The end of free market fundamentalism not of the mixed economy

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.