What Happened to Free Markets?

A cry can be heard in the canyons of Wall Street and the winding roads of the City: “Capitalism is over. Free markets are dead.” And good riddance, smirked French President Sarkozy and German Finance Minister Steinbruck, Anglo-American financial supremacy is over. Joining them was a cackle from the UN session, where many of the broadsides against globalization were thinly veiled criticisms of Anglo-American capitalism.

Neither is Right

Hand wringing is not needed. Free markets cannot be dead, because they never existed in the first place. Schadenfreude is premature. Anglo-American capitalism may very well emerge from this financial crisis stronger, more vibrant and more competitive.

There is this myth that once upon a time there were free markets and then the state encroached. But what was meant as allegorical has been assumed as fact. The narrative is simply not true. Positive state action was needed to turn the factors of production (land, labor and capital) into commodities that could be bought and sold. The corporate form of organization has been sanctioned by the state. The state’s power of taxation can have significant impact on the incentive structure for economic activity.

The whole notion of an economy as a separate sphere of activity is nonsensical. The patron saints of the church of laissez faire, Adam Smith and David Ricardo, thought they were analyzing political economy. Moreover, they understood this political economy to be a moral economy insofar as it tried to promote certain values and behaviors. Pssst, Adam Smith was not an economist. He was a moral philosopher.

For a little more than half a century, the state has played a critical role in resolving a key problem at the core of the modern political economy and that is surplus capacity—the ability to produce more goods than there is effective demand for. Before the recent spending splurge on guns and butter, the US government absorbed a little more than a third of all the goods and services produced in the US (government expenditures as a percentage of GDP). The UK is near US proportions, while continental Europe is nearer to 50%.

Crisis Management

This is not to deny that the state is taking a more active role during this financial crisis. However, while some of the measures seem new and innovative, most of them have been employed before in essence. No Rubicon has been crossed.

That is an important point. Modern industrialized countries have experienced many banking crises over 30-40 years. Along with producing stuff in a variety and scale unimaginable to any other generation, the modern economy generates financial excesses from time to time. Deal with it.

In bygone days, debtors would be imprisoned. Modernity has de-stigmatized debt. A combination of forces, like the development of a service economy, better inventory management, and, of course, the modern state’s intervention, has served to smooth out the business cycle. Imagine, that through H108, the US experienced a total of six quarters of negative growth in the past 25 years but experienced six quarters of negative growth in the 3 years previous to that.

To be sure the business cycle has not been repealed. It has been managed and mitigated. The amplitude of the swings has diminished and the frequency and duration of the downturns have been reduced. That volatility instead was transferred to another set of shock absorbers, the prices of financial assets, including and especially the price of money itself.

Speeches by the one-time maestro (now demon) Greenspan and the still-revered (and Paulson’s predecessor from Goldman Sachs at the helm of the Treasury Department) Robert Rubin seemed to recognize that one of the lessons of the Asian financial crisis was that the volatility of the capital markets themselves could in turn undermine the real economy. Now officials talk about this in terms of “negative feedback loops.”

Just like every business cycle is different, so too is every credit cycle, even though the cast of characters in the drama remain the same. There are always villains and crooks, heroes and Cassandras (who was cursed with the ability to see the future without any one believing her), and innocents and unfortunates. The abstract models that economists are so fond of are predicated on balance, and thus they and the policy makers that rely on them, knowingly or unknowingly, have ideological blinders that all too often prevent understanding the forces of instability.

Fever Blisters on the Body Politic

The crisis can be seen as both a problem and an attempt to cure a fever to our physical bodies. The imbalances became unsustainable. This is not a reference to the current account imbalance, but imbalances such as the one between sell-side’s creation of new-fangled financial products and the buy-side’s understanding and commitment. There is an asymmetry between the capabilities and activities of financial institutions and the regulatory regime. That the financial sector accounted for such a large share of corporate profits in America is another troubling imbalance. Perhaps the most disturbing imbalance is that the price of the American dream (a house and college education for one’s children) is often beyond the reach of good hard-working people.

What we have done with the business cycle, we should to with the credit cycle. Accept the fact that it is part of the modern political economy and develop the tools that allow it to be mitigated, elongated, and routinized. It will entail a new regulatory and accounting regime. The result will ultimately be a more transparent finance capitalism.

As finance capitalism helped rationalize other industries, it too will become rationalized. Owing in large measure to its own investment in technology, there is incredible financial capacity. The way the capacity was able to be used was a profound mis-pricing of risk. The re-pricing of risk exposes the incompetent, inefficient, and unlucky. The concentration and consolidation will cull the excess capacity in a dramatic fashion. What will most likely emerge are fewer, but stronger, more resilient, and even more competitive financial institutions.

Monsieur Sarkozy and Herr Steinbruck are mistaken if they think that Europe’s different regulatory regime will prevent the credit crisis from profoundly challenging its own financial institutions and depressing economic activity. In some ways, measured by assets to shareholder equity, many top European banks are even more leveraged than their US counterparts. Moreover, European banks suffer a severe currency mismatch, having financed the expansion of their balance sheets with dollar borrowings that they are now scrambling to secure. Perhaps it may be helpful for them to recall the immortal question: And why behold you the mote that is in your brother's eye, but consider not the beam that is in your own eye?