The latest column by Gillian Tett provides further support for our pet thesis: that the role of the state in banking is so great and the subsidies so wideranging that they cannot properly be considered private companies and should be regulated as utilities.
By the time you read this column today, a fascinating shift will almost certainly have occurred in the nature of US finance: for the first time the government will be the biggest source of outstanding home mortgage and consumer credit loans in the US, eclipsing private sector banks or investors…
What should investors make of this? There are at least three lessons to ponder. First, the data provide a powerful sign of just how distorted the US financial system remains in the aftermath of the great credit crunch…
The second fascinating point, though, is the cognitive dissonance surrounding this pattern. Six years ago, when I first started writing about the credit markets, I often heard US financiers praise America’s capital markets as the most developed system of free market finance in the world. Indeed, techniques such as securitisation were presented as a natural outcome of American enthusiasm for free market ideals.
But the dirty secret behind this rhetoric was that government-backed institutions such as Fannie and Freddie were playing an important role in the modern financial system, even before the credit crisis erupted. And what is remarkable now, given that the role of Fannie and Freddie has swelled, is just how little debate this patter continues to generate.
I agree that there is cognitive dissonance aplenty. As we discussed in ECONNED at considerably length, the concept of “free markets” is inconsistent and internally incoherent.
But Tett doesn’t have it right either. As Amar Bhide pointed out in a 1994 Harvard Business Review article, when US capital markets really were held in high esteem around the world, it was because they were the cleanest: they were the best policed and had the most extensive disclosure requirements. That was the result of effective and heavy regulation of securities markets that dated from the 1933 and 1934 securities laws (former Australian Treasury official and hedge fund manage John Hempton has declared the Securities Exchange Act of 1934 to be one of the best pieces of legislation ever written).
What bizarrely appears to have happened is that the belief that markets were effective devices got a considerable boost from the performance of US securities markets. In fact, the “free markets” ideology may be an attempt to claim the success of these heavily regulated markets and would have occurred in a state of nature. Our Andrew D observes:
Consider provisions like bans of insider trading, mandatory disclosure of business financial information, separation of the financial sector from the business sector. All of them seem geared to set up a model in which:
• Businesses are not allowed to freely provide or not provide propaganda about their current status
• Instead they are forced to provide “objective information” about their well-being
• And securities market participants are put in the role of evaluating this (presumably accurate) “information” and of deciding how to reward or penalize the company in its access to capital markets.
This vision for securities markets is far from a radical one. In fact, it resembles nothing so much as a neoclassical point of view – and SPECIFICALLY, it is the vision of financial economics, EMH, CAPM, etc.
So maybe the New Deal planners were trying to instantiate the vision of classical economics, applying it to the field of securities instead of just goods. But there is a little chronological problem here…
Which is that financial economics, as a discipline, almost entirely postdates World War II. That means that it is quite possible that, far from the New Deal regulators trying to implement financial economics, certain economists of the 50s and 60s took the heavily regulated securities markets of their time, pretended as if they were unregulated and had arisen naturally, and proceeded to produce a theory (financial economics) that described this “spontaneous”
system as the most perfect way conceivable to allocate capital to different pursuits.
If this is correct, then little of modern financial economics would exist without the interference of the Roosevelt administration.
I’m not as keen re Tett’s third point, she starts on the usual concerns about US debt levels. The problem is that these worries focus unduly on the numerator and neglect what is happening with the denominator. That’s why Europe is madly deflating its economies, acting as if they can stave their way to growth, when the resulting contraction leads debt to GDP to worsen rather than improve. A sovereign currency issuer like the US will never be unable to service its debts, ex mad Congressmen who refuse to send the checks to people we owe the money (that is, we have political rather than real economic constraints). The risk is generating too much inflation.
It is also important to note (but we’ll get to that in a separate post) that financial flows (those are often not properly accounted for; that’s how we could have a huge shadow banking system develop and have regulators remain blissfully unaware of its existence until its collapse nearly destroyed the global economy. So as much as Tett’s narrow conclusion is correct (the fact that the government has pretty much take over mortgage finance is not news; it’s disproportionate role in consumer credit is an interesting factoid), the shadow banking system still remains large and largely unrestrained. So even though the authorities are involved in the financial markets in a profound way, the perception of largely unregulated markets exists because there still is a lot of terrain where the cowboys are free to roam.