The Light-Handed State and the Heavy-Handed State

Does the blame for our economic woes reside with a government that shirked its regulatory duties or rather one that proved too intrusive in the markets? The answer is “yes.”

My last piece, written an unforgivably long time ago, showed in detail how the downfall of a major financial institution can spark a broader unraveling of the financial system. A similar scenario occurred last fall after the failure of Lehman Brothers. And we would be deceiving ourselves to deny that a collapse of far greater magnitude remains possible, if not probable.

How did we get to this point? The question of what causes financial booms and busts splits analysts along the conventional left-right political divide. Those on the left hold that they result from too little state regulation; markets, when left to their own devices, have a tendency to run out of control and must be reined in if perennial instability is to be avoided. Those on the right make the opposite claim that it is excessive regulation that distorts markets and produces the boom-bust cycle. Who is correct?

The Light-Handed State

The factors at work in the current crisis certainly lend credence to the leftist view; the government, in a number of ways, abrogated its regulatory responsibilities through feeble oversight of financial markets. In a celebrated article published recently in The Atlantic, economist Simon Johnson details the erosion of financial regulation over the past 20-odd years. During that time, he argues, a group of powerful Wall Street firms managed to persuade lawmakers to relax a series of regulations that previously limited their growth and freedom to speculate.

Referring to the heads of these institutions as “oligarchs,” the author quite consciously evokes the image of similar crises that befell less developed countries in the 1990s such as Russia, Thailand, and Indonesia. If he does so it is because the momentous regulatory shriveling that took place in America, often at the behest of financiers, mirrored the light hand these other governments took in managing their own financial sectors. Johnson details a host of regulatory rollbacks that spanned both Democratic and Republican administrations and which now appear shocking in light of what has happened. They include:

*The promotion of free capital flows across borders;
*The repeal of regulations dating back to the Great Depression which mandated the separation of investment and commercial banking;
*A Congressional law banning the regulation of credit default swaps (for an explanation of these, see “Financial Market Chaos Explained”);
*A loosening of controls on the amount of leverage investment banks are permitted to take on (for more on leverage see, again, “Financial Market Chaos Explained” and “Anatomy of a Bank Run”);
*Lax regulatory enforcement by the Securities and Exchange Commission;
*International conventions that allow banks themselves to measure the amount of risk they are carrying; and
*An “intentional failure” by regulators to bring regulations into line with the enormous innovation in financial markets.

If Johnson’s talk of an “oligarchy” strikes some as extreme, recall that it is coming not from a foul-smelling schizophrenic on Berkeley’s Telegraph Avenue but rather from the former chief economist of the International Monetary Fund and an esteemed professor of economics at M.I.T. It is penned, in other words, by a beacon of the establishment.

And, clearly, he is correct; deliberately lax enforcement by regulators played a major part in the buildup of financial risk and its subsequent unraveling.

The Heavy-Handed State

Yet this is where most left-leaning analyses end and the rest of the story begins. For if government regulation proved too permissive in some respects, in other ways it served to distort markets and cushion risk-takers.

To begin with, the mountain of mortgage debt managed to reach the extremes it did partly because it received backing from Fannie Mae and Freddie Mac, two quasi-governmental agencies. These institutions are charged with guaranteeing the mortgages issued by banks and other lenders; if the bank that lent you the money to buy your home wants to sell your mortgage but nobody wants to buy it, Fannie Mae will. By serving in this role, Fannie and Freddie allow banks to issue more mortgages at lower interest rates and thus increase the level and affordability of home ownership.

Over time, however, they have come to serve as state-sponsored rackets. On the one hand the government will not allow them to fail, and everybody knows this. This gives them access to cheap financing which they can then lend out at a higher rate of interest and log an easy profit. On the other hand they technically are privately-owned companies. So the profits they create by borrowing cheaply and lending dear go not to the taxpayer but to their private shareholders and executives. It is a license to print money, and print they did. In the process they facilitated the buildup of a huge amount of mortgage debt, the consequences of which have now become clear.

Yet the excesses promoted by these state-sponsored entities are dwarfed by that enabled by our own central bank, the Federal Reserve. Of the scores of books to have emerged on the current financial turmoil, The Origins of Financial Crises by George Cooper, a former fund manager and strategist on Wall Street, stands out as perhaps the best. Cooper, in elegantly lucid prose, lays down a devastating critique of the major intellectual edifice adopted in recent decades by central banks and financial economists. Termed the “efficient markets hypothesis,” it makes two claims – first that financial markets, if left alone, allocate money efficiently to where it is needed most and, second, that the markets are essentially tame and not prone to manias and panics.

If events have shown this view to be wrong enough, Cooper argues that central banks, and particularly the Federal Reserve, have made things worse by perverting it. And this is where we see the distorting effects of government intervention. The space available here is far from adequate to do justice to the nuances of Cooper’s analysis, much less his smart and original policy prescriptions. But the thrust of his argument is as follows. While asset prices are rising and a bubble is forming, monetary authorities enthusiastically follow the tenets of the efficient markets hypothesis by leaving markets alone. However, as soon as the bubble bursts, causing distress among those who borrowed too much, central banks suddenly rediscover that the markets are not efficient after all. They accordingly respond by flooding the markets with money and credit. This serves to bail out irresponsible borrowers by giving them access to cheap financing when they would otherwise be forced to pay the consequences of their frivolous risk-taking.

This pattern has been repeated numerous times over the past two decades and was manifest in a series of aggressive monetary interventions by the Federal Reserve – first following the 1987 stock market crash; again from 1990 to 1992 to mitigate a recession; again in 1998 in the wake of the Russian financial crisis and the collapse of Long-Term Capital Management; and finally from 2001 to 2003 to weaken the effects of another recession.

The Light-Handed State and the Heavy-Handed State: A Combustible Combo

In each of these instances, the Wall Street banks, enjoying the benefits of scaled-back regulation, enthusiastically took the money the Fed had pumped into the markets and used it to finance more speculative activity. New mortgages, guaranteed by state-sponsored institutions Fannie Mae and Freddie Mac, along with other forms of debt such as corporate loans, ballooned. And whenever an economic downturn seemed possible, the Fed would come to the rescue and flood the markets with still more cheap money. This enabled irresponsible borrowers to get their hands on easy credit to repay their debts. Once relieved of their old financial obligations, they used more of the cheap Fed-provided money to take on even more debt to finance still more speculation. Over time and through repeated interventions, the mountain of debt grew bigger and bigger.

The consequence of all these bailouts was not just to delay the final reckoning but to make it worse once it arrived, as it now has. And yet the Federal Reserve under Bernanke is attempting exactly the same response it took in previous crises. Only this time the level of debt that has built up through the years has become so massive that no amount of central bank intervention can do much about it.

The unfortunate state of affairs we now face was the result neither of government policies that proved too weak nor a state that was too interventionist – but rather of both. Our political, social, and economic reality is a complex organism. It is rarely reducible to simplistic explanations from either the right or the left. The current crisis is no exception.

In future installments I will examine the potential solutions to our troubles – both short-term, for solving the immediate crisis, and long-term, for preventing future ones. As we will see, the measures that would clean things up quickly and equitably are quite the opposite of what the government is doing.