The technocratic view is that the dysfunction that was set off in August 2007 and has since grown to alarming proportions, was due to reckless deregulation of the financial system and more generally to the withdrawal of governments from their controlling and safeguarding role. Since the invisible hand has proved to be unsafe, let us once again put our trust in the strong hands of the state and let us, without procrastination and horse-trading, build a new regulatory framework that will preserve the strengths of free markets while ensuring their smooth working and protecting them from wild stress and strain.Agreed.
It should not surprise us if future historians were to conclude that this reasoning was a typical case of post hoc, ergo propter hoc--the troubles came after deregulation, therefore they were caused by deregulation. In fact, the chain of causation was probably less pat and simple. An exceptionally low real interest rate spectrum due primarily to the gigantic East Asian excess saving has generated a housing price bubble in the United States, Britain, Spain and Ireland. It is very doubtful whether the Federal Reserve could have resisted this even if it had wanted to. At least partly if not wholly as a result of stimulation by public policies favouring home ownership by very low income groups, there was much overlending on mortgages, risky even if house prices had remained at their inflated level and loss-making if they turned down--as they duly did. Fannie May and Freddie Mac could not hold off the degradation of mortgage portfolios. The physical capital represented by the mortgaged housing stock was not damaged, but the securities that had big batches of both prime and subprime mortgages as their collateral (and that bankers allegedly did not even understand) were damaged by a loss of confidence that temporarily froze them into illiquidity. There were many would-be sellers but only a few "vultures" would buy, and they only at near-absurd prices. Securities whose mortgage collateral may have become 30 per cent non-performing and that percentage, in turn, would all end in foreclosure and permit, within a year or so, no more than 50 per cent of the mortgage debt to be recovered, would under these conditions have an intrinsic worth of roughly 85 per cent of their par value (a loss of 50 per cent on the 30 per cent of defaulting mortgages, i.e. a 15 per cent on all the mortgages). The "vultures" might buy some at 20 per cent of the nominal value which very few banks would willingly accept. However, in that case under the "mark to market" rule, they had no choice but to devalue their mortgage-backed securities to 20 per cent of the par value, declaring a truly frightening loss of 80 per cent. This was the trigger of the panic.
From then on, the rest follows fairly easily. Credit default insurance losses are a multiple of the mortgage-based losses, although they are matched by the gains of counterparties. In fact, all purely financial losses are matched by gains or avoided losses, the whole being a zero-sum game that impacts the distribution of wealth, but not its total, amount. However, at this point the effects on confidence enters the game. In particular the influence of modern, aggressive media on partly-informed opinion becomes decisive. "Things are really not too bad" is not a good headline but "things are catastrophic" is. August authorities, including the head of the IMF, get into the headlines and the evening news by announcing that much, much worse is to come. Such prophecies are self-fulfilling. Even the prudent customers who have no credit card debt will stop buying durable goods, and the financial mayhem infects the "real" economy. It is a perfectly open question whether more regulation could have prevented such an outcome. Quite possibly it might have aggravated it, and may yet make any recovery slow and awkward.
Be that as it may, the politicians and the technocrats will now pile regulation on regulation, making the economy more rigid and sluggish, because the groundswell of popular sentiment imperatively demands it.
Monday, June 15, 2009
On the Library of Economics and Liberty site, economist Anthony de Jasay cautions against over-simplifying the explanation for the credit-crisis: