Wolf: Free Market Capitalism Just Passed Its Peak

Martin Wolf of the Financial Times sees the Bear Stearns bailout as the high water mark of free market capitalist ideology. Staunch advocates of a light regulation, both the Fed and Hank Paulson, moved aggressively forward with a government sponsored salvage operation. Wolf says greater regulation is inevitable: the public simply (and correctly) will not tolerate no-strings-attached subsidies to a once highly profitable industry that caused so much havoc.

In a related comment, the FT’s John Kay argues that the object of regulation should not be to prevent financial crises, which he sees as an unattainable goal. Instead, the objective should be to limit damage to the real economy. As Kay posits:

The notion that future banking crises can be averted by better regulation demonstrates unrealistic expectations of what regulation might achieve. Banking supervision asks public agencies to second-guess the decisions of executives who earn millions in bonuses and business strategies that yield billions in profit. If Hank Paulson, US Treasury secretary, were doing the job of day-to-day regulation personally, he might – just about – have the respect and competence to get away with it. But the work is done by relatively junior administrators who lack the authority to intimidate the bankers and who have little confidence that their controversial decisions will win political support…..

Since financial stability is unattainable, the more important objective is to insulate the real economy from the consequences of financial instability. Government should protect small depositors and ensure that the payment system for households and businesses continues to function. There should be the same powers to take control of essential services in the event of corporate failure that exist for other public utilities. The deposit protection scheme should also have preferential creditor status to restrict the use of retail deposits as collateral for speculative activities.

From Wolf:

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Joseph Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

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Mine is not a judgment on whether the Fed was right to rescue Bear Stearns from bankruptcy. I do not know whether the risks justified the decisions not only to act as lender of last resort to an investment bank but to take credit risk on the Fed’s books. But the officials involved are serious people. They must have had reasons for their decisions. They can surely point to the dangers of the times – a crisis that Alan Greenspan, former chairman of the Federal Reserve, calls “the most wrenching since the end of the second world war” – and the role of Bear Stearns in these fragile markets.

Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

The implications of this decision are evident: there will have to be far greater regulation of such institutions. The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices (see chart below). This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions. Greater regulation must be on the way.

The lobbies of Wall Street will, it is true, resist onerous regulation of capital requirements or liquidity, after this crisis is over. They may succeed. But, intellectually, their position is now untenable. Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted. This is not just a matter of simple justice (although it is that, too). It is also a matter of efficiency. An unregulated, but subsidised, casino will not allocate resources well. Moreover, that subsidisation does not now apply only to shareholders, but to all creditors. Its effect is to make the costs of funds unreasonably cheap. These grossly misaligned incentives must be tackled.

I greatly regret the fact that the Fed thought it necessary to take this step. Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion. A vast amount of risky, if not downright fraudulent, lending, promoted by equally risky finance, has made securitised markets highly risky. This has damaged institutions, notably Bear Stearns, that operated intensively in these markets.

Yet the extension of the Fed’s safety net to investment banks is not the only reason this crisis must mark a turning-point in attitudes to financial liberalisation. So, too, is the mess in the US (and perhaps quite soon several other developed countries’) housing markets. Ben Bernanke, Fed chairman, famously understated, described much of the subprime mortgage lending of recent years as “neither responsible nor prudent” in a speech whose details make one’s hair stand on end.* This is Fed-speak for “criminal and crazy”. Again, this must not happen again, particularly since the losses imposed on the financial system by such lending could yet prove enormous. The collapse in house prices, rising defaults and foreclosures will affect millions of voters. Politicians will not ignore their plight, even if the result is a costly bail-out of the imprudent. But the aftermath will surely be much more regulation than today’s.

If the US itself has passed the high water mark of financial deregulation, this will have wide global implications. Until recently, it was possible to tell the Chinese, the Indians or those who suffered significant financial crises in the past two decades that there existed a financial system both free and robust. That is the case no longer. It will be hard, indeed, to persuade such countries that the market failures revealed in the US and other high-income countries are not a dire warning. If the US, with its vast experience and resources, was unable to avoid these traps, why, they will ask, should we expect to do better?

These longer-term implications for attitudes to deregulated financial markets are far from the only reason the present turmoil is so significant. We still have to get through the immediate crisis. A collapse in financial profits (so significant in the US economy), a house-price crash and a big rise in commodity prices are a combination likely to generate a long and deep recession. To tackle this danger the Fed has already slashed short-term rates to 2.25 per cent. Meanwhile, the Fed also clearly risks a global flight from dollar- denominated liabilities and a resurgence in inflation. It is hard to see a reason for yields on long-term Treasuries being so low, other than a desire to hold the liabilities of the US Treasury, safest issuer of dollar- denominated securities.

“Some say the world will end in fire, Some say in ice.” Harvard’s Kenneth Rogoff recently quoted Robert Frost’s words in describing the dangers of financial ruin (fire) and inflation (ice) confronting us.** These are perilous times. They are also historic times. The US is showing the limits of deregulation. Managing this unavoidable shift, without throwing away what has been gained in the past three decades, is a huge challenge. So is getting through the deleveraging ahead in anything like one piece. But we must start in the right place, by recognising that even the recent past is a foreign country.

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  1. John Harris

    The Fed is not “the chief protagonist of free-market capitalism,” but a government-created and -maintained, monopoly provider of fiat (diktat) currency. If anything it is the chief antagonist of free-market capitalism.

  2. a

    “the more important objective is to insulate the real economy from the consequences of financial instability.”

    Not going to happen. There is a natural credit cycle: banks lend too much, then they lend too little. This has to impact the real economy.

  3. a

    By the way I think the height of free market capitalism will be marked by the collapse in Seattle of the free trade talks. It’s been downhill ever since. Some just have noticed.

  4. Anonymous

    There are no free markets in the US and why this line of crap is even motioned is laughable. The US markets are rigged, capital flight will ensue as this become more and more apparent.

  5. Anonymous

    No such thing as free markets in the US for a while. If there were we would not be in this mess. Free markets that are not rigged ensure that capital is allocated where it produces the highest returns otherwise the players go broke. The government by their continuous meddling (industry protection schemes, targeted tax benefits, interest rate controls etc etc) ensure that capital is not allocated properly and that is why we are here. Trying to control manually the economy is futile (too many players with diverging goals) that eventually entropy asserts itself and collapses occur. Free markets ensures that there are not excesses by forcing failures before they get out of hand.

  6. Anonymous

    Who is Martin Wolf of the Financial Times?

    Does anyone care about the opinion from a writer?

    Marty Wolf cannot be too bright if he mistakens what we have — Crony Capitalism of Soft Fascism — for free markets.

    Look about you Marty Wolf. Most markets are oligopolies, protected by barriers to entry — government regulatory agencies, start-up costs in the millions, preferential treatment for commerical paper selling.

    Perhaps Marty Wolf sneaks off to the men’s room for a bit of wankering to his the Return of Keynsianism fantasy.

    Marty Wolf acts either like a Statist Shill or like an idiot.

    Which one are you Martin Wolf?

  7. S

    Investment banks have heretofore been able to maintain robust ROEs defying competitive advantange windows and return reversion. Case closed. “innovation” at the expense of the real economy is not creative destruction.

  8. Max

    Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene.

    The cynic in me says that what he really meant is that by securitisation the government no longer could intervene in the financial wheeling and dealing. These paper shufflers desperately want to sound like they really cared for the common good, and didn’t want to “burden” the government with too much regulation work.

    BTW, the fairy tale of a free market is just that – completely unsupported by empirical evidence. Never in the history of the world have markets been free in the sense of the naive Austrian ideology. I’m surprised how still entrenched is this fairy tale in the minds of so many. I blame the decline of the education system.

  9. Anonymous

    The bottom line in all this is that “prospects for the future” means that both the Repulicans and the Dems are happy to accept BIG BUCKS from any and all — to be paid back big time later…

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