The death of the free market?

The travails of the financial markets have triggered a degree of jubilation among the usual left-leaning suspects, as though this episode reflects badly on “neoliberalism”, deregulation and the free market order. This view is not sustainable because the problems can be traced to a witches brew of causes including over-complicated (and hence ineffective) regulations, moral hazard (knowing the Government will eventually come to the party with a bailout), other regulations that mandate loans to bad risks and old fashioned irresponsible borrowing (yes, and irresponsible lending).

This is same kind of anti-free market spin that was put on the Great Depression, as though the great trading nations of the world through the late 1920s and early 1930s were practicing laissez faire capitalism with unfettered free markets etc etc. Then as now the debacle can be attributed to the failures of intervention, not to the failure of free markets and the other elements of classical liberalism.

Arthur Koestler has left a vivid impression of the economic illiteracy that stampeded so many people into the communist movement during the 1930s when they saw food being destroyed under the New Deal in the US. They thought that was the free market at work!

The event that aroused my indignation to a fever pitch never reached before was the American policy of destroying food stocks to keep agricultural prices up during the depression years at a time when millions of unemployed lived in misery and near starvation. In retrospect, the economic policy which led to these measures is a matter of academic controversy; but in 1931 and 32, its effect on Europeans was that of a crude and indeed terrifying shock which destroyed what little faith they still had in the existing social order. By 1932 there were seven million unemployed in Germany which means that one in every three wage-earners lived on the dole. In Austria, Hungary and the surrounding countries the situation was similar or worse. Meat, coffee, fruit had become unobtainable luxuries for large sections of the population, even the bread on the table was measured out in thin slices; yet the newspapers spoke laconically of millions of tons of coffee being dumped into the sea, of wheat being burned, pigs being cremated, oranges doused with kerosene to ease conditions on the market. It was a grotesque and incomprehensible paradox incomprehensible to the simple-minded among its victims, and to the socially conscious a sign of the complete breakdown and decomposition of the economic system. Had not Marx foretold that Capitalism would perish through its own internal contradictions; that the cycle of prosperous periods ending in a crisis would repeat itself in an accelerated rhythm and each crisis be worse until the last would certainly bring the capitalist system to its end? Clearly, the prophecy was on the point of being fulfilled. When people starve and food is destroyed before their eyes so that their fat exploiters may grow even fatter, then the last judgment must be at hand.

Woe to the shepherds who feed themselves but feed not their flocks! Indignation glowed inside me like a furnace. At times I thought that I was choking in its fumes; at other times I felt like hitting out, and shooting from a barricade or throwing sticks of dynamite. At whom?My seething indignation had no personal target; it was directed at the
System in general, at the oily hypocrisy and suicidal stupidity that were driving us all to perdition. In my rage fantasies no people were killed but huge buildings burst open and their walls came tumbling down, as in an earthquakeEchoes of the hundred days of the Hungarian Commune; echoes of the indignant wrath of the Hebrew prophets, and of the forthcoming Apocalypse according to St. Marx; the memory of my fathers bankruptcy,, the sound of the hunger-marchers broken-down boots on the pavement and the smell of fresh wheat being burned in the fields all these ingredients fused into one emotional experience. My political latency period had come to an end.

Though the mixture that set off the explosion varied from case to case, the reaction was the same for a large number of writers and intellectuals the world over: Barbusse, Romain Holland, Gide, Malraux in France; Piscator, Becher, Seghers, Brecht in Germany; Auden, Isherwood, Spender, Day Lewis in England, Sinclair, Dos Passos, Steinbeck, Caldwell in the USA to mention only a few. In the nineteen-thirties conversion to the Communist faith was not a fashion or craze it was a sincere and spontaneous expression of an optimism born of despair an abortive revolution of the spirit, a misfired Renaissance, a false dawn of history.

To be attracted to the new faith was, I still believe, an honourable error. We were wrong for the right reasons; and I still feel that, with a few exceptions I have already mentioned Bertrand Russell and H G Wells those who derided the Russian Revolution from the beginning, did so mostly for reasons that were less honourable than our error.

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30 Responses to The death of the free market?

  1. JC says:

    I’m staggered that some commenters suggest the US needs more regulation, Rafe. I’m absolutely staggered. There’s 70,000 pages of friggen regulation covering financial institutions over there. You can’t take a leak without being covered by regulation.

    Ironically the two I-banks that were in trouble last week- Morgan Stanley and Goldmans- as well as the I-banks that failed were creatures of depression era regulation that separated i-banks from commercial banking.

    here’s a sampling of the regulatory environment in the US:

    1. State banking examiners
    2. Federal Reserve examiners
    3. Futures bodies examiners
    4 External auditors
    5. Internal auditors
    6. Whistle blowing phone numbers.
    7. compliance office.

    IPO issuance fell in the US after Enron as new (knee jerk) regulation such as the Sabarnes Oxley act moved a great deal of the IPO business to London to escape the cumbersome US regulatory environment.

  2. Rex says:

    This view is not sustainable because the problems can be traced to a witches brew of causes including over-complicated (and hence ineffective) regulations, moral hazard (knowing the Government will eventually come to the party with a bailout), other regulations that mandate loans to bad risks and old fashioned irresponsible borrowing (yes, and irresponsible lending).

    /

    I assume you’ll be providing your evidence in due course rather than just leaving it as an assertion.

  3. Chris Lloyd says:

    Your list of causes is very selective: over-complicated regulations, moral hazard, other regulations and old fashioned irresponsible borrowing. So if the government just had less regulations this disaster wouldnt have happened?.WRONG.

    You dont mention the ratings agencies and the lack of accountability of senior managers. Senior managers have little incentive to avoid risk as they get huge bonuses in bull markets and do not pay the full downside of their bad risk management in the bear market. The ratings agencies completely failed. So we ask: if the managers had really cared about the long term risks to their companies and if the ratings agencies had done due diligence on all the AAA securities they were supporting, this disaster wouldnt have happened?….RIGHT.

    In the past week, the government has nationalized AIG and banned short selling (even covered short selling here). It is hard to think why lefties would not take comfort from this turn of events. Let them have their 15 minutes of I told you so.. They dont have the answer either.

  4. JC says:

    Chris:

    There isn’t a large i-bank or commercial bank that pays cash bonuses. The largest compensation component is restricted stock (options and fully paid) where most goes out to 5 years.

    Triple A status was given to securities primarily because of modeling that was wrongly premised (as we later found out).

  5. JC says:

    and old fashioned irresponsible borrowing (yes, and irresponsible lending).

    I assume youll be providing your evidence in due course rather than just leaving it as an assertion.

    Yes. Check out the HUD demands that later turned into FED demands in 98 (approx) accusing the banks of racist lending practices because they weren’t lending in poorer neighborhoods. The authority (the Fed) that is vested with protecting the banking system cried mea culpa and directed banks to lend in poor areas thereby creating a lax lending environment. That’s something that no Australian government no matter which stripe would dare suggest.

  6. Armagny says:

    “as though the great trading nations of the world through the late 1920s and early 1930s were practicing laissez faire capitalism with unfettered free markets etc etc”

    To about the same extent that the Soviet Union was practising communism, I guess.

    When the banks offered us 6 times our income in our loan approval process (we self-capped at about 3.5 times, which we calculated would barely leave enough for Bear’s nappies and a loaf of ALDI bread) were they really acting under legislative imperative?

    Granted, I’m not going to crow and say this all shows the failures of the free market system. In fact, by that system’s own terms of reference, this should have happened ages ago.

    But it would be nice if those whose allegedly predictive profession failed so absolutely in that aspect at least stopped using offensive terminology like “illiteracy” to describe those who simply don’t follow their school like an irrefutable set of perfect formulae.

  7. Richard Green says:

    Thinking about whether this was caused by the Free Market, or whether this was the Free Market or not puts us on a bad footing to start with, since we start arguing about the failure of manifestly non-market institutions (banks and corporations) on the basis of market institutions.

    Afterall, a bank or institution operates in a market, but they are not conscious agents, but messes of individual agents in a corporate structure. An individual in a market responds to price signals and other information with regard to their own interests that directly result from their interests, but a corporation does not. A corporation makes decisions based on the incentives of heirachy and incentives divorced from the outcome of a particular decision.

    In the case of sub prime mortgages, I could, as an individual, make a decision to make a personal loan based on my information on the borrower and the interest they are willing to pay, and if they default, I bare the brunt. Aggregated, this is a market which works (or not, if you are so inclined).

    But a loan officer does not. They make decisions based on what bosses call for in targets for instance, almost like a central planning quota. Their bosses want to look good to their bosses to get a promotion, and the CEO wants to get good press by doing dynamic actions to get a higher play cheque. Stock options were intended to prevent this, but with tenures being so short, no-one making decisions bears ramifications for the companies actions beyond a year, except shareholders.

    But shareholders are increasingly institutional, like super funds, insurance funds etc. They make decisions based on their own non market internal structures.

    We see a failure of bodies that make decisions based on non-market (and non-government) incentives, and we’re arguing about whether the market was too free or not free enough? We’re going completely sideways to the issue!

    Corporations (as they exist) may be an integral part of our capitalism, but capitalisms are far more than just the market.

    So the question should be, is this the death of the corporation as we know it. Does it need to change, or does government intervention into this particular form of economic entity need to change?

    I will say with definate certainty that this is a death of capitalism as we know it. But capitalism as we knew it has died 4-5 times a year since the 17th century because it is not really ideology (and rarely looks like what it’s apparent defenders are defending even in its success) but the organic mess we are pointing at when we say the word.

  8. Sinclair Davidson says:

    The role of the US government in creating the current crisis conditions is documented here (by Stan Liebowitz) and here (by John B. Taylor).

  9. Rafe,

    I must say this is one of the silliest and emptiest posts I’ve seen on the subject – though I concede that I could find sillier ones if I looked for them – indeed I think there’s a fair chance you’ve consulted some of them in your research.

    It is not particularly enlightening for left boosters to cry ‘socialism’, but at least it’s true at some simple level.

    Meanwhile, if you want to help out thinking about the situation may I suggeset that you begin by foregrounding the problem. Liquidity is a public good, and it’s collapsed.

    That’s what this is about, the preservation of one of the public goods, and as you know well there are many – that make markets that are half way efficient possible.

  10. Rafe Champion says:

    Nicholas, can you explain what value is added to the discussion by calling liquidity a public good?

    At what level is it true for left boosters to cry “socialism”?

    Of course the level of hysteria is higher in the US than here but the predictable left boosters are calling the death of markets in favour of more regulation (despite a plethora of regulation). The foreground of the problem is surly to have less bulk of regulation and more effective institutional constraints, also more appropriate incentives. The gist of my “silly and empty” post was to flag some causal factors that need to be addressed but will be overlooked by the boosters of socialism.

    Anyway, as a consultant on deregulation you need to recall your image of the deregulator as a sculler, looking in one direction but travelling in the other. Which way are you travelling on this issue?

  11. Rafe,

    Regarding your first question, ask around.

    I could say the same regarding the second question, but I can’t resist. The level at which it is true for left boosters to cry socialism is that the market has screwed up and now the state is buying them out. It looks like a duck, quacks like a duck etc. Rafe – the market is being socialised – really it is.

    Regarding your last question, in areas in which regulation is inevitable – which is the case here – I’ve always regarded slanging matches between those who want ‘more’ and those who want ‘less’ regulation as the wrong thing to be arguing about. Regulation is a difficult business, and where it is inevitable, regulation is about trying to construct the most felicitous hybrid between public and private purposes one can.

    Passionate intensity on the wrong question while the place falls apart is not my idea of a good time.

  12. Rafe Champion says:

    “Regarding your first question, ask around.”

    That does not answer my question.

    “The level at which it is true for left boosters to cry socialism is that the market has screwed up and now the state is buying them out. It looks like a duck, quacks like a duck etc. Rafe – the market is being socialised – really it is.”

    And very rapidly as well. Is that a good thing, or is it just saving people from their own mistakes by making other people pay the price?

    “Regulation is a difficult business, and where it is inevitable, regulation is about trying to construct the most felicitous hybrid between public and private purposes one can.”

    I like that. And I really want to think that the next bundles of regulation will be more felicitous than the hundreds of pages per annum that have been promulgated in the past. Will there be a new breed of regulators, or have the existing ones learned something since last year? Did they learn anything from the Savings and Loans disaster and bailout?

    “Passionate intensity on the wrong question while the place falls apart is not my idea of a good time.”

    People like you who have the qualifications to understand these kind of things and operate daily in the financial marketplace should have seen this situation coming years ago. What did you do to warn people so that preventive steps were taken sooner instead of having the overnight fix that is happening at present?

  13. Rafe I can only repeat. This stuff is really difficult. I’m thinking that you seem to have some idea that financial regulation can be made easy – perhaps just a few pages. Perhaps none at all. I think that’s completely fanciful for a lot of reasons.

    As for what I’ve done to warn people. Well I have proposed means of making things better. But you may regard it as dangerous socialism.

    A couple of threads ago, Sinclair Davidson proposed the same thing as me – paying interest on ATO accounts. But when I pointed this out to him he thought I was having a lend of him. My proposal wasn’t kosher because I was proposing to use government infrastructure in such a way that the uncompetitiveness of private provision would have been exposed. Now you’re not responsible for Sinclair, but forgive me for thinking that I might be arguing against people who make up their mind on something other than the merits of the case carefully considered.

  14. Tom N. says:

    ANOTHER BORING STOUSH BETWEEN STRAW ECONOMIC MEN

    Reading the soft-left media and blogs over recent weeks, together with retorts along the lines of Rafe’s post*, has reminded me of the barrenness of the “free-market vs government” debate. It seems that, for a number of people in the former group, the US meltdown is conclusive evidence of the failure of free markets, and all those economists who believe in markets free from government intervention – an empty set, but never mind – need to learn the lesson and repent. This line of argument has reminded me of Michael Pussey’s misrepresentations of “nasty narrow-indeed New Right neoclassical economic rationalists” a decade or so back. KRudd’s recent revelation that there is a role for government intervention, not just market forces, is another example of the false characterisation of the practice of economics.

    In reality, day-to-day economic policy advising is – as it has long been – about optimum levels and the design of regulation; not whether or not there should be any. Similarly, no economist I know thinks that the appropriate place of the free market is anywhere other that in the textbook, as a useful device for thinking about some matters, but not as something that should, or could, exist in practice in a modern society.

    Of course, discussion of the nuts and bolts of good regulation and policy is unlikely to keep the interest of many readers, so one can understand the attractiveness of “government vs market” type grand narratives. I just wish commentators would label this stuff “fiction”. Perhaps its another case for appropriate regulation.

    TN

    * To be fair, Rafe did admit to there being a “witches brew” of causes for the meltdown. The problem is that he was only able to think of the regulatory ones; not the ones eminating from the unfettered behaviour of private actors in the market.

  15. TerjeP (say tay-a) says:

    American policy of destroying food stocks to keep agricultural prices up

    I think the current crisis does ultimately stem from a quite similar price fixing problem. My take on this issue here:-

    http://alsblog.wordpress.com/2008/09/22/price-fixing-and-credit/

  16. Temujin says:

    That’s not true Tom. You know me… I’m an economist… and I believe that free markets should jump out of the textbooks and give everybody a good slapping.

  17. Temujin says:

    And Tom, Rafe clearly mentions irresponsible borrowing and lending. Those are human failings not specific to the government.

    This is a mix of government failure and business failure. But I can’t see the market failure.

    In a properly functioning market, some businesses fail. Market success does not mean “every business suceeds”. It means that competition through the marketplace leads to the quickest distribution of knowledge through the economy so that relatively better decisions can be made by the (inevitably imperfect) economic players.

    Tom is of course right that perfect-competition theory is just a textbook case, not taken seriously even by people who believe in free-markets. But that’s only half the story. Many free-market advocates understand the Institutionalist critique of neo-classical economics and accept that you must consider the dynamic benefits and costs of human behaviour. But unlike the Veblen/Galbraith set, free-market dynamic economists (ie Austrians) appreciate that the introduction of time and uncertainty actually strengthen the case for markets.

    Tom is an excellent neo-classical economist. Somebody hand him a book on Hayek. :)

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  19. Sinclair Davidson says:

    Rafe, liquidity has the technical properties of a public good. But that does not mean that liquidity should be provided by the public – generally it is not, nor should it be. I think it’s best to think of the current crisis having two problems. (1) An inefficient business model is being cleared out of the market – that is how capitalism is supposed to operate. (2) Liquidity has dried up. The problem at present is that (1) and (2) are inter-related. They aren’t always inter-related, but in the current crisis they are, that’s what makes it a crisis. Government providing liquidity to the financial system under the current circumstances is how our financial system is designed to operate. To call this a crisis of capitalism is just silly. Government providing bailouts to failed business models is a problem. Part of the problem is differentiating between economic failure and financial failure. Those firms that experience economic failure should be allowed to die; while those in financial failure should be saved. The difficulty is telling the difference between the two types of failure. It is also the case that time is at a premium when dealing with failure in the banking system so it took a long time to work out that Ansett was an economic failure and the overall economic costs werent that great in the process while the economic costs of taking a long time in the financial markets would be catastrophic.

    As a general point, I think people have a caricature of capitalism in mind when they think about these things. Critics are comparing the real world with an anarcho-capitalist model. Coase has warned against this type of analysis.
    +++
    Nick, while we’re in violent agreement about the ATO paying interest on cash balances, I’m not sure that we agree on government providing bank services. The main function of banks is financial intermediation (and deposit taking is a part of that) but I don’t think the ATO should be making explicit loans or have a balance sheet resembling that of a bank. The ATO, of course, makes explicit loans to those who end having to pay in at the end of the year – that is a function of the mechanics of tax collection, not an explicit business model. (As a complete aside, banking with the Tax Office is a good idea to propose in developing countries with poor banking systems – it will also help in the development of property rights and formalising the economy; if implemented properly.)

  20. Sinclair,

    If you follow the link I provided, you’ll find that I didn’t propose the government lend to citizens. We both think that the ATO should pay interest on balances and I think that that makes the perfect platform for a payments system. – a cheaper and more secure system than the current payments system.

    If you don’t agree with that, I presume you don’t like the idea of the government doing things to improve its efficiency if it might out-compete the private sector. Or perhaps I’m wrong and you do agree.

  21. Sinclair Davidson says:

    I have no problem with the government improving efficiency and out-performing the private sector – I’m just not convinced it happens all that often. There was a lot in your Fin piece that I disagreed with, but on just the payments side of things I have no problem (assuming the ATO could do it better than the banks – based on their online tax forms and lodgement though I’m not sure they would be.)

  22. Tom N. says:

    Woops – my apologies to Rafe for the misrepresentation.
    Regarding Tem, I had thought of including something along the lines of “apart from the odd extremist from the Libertarian party”, but thought I would economise on the word length. Obviously, taking this post into account too, that didn’t work! That said, while I know Tem might advocate free markets in many contexts, I don’t think he does so reflexively or comprehensively: as I recall, even he recognises instances where government intervention is warranted.

  23. ludwig von hayek says:

    dear Nick

    well, you guys let Rafe onto the site. You should have known he’s a foolish old obsessive, too whacked out even for catallaxy. in letting him in you’ve cut the quality of troppo – which was valuable for the measured and thoughtful quality of its posts – by about half. Show him the door, Troppists! You wouldnt be the first.

  24. Sinclair,

    The Fin piece was pretty much a description of what we’ve talked about – which you agreed with. That’s nice. But it seems you want to be able to say how much you disagreed with. Like what?

  25. Sinclair Davidson says:

    The piece had a whole bunch of comments about banks and stuff up front. This lead me to think that you were talking about the government taking over heaps of banking functions. The notion that government could borrow for even less is wrong; the ‘cheapness’ of government debt and finance is problematic. There are still big differences between our views, even if we both accept that the ATO pay interest on cash-balances.

    Anyway, I’m off to Tasmania for ten days, if the thread is still going when I get back we can continue this.

  26. Ludwig,

    I for one am happy to have Rafe contributing here. He is a scholar and a gentleman, though my irritations with this piece are clear enough. If you want to sling mud, perhaps you could at the very least identify yourself.

  27. Melaleuca says:

    At least least Rafe provides us with some comic relief, albeit unintentional.

  28. JC says:

    Rafe:

    I find it interesting how there are so many people calling the end of neo-liberalism (whatever that is supposed to mean), or American style capitalism is dead aren’t recalling the very serious financial crisis we went through in the early 90s. I wasn’t here then but didn’t every state bank fail with possibly one exception? Didn’t quite a few of the savings co-ops go belly up while Westpac was on the brink under RBA close supervision requiring a recap?

    Wasn’t there a shotgun marriage dictated by the Federal government between the State bank of Vic and the CBA in order to keep it going?

    Didn’t the largest firm by sales- Elders – basically fail? Didn’t a number of shadow banks fail as well? Didn’t all “the colorful racing identities” such as Bond, Elliot and Co. go to the wall.

    In other words our plight at the time seems every bit as serious as the one the US is going though now.

    And what exactly happened after?

    We dusted ourselves off and experienced 15 odd years of unbelievable economic expansion that is still continuing.

    And yea we had around 90 billion of federal government debt by mid decade, our current account was still in deficit, some of the states were on life support and out future looked bleak.

  29. Temujin says:

    Tom — I accept the possibility of the government doing something correct some day. :)

    If liquidity is drying up, then the government needs to print more money to keep “broad money” roughly constant. Otherwise, let the banks fail.

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