“This crisis is so big it is forcing Americans to re-think concepts as essential as free-market capitalism and the role of government. …[Henry Paulson)) now seems set to preside over a more massive nationalization of assets than Vladimir Putin…On September 15 2008 the era of Ronald Reagan officially came to an end.” Chrystia Freeland ((“It’s Mourning Again for Americans,” Financial Times September 20, 2008.]
“With the government already deeply implicated in the financial markets—and a substantial cause of the mistakes leading to the panic—Treasury and the Federal Reserve had to act to prevent a crash.” (Editors of The Wall Street Journal) ((“Stopping the Panic,” The Wall Street Journal, September 20-21, 2008.))
Chrystia Freeland says that Americans are in mourning over the re-regulation of the financial services industry as embedded in the dramatic rescues by the government last week. But how much “re-“ is there about the new regulatory regime announced last week? Shall we start mourning now, as pundits suggest?
If Chrystia Freeland thinks we have a free-market financial system, she should think again. A free market avoids the distortions due to regulation; competition is rigorous and can produce volatile results; there is free entry and exit; investors are free to take risks, harvest any gains and bear any losses. But that does not describe well the financial services industry in the U.S. or other developed countries for at least the last century.
Over the past two weeks, the nationalization of firms and the widespread government guarantee of debts are breathtaking in their scope and departure from previous government policy. But consider what that policy has amounted to: ggovernment agencies regulate the entry, exit, and combination of financial institutions; they oversee the transparency of financial reporting and securities underwriting; they influence credit and capital policies of lenders; they manage the money supply through which they drive interest rates and inflation expectations; and they provide the electronic system through which vast quantities of cash are transferred. Since passage of the Humphrey-Hawkins Full Employment Act in 1978, management of the financial markets has been an important instrument through which the Federal Government has sought to maintain full employment and stimulate economic growth. With this much government intervention, it is hard to call the U.S. financial services industry “free-market capitalism.” American financial markets are comparatively free relative to other countries—certainly much more free than those in North Korea and Cuba, for instance. Some sectors of the financial services industry are more free than others—think of hedge funds and private equity funds. And as the shareholders of Lehman Brothers and Bear Stearns have been reminded, the system is free enough to let them absorb some stunning losses. But make no mistake, the U.S. government is involved cheek-by-jowl in the functioning of financial markets.
We shouldn’t endorse government regulation carelessly. First, regulators can become captive to the very industries they regulate. Second, the private sector tends to squirm away from regulators. Make a rule and executives and their lawyers will find exceptions and/or a way to skirt it entirely. Third, private markets innovate relentlessly. This means that, like the general who always prepares to fight the last war, regulators tend to manage the private sector the way it used to be. Think of the difficulties the Federal Communications Commission has had in dealing with wireless telecommunications or the Internet. Then there is the Federal Drug Administration and biogenetics. Or the U.S. Patent and Trademark Office and business process inventions. Like the barking dog that chases, but never catches, the bus, regulators may never catch the wave of new developments in industry. Fourth, it is all too easy to saddle taxpayers with the costs of saving firms, jobs, and industries. Do we want an absolutely risk-free society? To be sure, where human safety is at issue, I want no doubts. I want medicines evaluated for safety and efficacy; I want pure food; and I want the aircraft on which I fly to be inspected frequently for airworthiness—perhaps government is the best way to achieve this, though I wonder whether private sector might not also offer a solution. Eventually there will be a reckoning of the government’s role in contributing to this crisis.
We want this kind of intervention in the financial services industry because the costs of coordination are too great and the consequences of failure are too high. As I explained in my previous posting, the current crisis is distinguished from previous crises by very great complexity, high speed of news and cash, and very large scale. Unlike in 1907, when J. P. Morgan could gather all the financial bigwigs in his study (and lock them in until they agreed on a rescue plan!) the task of organizing collective response to the crisis today would be impossible for a private individual. It is hard to imagine the wreckage that would have occurred by now without the government’s interventions to date.
Against this backdrop, the regulatory innovations of this past week, do not strike me as the death-knell of comparatively free-market capitalism. Or at least, if there is a death to grieve, then it must have happened a long time ago. Let the pundits mourn; it sells copy. American taxpayers will be mourning for quite some time, although for a different reason.