Can the Principles of a Free Market Survive in a Society Treading on Financial Eggshells?

Julie Masters  

The financial crisis has left the notion of a truly free market economy somewhat battered, perhaps down and out. For years both London and New York enjoyed have enjoyed prosperity with a culture of expense accounts and endless lunches. However, by 2007 things were beginning to look a little less rosy, and after 2008, the lunches and flamboyant Wall Street corporate gifts seemed like a distant memory.

Many commentators point to the injections of debt into many of the world’s largest economies as evidence that the neoliberal animal which has lived during this era has privatized its last rail system or cut its last tax.  Can liberalism be given a new lease on life with a political and economic reshuffling?

An era of Neoliberalism

Neoliberalism was an economic claxon--the growth of rich nations in recent decades has been exponential. Its advocates suggested it provided a path for investment and economic efficiency against the backdrop of socialist reform in postwar years. In fact, many would argue that as the disposable cash reserves among the poorer echelons of society fell (together with those of the state following tax cuts) demand fell.

It’s critics would further comment that the resultant low incomes created a stranglehold on demand that in turn thwarted employment and created a cycle of debt. It is fair to say that neoliberalism has defined the free-market policies of recent history. It is also fair to say that it has created enormous credit growth that, if perhaps managed more prudently, might provide a solution. But how could policymakers have come up with a means of avoiding the crash in 2008?

Lehman and the 2008 crash

The crash of 2008 began in 2007, arguably signposted by BNP Paribas's decision to cease activity in US mortgage debt. This wiped out confidence among the interbank community as, although losses could not be known, they certainly could be estimated in large multiples of trillions of dollars. This destroyed trust between banks, and business ground to a halt. However, it wasn’t until the US government allowed Lehman Brothers to go under that the situation could be seen. 

Overnight, complete confidence in the Western banking system collapsed. If an institution like Lehman could go bankrupt, then any bank could go bankrupt.  Until then the US had bailed out numerous institutions (with taxpayers’ money) to the tune of hundreds of billions of dollars, with the UK similarly bailing out Northern Rock. Corporate culture was from that moment on set to change.  Anyone working in London or New York during the booming years of the early to mid-2000s will remember that an expense account was simply there to be run up. 

Golf days and numerous corporate gifts were commonplace. What followed was an injection of government capital into the banking system, which was enough to save the banks, but not the associated economies. Could a more prudent system of financial regulation have prevented the crisis of 2008, keeping credit cycles constrained before they boiled over? 

There are numerous tools which economists and policy makers have at their disposal in this regard, one of which includes placing a ceiling on the risk portfolio of financial institutions, an exercise in drafting that, when combined with others measures such as liquidity buffers, could have prevented the catastrophic demise of Lehman, as The Wall Street Journal suggested at the time. What such measures do is provide a safety net. They allow the development and innovation of new financial products and services by keeping checks on the total amount of credit in the system. If it was possible for regulators, through historical identification of credit cycles, to keep one step ahead of innovation, then regulatory tools may have a place or provide a means to save neoliberal system.

The end of Thatcher/Regan economics?

Should neoliberalism be condemned to death?  It could be said that all it has created is history’s largest and deepest financial crisis, prior to which it suffocated productivity and created inequality in economies in which it was left to thrive. This would be a harsh and inaccurate view, with perhaps a fairer conclusion being that it gave a breakeven situation for the past few decades. Ultimately, the effects of a free market can have a hugely positive effect on kick starting economies, and as has been shown in Chile (which also adopted a system of neoliberalism) it can flourish. It could also be true that Western economies could also benefit from the stimulus economic freedom brings through neoliberal principles. However, if institutions are to avoid the cyclical credit risk that this brings, innovative regulation must be at the root of such an ideology.

Julie Masters, a freelance writer, has made a guest contribution. The views reflect those of the author and are not mine.

Congressman Paul Kanjorski Is One Confused Dude

Jim Crum and Mairi have forwarded this video of Congressman Paul Kanjorski's explanation of the "bailout". Kanjorski is one confused dude. There is no benefit to the public from the government's subsidizing incompetently run banks by buying their bad mortgages. It is true that what Congress is doing now is even worse, and the caller has a right to be disturbed. But it is unfortunate that she cannot obtain the information necessary to analyze this problem. Wall Street's publicists, the New York Times, CNN, Fox, et al. have seen to that.

Kanjorski's confusion is particularly acute in his dramatic depiction of a run on money market funds. There is no such thing as a "run" on money market funds. Money market funds are fully backed by loans. The funds could refuse withdrawals until the short term loans expire, and then pay the depositors.

Nor is the current approach to banking essential to the American economy. The banking system is not worth a trillion dollars to the public. It is not worth a dime. It has been a cancer on the American economy for two centuries.

If Kanjorski had bothered to inform himself about the history of money, he would know that America's current arrangement, the fiat paper system and the Fed, is the result of historical decisions that have not been beneficial and that the public fared better under the gold standard. In the 1970s there was a possibility that Milton Friedman's fixed monetary rule might work, but it did not. The only choices are (a) gold and silver without fractional reserve banking, which would result in gradual, stable growth, and (b) the unstable paper and fractional reserve system that has resulted in the Great Depression, the current instability, the 1970s deflation and absurd investment in worthless construction and mortgages.

The Banking System Has Caused Economic Slowdown

The consensus argument (which is often wrong) is that the banking system has caused the current economic malaise. In general, recessions and depressions are monetary. The Great Depression was a monetary phenomenon. This time, the Fed has ballooned money supply yet the slowdown continues. Of course, it is likely that there is a lag, and in a month, two or three there will be a turnaround. The stock market, however, continues to fall. This may have to do with continued media publicity. If the lag or media publicity arguments do not turn out to hold, the culprit is the banking system itself, which is what I keep hearing.

Not that money supply is independent of the banking system. Much of the money supply is created by the banks. But if the money supply is the reason for depressions and recessions, there is an argument to maintain the current banking system--the Fed can counter panics and so fractional reserve banking's chief problem (the threat of runs) can be countered. But not if the banking system itself is faulty. Then the argument for the current fractional reserve system is attenuated. Then, fractional reserve banking is in part responsible for misallocation and slowdowns, and money supply (itself a product of fractional reserve banking) is only partly to blame. In that case, a clear thinking public (sans the New York Times, pro-bank "liberals" and the like) ought to ask why the the banking is perpetuated given its dismal performance.

Fractional reserve banking is a form of fraud and need not be legal. Bankers lend out more money than they have on reserve. For every one dollar deposit, banks lend out up to six additional dollars. These dollars are covered by incoming new deposits. The system is not far from a Ponzi scheme. New investment covers old loans. It works if borrowers come and go with regularity. The problem until the days of the New Deal was that they frequently did not. There would be "runs", banks would falter and depressions would result.

Without fractional reserve banking there would be more savings and less economic activity. The economic activity that occurred would be more rational than it is with fractional reserve banking. Over time, better projects would be built and there would be more innovation because investors would be more focused on rational investments. This would stabilize economic outcomes over time, as more good ideas were implemented as were fewer bad ones. There would be less reckless depredation of the environment as unnecessary housing and manufacturing would be cut back. Higher unemployment levels over the intermediate and perhaps long term could be subsidized through relief, just as it is now. Interest rates would be higher and more people would save. There would be less or no inflation (and perhaps deflation) so people planning for retirement would not need to rely on the stock market. Savings would generate adequate returns for retirement. Better investment would be made, so that statistical economic growth might be slower but substantive economic growth would be much faster. The difference to which I'm alluding, satistical versus substantive economic growth, is that statistical growth includes garbage investment like sub-prime housing and public schools that do not produce value. Substantive economic growth would include private schools that do produce value and housing that people really want.

Banks need not be permitted to lend more money than they have. The argument for doing so is economic growth. But the argument against it is the rape of America's retirees; and the stifling of innovation caused by the misallocation of credit and irrational turns in the economy due to banking panics--on the part of bankers themselves.