On Markets and the Recent Economic Crisis

What follows is an essay that I wrote back in March of 2010.

Many claim that the current economic debacle is a prime example of why market forces cannot be left to themselves and why the government must play a greater role in economic activity. However, an exploration of some of the major factors that contributed to the current crisis could easily lead one to conclude the opposite, which is that the government was a major culprit in amplifying this catastrophe. This argument is reinforced by examining three major contributors to the financial crisis. The first contributor to the current crisis is over participation of the federal government in the mortgage market. Second, is undue faith on the part of market participants in the assessments made by rating agencies and third, is government induced moral hazard. Consideration of these factors provides useful guidance as to the appropriate steps the government should take so as not to aggravate the economy. Economic downturns are endemic to the capitalist system, but certain actions taken by the government can make economic calamities worse.

There is some merit to the argument that the government should facilitate the purchase of homes by families that would have otherwise been unable to do so, in order to foster support for property rights. In that, a country with a large proportion of property owners is likely to have an equally large proportion of individuals that have a respect and appreciation for property rights, which lies at the foundation of a successful capitalist economy. Yet, the federal government over stepped its bounds in terms of an appropriate level of participation in the real estate market via Fannie Mae and Freddie Mac. The federal government’s originally implicit but ultimately explicit guarantees exerted a substantial upward pressure on real estate prices. While studies have shown that capital inflows from foreign countries such as China played a major part in the housing bubble; the attractiveness of investing in the mortgage market was sweetened by government participation. The government compelled government sponsored enterprises (GSEs) to provide a strong secondary mortgage market, but these markets behaved as if they were on steroids, in that they grew very large, very quickly.

Market participants failed to consider the limitations of assessments provided by rating agencies. There exist major problems with the industry in which rating agencies operate. This has fostered a substantial amount of distrust among banks, which fanned the flames of illiquidity. The first problem is that the Securities and Exchange Commission and other entities that are tasked with bank oversight have made ratings a formal part of the financial system. This government endorsement makes rating agencies such as Standard & Poor’s, Moody’s and Fitch into oligopolists, ultimately allowing them to earn the profits that come along with that position. The second problem with these rating agencies is that they hold that they are private entities that are merely giving their opinion of the credit risk associated with certain financial assets, and their right to provide their opinion is constitutionally guaranteed by laws regarding free speech. Therefore, they argue that they should not be prosecuted for any impropriety in the way that they rate certain assets. The third and main problem with these rating agencies is that they are hired to rate the very securities and collateralized debt obligations which the companies that hired them are issuing. This constitutes a considerable conflict of interest, in that they have a strong incentive to give an asset a high rating so that they can continue to do business with the company that hired them. These rating agencies even help issuing institutions design the packages so that they receive the coveted AAA rating; this situation clouds the objectivity of rating agencies.

The fed assisted bail out of LTCM set an unhealthy precedent which led a number of major financial institutions to conclude that they were insulated from the potential adverse consequences associated with the kinds of risky positions in which they were engaged. Too much emphasis has been put on the danger of complicated financial assets and derivatives, when the basic problem is simple; it is dangerous for an institution to be highly leveraged, particularly in the event that liquidity dries up. These institutions reaped the benefits of their positions, as they should, but they should also be forced to bear the painful costs. Government induced moral hazard dulls the blade of market discipline that would otherwise temper widespread risk taking.

There seems to be a widely held belief that economic crises are preventable. This is not the first economic crisis, nor is it likely to be the last. During economic booms market participants convince themselves that they are living in a new era, where old rules no longer apply. This was the case during the dot com bubble as well as the over speculation in the railroad industry in the 1800’s. However, these busts serve an important purpose; they provide an opportunity for an economy to purge itself from institutions, ideas and practices which are no longer functioning. Government over participation in markets impedes this cleansing process. The government should limit its participation to combating the prevalence of externalities.

There is no magic bullet that will alleviate the current crisis, but the government strategy going forward should be to avoid regulation that will strangle private enterprise and the entrepreneurial spirit. The government needs to begin to unwind its positions and send the message to companies that they are free to take risks for their own benefit, but at their own expense. The government must allow market discipline to be restored by limiting its participation in markets. The government must also refrain from endorsing any rating agency. Finally, the government should be prepared to let large companies fail. More regulation is not the answer. It often serves to distort markets rather than help. For the most part, even fervent free-market advocates will concede that free markets have some limitations. But, one would be hard pressed to demonstrate that the government will do a better job at ordering economic activity than a free market.

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