources based on contract and market forces, and the honoring of promises, we have attenuated property rights, government intervention in the market, and breach of contracts or modification of the terms based on political status.  Hayek argued in The Constitution of Liberty that government policy if the desired goal was to be consistent with the rule of law (as opposed to the rule of men) had to follow the 'generality norm' --- no policy shall be pursued which permits discriminatory coercion to favor one party at the expense of others ... see this discussion by James M. Buchanan of non-discriminatory politics.

Where is this discussion today?

One final point, whatever happened to Milton Friedman's wisdom about the long and variable lag in our current political economy discourse?  Ironcially, I was talking on the phone last night with my brother --- a very wise man who has in fact worked his adult life on the ground in the construction industry in NY/NJ.  We were talking about Wall Street and the financial problems, and I just said well it is going to make for an interesting election.  My brother wisely stopped me and asked why, "what are either of these jackasses going to do to fix this?"  He then went on to utter Milton Friedman's argument about the long and variable lag (as far as I know my brother doesn't know who Milton Friedman was let alone the details of his argument, but Fred nailed the argument).  He explained to me how our current financial crisis is the by-product of policies that Clinton introduced over a decade ago and Fed policy.  The President, he told me, cannot fix this and we shouldn't be looking to the government for the solution.  I laughed at the end of my brother's comments and simply said, Fred I couldn't say it better. 

Why don't others get it?

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*Hayek's best remark concerning economists and their task is arguably from The Fatal Conceit where he argues that "The curious task of economics is to demonstrate to men how little they know about what they imagine they can design."  This statement is exceedingly relevant.

Comments

[Joseph Logan]

Well put. I suspect people cast their lot with government intervention for two reasons: power and habit. Power is obvious; government has a tendency to perpetuate itself and the wherewithal to do it. Habit, on the other hand, has to do with people understanding (slightly) government and understanding economics very little at all. If basic economics concepts were taught as part of social studies in early education, it is easy to imagine a more cooperative public.

[Daniel J. D'Amico]

Drinking with Bob gets the lag too:

http://www.youtube.com/watch?v=8W49NDI-wR0

[Ed Weick]

Pete,

Did Mises contribute any wisdom to the issus at hand?

ED

[Joseph Logan]

It's as if the editorial staff at the New York Times made your point for you:

"The regulatory failure is rooted in a markets-are-good-government-is-bad ideology that has been ascendant as long as Mr. McCain has been in Washington and championed by his own party."

[Roger Koppl]

Joe Biden was on one of the morning news shows yesterday blaming "laissez faire" for the crisis. Republic rhetoric about free markets has damaged the reputation of pro-market policy.

Devotees of this blog may tend to forget that economics is hard and unnatural. Economics is hard, so we should not be surprised when people don't get it. It is also unnatural in, I think, a very literal sense. We were shaped by natural and sexual selection for life in small groups of 15 to 150 persons. There's not much in the way of spontaneous order in a society of 50 persons. I imagine "social issues" were about things like whether to kill the current headman, which (literal compass) direction to go next, and whether to make war with another local band. These are planned, collective issues in which the headman plays a privileged role. We bring such atavistic logic to our understanding of modern politics. It's only natural. Unfortunately, it's also wrong. Imagine if we had to vote on the correctness of Newtonian mechanics or, say . . . Darwinian biology. There is no reason to expect candidates to correct popular errors in scientific understanding.

[Daniel]

I think there is a lot of confusion in people's minds because they mistake our heavily regulated and subsidized economy with free-market capitalism. This has been drilled into the public's mind time and time again. And the existence of GSE's confuses matters even more. And even if people are wise to government's shortcomings, what choice do they have but to succumb?

Secondly, yes, habit. It is impossible to imagine a world without the heavy hand of government because we simply haven't experienced it in our lifetimes.

[Bruce]

I appreciate Daniel's point that people confuse our current economy with free-market capitalism and then blame the market or claim that it is broken when problems arise. I am also very sympathetic to the point of the main post that government is not a corrective but very often a source of the problems the market experiences. And I believe the market has an important disciplinary role to play that in some ways we dare not prevent. But here is my question: where do we see the purest form of free-market capitalism around us and how does it go? It seems to me, and I am no economist, that we see something like this in the virtual world and it inevitably takes on nightmarish proportions. We find it necessary to trust one another but do not trust one another very well or prove ourselves trustworthy. We know our guilt and suspect it of everyone else and find this suspicion constantly confirmed day-to-day. If trust is foundational to the proper function of a free-market economy then what is necessary to establish the conditions for a free-market economy and how does one distinguish this (what, rule of law?) from regulation or is it, after all, just a matter of good and bad regulation? Since trust is interpresonal and subjective it seems that what is necessary to maintain trust could differ from time to time and culture to culture (and thus take on differing regulatory expressions) even if grounded in universal principles and precepts. It seems to me that most arguments for regulation try to appeal to the underlying sensibilities Hume sketches. (Note: I would distinguish between trust from "confidence" at least as it is often used in referring to confidence in the market or of consumers and the like--seem fair?)

[Mike H.]

Clinton's fault. It's always Clinton's fault.

[Bill Woolsey]

Once upon a time, investment banks underwrote securities. Recently, by overnight borrowing, they were effectively creating money, and buy holding portfolios of mortgage backed securities, they were effectively making loans for long term home purchases. This activity was not heavily regulated, and they operated with very small capital ratios. It was a lot like the savings and loans, before the last crisis.

Traditional, commercial banks, are much more regulated and have capital ratios of 10%. However, they are heavily invested in mortgages. Many of them hold mortgage backed securities as well. They didn't have to do this.

With the S&L crisis, a spike in interest rates showed the dangers of a portfolio heavy in mortgages. This time, it is the discovery that home prices can drop.

Is this a market failure? Only in the sense that that bad, money losing investments, are a market failure. All the resources used to promote "new coke," were wasted.

Anyway, I still support privatizing deposit insurance and privatizing the Federal Reserve. But I don't think the time is ripe. I think FDIC currently has an important role in rapidly resolving failed commercial banks rather than using traditional bankrupcy procedings.

I think allowing a deflation of spending in the economy and an appreciation of the purchasing power of money is not an option. While there are sectors of the economy that should shink (not that any of us should pretend to know which, though I can't help but say, housing," I believe that the best macro framework for this to occur is for there to be roughly matching shortages of other sorts of goods at current prices.

I believe that the way to make sure that nominal expenditure continues to rise is to keep the money supply growing. None of the money supply staticis mean much anymore. (Well, base money means something, it just isn't too relevant.) If the Fed needs to purchase all 5 trillion of outstanding Federal debt, and nominal spending drops, then, it is time to look for something new.

In that framework, problems with financial intermediation may well depress real producing and lead to inflationary pressures. That is, firms could sell more product at current prices, but they can find the financing to expand producing. Or, they cannot maintain producing because of difficulty finding finance, so they cut producing leading to shortages.

In my view, the profit opportunity there should result in currently small banks, that are perhaps poorly capitalized because of loses in mortgages and mortgate backed securities can be "bailed out" by private investors and then expanded to make profits in these "credit starved" sectors.

[Jim Lorenz]

Fiat justicia ruat coleum. I now think I know what the mythical Samson might have felt between the pillars of the temple as he considered the options. Let'er rip.

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[fixingbadcredit]

Economic growth cannot last forever without getting in trouble in my opinion.We have a limited supply of raw materials on this planet so...The ''club of Rome'' in the 60's already said this but no one seems to care.

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I think government did not make the most of the shares they have bought on Goldman Sacks and other banks. Instead of letting them pay the tarp moneys back they should get the return on that high risk funds. They had it easy for insuring their safety.

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The current economic crisis in the usa and the world is due to usa printing money out of thin air policy. Same as europe as well. Ron Paul is a big advocate of austrian economics and i hope he runs for election and wins. The gold standard must return to the world. The current governments are just running a ponzi scheme. It will go bust eventually