The end of free market fundamentalism not of the mixed economy

Capitalism these days does not resemble the “free market” model conceptualised by critics on the left. Economies have substantial public sectors - in Australia, government absorbs one third of output. It is best to refer to “mixed economies” with dominant private sectors but large public sectors providing public goods, redistributing incomes, stabilising the economy and delivering a safety net protecting the vulnerable. Where the boundary should be drawn on public activity lies at the centre of political debate but “mixed economies” not laissez faire are the dominant global economic system.

As such, capitalism has performed well raising many societies from poverty to prosperity. For example, numbers earning less than $1US per day fell by one-half to one-third of their 1970 levels by 2000. Australia experienced continuous, strong growth for 17 years with improving living standards, low inflation and unemployment in 2007 at its lowest level in 34 years.

The success of capitalism is a source of recent problems. With prosperity those aspiring to accumulate wealth have developed optimistic biases borrowing incautiously to purchase assets in the expectation that values would steadily increase with prosperity. Those with longer memories have sounded warnings about “irrational exuberance” but have typically been ignored.

The current crisis has ended the exuberance and raised questions about the staying power of capitalism, the extent of increased government control and the likely regulatory reforms. Some question whether capitalism should be replaced by socialism with party bureaucrats directing investment and consumption. For sane people the question is what are the regulatory lessons? “Free market fundamentalism” (FMF) has a limited role in thinking about how financial markets should operate but capitalism as a whole has not failed.

Indeed, almost no economists subscribe to FMF. Most regard libertarianism as an extreme doctrine akin to the ideology of doctrinaire socialists with their insistence that markets can never work so governments must run everything. For most economists the “mixed economy” with social democracy imposed to “civilise capitalism” and with a preference for liberalising trade and a dislike of “nanny state” paternalism provides a core model.

Most economists I know learnt from a text like Paul Samuelson's Economics. This text - and the imitators which followed it - acknowledged the role of markets but emphasised they often do not work well. Market failures arise with certain public goods best provided by natural monopolies. Monopoly power itself should be regulated. Moreover, Samuelson as an interpreter of Keynes saw the imperative for active macroeconomic management. As Samuelson's students, most of us accept Keynes’ view that the economy cannot be relied on to clear markets implying a need for regulation.

In the 1970s and the 1980s some economists blamed high inflation and unemployment on Keynes. The argument was that governments, by “pump priming” would create inflation which would become built into expectations leading to the need for restrictive monetary policies which would drive unemployment. This largely correct analysis is not an argument for FMF but provides a case for moderate monetary expansion, for targeting inflation and for using monetary policy sparingly.

Since Samuelson wrote his textbook, economists have become more concerned with uncertainty in markets and consequent prospects for market failure. Often these are agency problems where market participants take advantage of private information to engineer good outcomes at society’s expense. Then contrary to Gekko's dictum, greed is not good. It does not drive the social advantage.

Concentrating on the US we can discern conflict-of-interest issues as factors in the current crisis:

1. There have been agency problems in US mortgage markets partly due to brokers who provided mortgages and received a commission based on loans sold not loans successfully repaid. These brokers had incentives to lend to non-credit worthy borrowers because this maximised their advantage but left society exposed to huge risks.

This outcome was fed in part by US attempts to increase home ownership through an attack on underwriting standards http://www.independent.org/pdf/policy_reports/2008-10-03-trainwreck.pdf. Academics applauded this decline in standards as innovatory financing increasing home ownership among poor groups. Resulting foreclosures reflected this misplaced social romanticism. In fact, foreclosures began in 2006 before the dramatic decline in US property prices when the US economy was strong. The surge in foreclosures in 2008 - in prime and subprime markets - increased pressure on property prices and worsened the crisis.

The crisis is not primarily of bankruptcy and bad debts. US mortgage and credit card losses could have been paid for by amounts already contributed to bailouts. The problem is fear that loans may be awarded to those with solvency problems - those seeking loans often have solvency concerns. Hence there has emerged a freeze on lending crippling the economy. This fear can be addressed by restoring confidence through public guarantees and through governments taking equity in institutions to improve market viability.

2. Rating agencies deriving fees for providing signals concerning credit worthiness of securities are subject to conflicts of interest because security issuers pay them to gain ratings. Moreover, advice often has quasi-official status with institutions (including Australian local government) only allowed to invest in instruments with AAA ranking. Relying on private firms to provide information when there are incentives to deceive is an inappropriate privatisation.

3. US lending institutions (Fannie Mae, Freddie Mac) who issued sub-prime mortgages believed loans were subject to an implicit government guarantee - moral hazard. Indeed, the Savings and Loan Crisis of the 1980s and 1990s resulted from a liberalisation to permit lending to broader classes of borrowers while deposits were guaranteed. Regulators should have learnt from this disaster. The S& L crisis cost US taxpayers $160 billion while the current crisis - involving the same moral hazard - will cost at least $1.25 trillion!

Providing “deposit guarantees” looks sensible but isn’t if it encourages managers to gamble on the understanding that governments will come to the rescue should things not work out - a “heads I win, tails I don't lose much” proposition. Populists like Kevin Rudd do not understand this when they guarantee deposits of a subset of Australian institutions ignoring broader ramifications.

4. There are problems with the complexity of products in global capital markets. Warren Buffett describes derivatives as instruments of “financial mass destruction” since while they can be used to reduce risk their value depends on the credit-worthiness of counterparties. Those issuing these securities - particularly when they are complex - have incentives to make fanciful assumptions about profitability to boost their financial standing. These problems call for regulation. Indeed, issuers of unregulated credit derivatives have been known to pose a threat to the monetary system since 1997 when Long-Term Capital Management failed.

The difficulty here was that no one acted. A few economists with libertarian views - Alan Greenspan obviously - were in positions of power and maintained that credit derivatives effectively reduced risk without considering circumstances where they might destabilise markets.

In these cases market failures result from particular people having information advantages. People took advantage of such information to advance their self-interest to the detriment of society. The problem is to address this regulatory failure.

Four events fostered the current situation:

1. high savings in China and among oil exporters which - despite local investment booms - could not be absorbed and which spilt into international markets driving down interest rates;
2. the overvaluation of the US dollar that facilitated high Chinese savings and the debt-financed consumption boom in the US and other countries;
3. inappropriate monetary policy in the US and elsewhere leading to the glut in funds that kept interest rates too low for too long; and
4. a boom that became a bubble in global asset markets as a consequence of low borrowing costs and exuberant expectations;

In addition, international developments changed the economic environment. Globalisation increased world trade but had a downside in fostering financial complexity and contagion of shocks. Moreover, financial institutions become large so shocks that occurred were large.

Also stresses now observed signal the end of US/European dominance in economic affairs and a shift toward countries such as China, India and elsewhere. That the US has had high consumption facilitated by excessive savings in countries like China suggests the former imperial empire is borrowing to sustain a non-viable role.

What are the implications of the current crisis for the future of capitalism? No country will adopt socialist administrations of the North Korean or Cuban type so those arguing for socialism must have in mind a model of socialist perfection to replace capitalism’s obvious defects. But this commits the fallacy that critics on the right make when they compare current imperfect systems with idealised laissez-faire - comparing the real with the hypothetical.

We do face the prospect of a more regulated financial system. There have been regulatory failures and the increased complexity of operating in a global environment with many significant players increases returns to more intrusive regulation. Is nationalisation of banking systems likely? Clearly the stakes governments have taken in banks indicate a drift toward greater regulation of lending and such things as executive compensation. It is difficult however to determine how long such interventions will last. For some there is the likelihood of divestment for budgetary as well as efficiency reasons.

Government controlled banks remove capitalistic excesses but impose their own problems. Politicians face short-term political constraints. If politicians rule over capital markets a new inefficiency will develop reflecting the core reason economists reject socialism. Looking at the current Australian scene, for example, disastrously inept and wasteful government investments in “green car” technologies and “Food Bowl” projects offer no encouragement that government run banks would outperform private banks.

There is a rethink of the role of government. US wages have stagnated over recent decades while incomes to top income earners have grown strongly. But the US is an outlier in its respect for FMF and regressive tax cuts. This bias may be removed by Barack Obama.

The move by the US government to provide $25 billion handouts to the US automobile industry represents a trend towards increased government involvement. These grants are conditional on objectives of “fuel efficient” cars but a poor move given long-term pressures that work against mass manufacturing in the US. It is just wrong to foster poor performers.

The intervention with respect to banks may be seen as a precedent for increased government involvement in health, education, transport along with restrictions on free trade and investment. Such restrictions would endanger living standards and keep millions in developing countries poor. It also denies residents in developed countries inexpensive products. We must learn from the current crisis and adapt regulatory settings not “shoot ourselves in the foot” with restrictions that reduce our freedom and build inefficiencies into the economy.

Society will change as a consequence of the crisis and incentives for “get-rich-quick” schemes through borrowing will be diminished. There may be a return to older values of “living within means”. There will also be less economic complacency - we may become more cautious. This increased caution has costs and benefits.

Finally, the discipline of economics will change as it did after the Great Depression. Specific changes might include a reassessment of credit derivative contracts. There will be a rethink of financial regulation especially international regulation. One reason for the current problems is the competitive pressure not to regulate domestic monetary sectors arises because of the chance to operate in less regulated international markets. The regulation of international financial markets will be heightened by the expanded role of China. These issues will play an increasingly role and the way they evolve will be linked to the damages the current crisis causes.