City Journal

Guy Sorman
The Free-Marketeers Strike Back
A counter-narrative of the financial crisis
Summer 2010
Leading free-market economists point to various culprits behind the 2008 meltdown, such as skyrocketing oil prices.
Marilyn Genter/The Image Works
Leading free-market economists point to various culprits behind the 2008 meltdown, such as skyrocketing oil prices.

Since the financial crisis began in September 2008, millions of Americans have lost their jobs, had their savings wiped out, or foreclosed on their homes. Any number of suspects have been blamed for the chaos, but according to an influential cadre of liberal economists, the real culprit is the free market. In his new book Freefall, for example, Nobel laureate Joseph Stiglitz declares that “market fundamentalists” and “deregulators” are to blame for the mess. New York Times columnist Paul Krugman, also a Nobel winner, demands ever more public spending to lift the U.S. economy out of recession—another blow for statism.

True, Stiglitz offers mere punditry, providing no data or models to support his contention. As for Krugman, one wonders who is making the argument: the Nobel economist or the liberal New York Times columnist? His argument for public spending rests on the unproved notion of the “Keynesian multiplier,” which holds that $1 in government stimulus eventually generates $1.50 in economic activity. (One of the few examples of serious research on this too-good-to-be-true idea, a study by Harvard economist Robert Barro, found that after five years, $1 invested by the state yielded less than $1 in returns—that is, that the multiplier was really a demultiplier.) Still, despite the liberal writers’ scientific weakness, they have been extremely successful in imposing their narrative. The conventional wisdom now is that economists failed, that free-market economists failed most of all, and that market fundamentalism bears grave responsibility for the economic crisis.

But talk to the free-marketeers themselves, and a different picture emerges. Disagreeing vehemently with the conventional wisdom, they argue that we need to learn from the crisis without disrupting the free-market model that has served the world so well.

From an historical perspective, the current crisis follows a well-known pattern,” says Princeton University’s José Scheinkman. “It is astounding,” agrees Columbia University’s Charles Calomiris, to what extent “the current banking crisis fits into the pattern of all banking crises that we have known about since the fifteenth century”: excessive leverage and a strong belief in ever-rising prices, followed by a collapse of trust in, and a run on, the banks. “The weakness of many contemporary economists is a short memory,” Calomiris adds. It’s an amnesia shared by the public, which tends to erase bad memories. After all, banks usually work pretty well, so long periods of time can pass without a crisis breaking out, making it much easier to forget.

The same forgetfulness holds for recessions, says Eugene Fama of the University of Chicago. The last major one was during the 1930s. Only after the 2008 recession began did the causes of the Great Depression again become a subject of widespread public debate. After World War II, five or six minor recessions struck the United States economy, but all were too short, Fama says, “to leave a deep impression on the collective mind, even in the economics profession.” Moreover, too few recessions of any kind have occurred for economists to develop a good descriptive—let alone predictive—recession model: there simply aren’t enough data yet. “Maybe each recession is different,” Fama suggests. Or perhaps, he adds, recessions are the result of productivity cycles. When no innovations emerge to drive growth, on this view, the economy slows.

“When major recessions don’t appear over three generations, one tends to think that they belong to the past and will never happen again,” adds John Cochrane, a colleague of Fama’s at Chicago. Free-market economists saw the world rally around their model from the early eighties through 2008—a period marked by healthy economic growth and price stability that Cochrane calls “the Great Moderation.” They may have become a bit self-righteous, he admits.

The nature of recessions is important because of what may be the free-market economists’ most surprising contention: that the recession triggered the financial crisis, not the other way around. Fama argues that the recession started as early as 2007, with consumers starting to spend less, borrowers falling delinquent on their loans, and homeowners who lacked a vested interest in their houses beginning to walk away from their mortgages. So the complex financial derivatives at the heart of the financial meltdown were not its cause but its victims. “For 25 years, before the current recession,” Fama points out, “the derivatives worked well in lowering the cost of capital.”

What has Fama learned from the crisis, then? “I learned a lot about government overreactions but not much about recessions,” he tells me. Confronted with a sharp economic downturn, governments face political pressure to act; stimulus spending and other state interventions seem sensible, even when the history of past crises suggests otherwise. Worse, the new public debt and regulations then hobble economic recovery. Rebounding from the post-2007 recession would have been quicker, Fama believes, if the government had mostly let free markets clean up the mess, reestablish true prices, and select the enterprises able to survive.

James Hamilton, at the University of California at San Diego, agrees that the recession provoked the financial disaster, but he submits that energy costs had much to do with the initial downturn. Energy expenditures as a percentage of total spending in the U.S. had fallen from 8 percent in 1979 to around 5 percent in 2004, he notes. By June 2008, though, the price of gasoline had reached $4 per gallon, blasting the energy share of spending back up to 7 percent. (The massive demand from emerging economies like China and India spiked the prices, a shock comparable with the 1973 energy crisis.) “While some people were ignoring $3 gasoline in 2007, $4 definitely got their attention,” Hamilton says. The subsequent shift in spending patterns was disruptive for key economic sectors. The number of light trucks sold (including SUVs) plummeted by 23 percent from the second quarter of 2007 to the second quarter of 2008, with auto manufacturing hemorrhaging 125,000 jobs over the same period. The rising energy costs likely had an impact on commuting and hence on housing, Hamilton adds, since they made suburban homes less attractive—and thus less valuable. Widespread mortgage failures began in 2007, in fact—before the financial crisis hit the next year.

If Hamilton is right, the American economy faces not just a bad recession but a long-term structural challenge. The financial system may heal, sensible new rules may lessen risks in the future, excessive leverage may come under control, but oil and commodity prices will begin to rise again and put downward pressure on economic growth. “Emerging countries aren’t going to disappear,” Hamilton says, so advanced economies need to find a way to combat inevitably higher energy costs. One answer is scientific and technological innovation, which could improve productivity per gallon of oil. Domestic oil and gas drilling (the offshore variant rendered politically toxic by the massive BP oil spill in the Gulf of Mexico this spring) and new nuclear reactors would also reduce energy prices by making the United States less dependent on foreign imports. “Regretfully, this structural challenge isn’t at the center of what the U.S. government is doing to restore sustained growth,” Hamilton says.

Stanford’s John Taylor grants that it is impossible to avoid recessions entirely. But we can avoid certain policies that we know to be conducive of them, he believes. A disciple of the great economists Milton Friedman and Anna Schwartz, he blames the loose monetary policy of the Alan Greenspan era for helping cause the current downturn (see “Monetarism Defiant,” Spring 2009).

Taylor is the father of the eponymous Taylor Rule, a mathematical algorithm that the Federal Reserve usually follows in setting the prime interest rate so that prices remain stable but sufficient currency and credit are available to finance steady growth. The Fed followed the Taylor Rule during the Great Moderation, with beneficial economic results. Why, then, after the 2001 recession, did the Fed let the interest rate fall beneath what the rule suggested and keep it extremely low even after 2003, when the economy was clearly growing again? “Greenspan wanted to do better than the Great Moderation,” Taylor guesses. “The quest for perfection became the enemy of the good—a case of hubris.”

Hubris, indeed: the easy money helped expand a massive credit bubble. And that credit helped fund a wild proliferation of risky subprime mortgages, often issued with little or no money down, thanks to relaxed mortgage-lending laws and to Fannie Mae and Freddie Mac, the now-infamous “government-sponsored enterprises” that busily bought mortgages from lenders to keep homeownership expanding. The bursting of the bubble in 2008 brought the U.S. banking system, which had invested extensively in the subprime mortgages, to its knees. Given the enormous scale of the crisis, Taylor says, it’s clear that the private sector could not have caused it on its own. “Distorted incentives encouraged private speculation,” he says. “Central banks should return to their former global targets against inflation and be less erratic and more predictable.”

Taylor’s analysis draws support from a comparison of the financial crisis in the U.S. and Canada. Canadian banks, it turns out, weathered the financial storm much more effectively than American banks did. The reason: Canadian mortgages, unlike American ones, legally required robust guarantees, usually a 20 percent down payment. That helped keep homeowners from running away from their mortgage payments when things turned south, as happened in the United States. Canada and the U.S., it’s worth noting, still have the same percentage of homeowners—roughly 67 percent—meaning that the American incentives that favored risky bank behavior failed to increase ownership levels.

Cochrane and Taylor, among others, believe that the panic that froze credit for a year beginning in 2008 was a direct consequence of how the government intervened after the bubble burst. “The banks probably had to be saved,” Cochrane tells me, “but the problem was that the salvation followed no pattern.” Some institutions, like Bear Stearns and Wachovia, were rescued; others, like Lehman, were not. It became impossible to know what the government was going to do next. “If governments couldn’t be predicted, nobody could be trusted any more,” Cochrane explains. Credit froze. “We knew, from a theoretical point of view, that without trust there is no market,” Columbia University’s Pierre-André Chiappori says. “For the first time, we saw the theory confirmed in practice. Regretfully, our textbooks were right.”

The free-market economists I spoke with aren’t extremists. All of them say that the severity of the financial crisis underscores the need for prudent new regulations. “Free-market theory has, in fact, always recognized the necessity of regulation in finance,” says Chiappori, because it considers economic actors as rational beings pursuing their own self-interest. Bankers clearly have a vested interest in going for the highest risks, which can bring in the highest rewards. So market economies have long made rules limiting the risks that bankers can take—and limiting potential losses for depositors.

But regulations won’t do much good, says Chiappori, if regulators, “who are only human beings, prove to be as bad as they were in recent years.” Any new financial rules must therefore avoid too much dependence on the clairvoyance of smart regulators. Echoing City Journal’s Nicole Gelinas in her book After the Fall, Chiappori supports simple, easy-to-assess measures like higher capital and margin requirements on financial institutions and transactions, so that loans can’t be made with excessive leverage, as was endemic among U.S. financial institutions. “We do not need an Olympian committee of clairvoyant regulators or new institutions for that,” he says.

Regulations also won’t be able to prevent destructive bubbles from forming, since these bubbles remain an inescapable part of the capitalist economy, Princeton’s Scheinkman believes. Capitalism bases itself on innovation; people with money to invest will flock to the most promising innovations; sometimes, an innovation looks so promising that it unleashes a mania. From tulip bulbs in seventeenth-century Holland to Internet firms in 2000 to subprime derivatives in 2008, “there is no way to convince people to be cautious when they expect stratospheric returns,” Scheinkman observes. But that doesn’t mean that governments are utterly powerless in the face of bubbles. Manias reach a truly dangerous size only when the money supply becomes nearly unlimited, as it did in the run-up to the 2008 meltdown. So a strict monetary policy, especially if combined with leverage requirements, could limit the size of bubbles and keep their potential destructiveness in check.

The free-market economists all see a need for greater transparency in financial markets. An International Monetary Fund economist who asked me not to use his name recommended greater transparency, particularly for credit default swaps, a form of derivative that provides insurance against default by bond issuers. The CDSs, which were at the core of the 2008 AIG and Lehman collapses, are currently traded directly between issuers and buyers and remain largely hidden from public scrutiny. A clearinghouse for the swaps and other complex financial instruments would let regulators and the public see which firms are exchanging them—and which might be heading for trouble.

However, the IMF economist warns against banning derivatives outright, which would “bring emerging countries to their knees, since this financial innovation has increased the availability of capital at a reasonable interest rate for these economies.” Similarly, the prominent French economist Jean Tirole—who blames lack of transparency in exotic financial instruments for the 2008 financial crisis—nevertheless says that “derivatives can be compared with powerful medicines. They cure poverty by providing investments in risky businesses, but excess can be dangerous for your health.” The last quarter-century of global growth probably wouldn’t have happened without them.

Nor are poor countries the only beneficiaries of complex financial engineering. “Derivatives have brought cheap capital to poor people in rich countries as well,” simply by increasing the quantity of money that financial institutions can lend and allowing for a more efficient allocation of risk in the economy, says Phillip Swagel, currently a visiting professor at Georgetown’s McDonough School of Business and a former assistant secretary for economic policy at the U.S. Treasury. “The possibility for poor people to buy cars or homes would wind up tremendously reduced if we repressed financial innovation too much.” Financial regulations need to walk a fine line between maintaining reasonable risk and ensuring the widespread distribution of capital.

Whatever new regulations lawmakers enact, they won’t be perfect, in part because we have insufficient knowledge of the global financial markets, says Columbia University’s Rama Cont, a leading expert in the field of financial modeling. Ingenious traders and instantaneous transactions inevitably escape evaluation and control (see “Wild Randomness,” Summer 2009). A huge investment in mapping the financial system should therefore precede any substantial new regulation, Cont argues: “How can you regulate what you actually don’t know and do not see?” He contends that the IMF should lead the project because it’s the only institution with enough data to draw a comprehensive map of how the financial market works.

Cont’s mapping project is overly ambitious, in Calomiris’s view, though he, too, supports the idea of greater transparency. But Calomiris—a banker by trade as well as an academic—interprets the financial crisis above all as a failure of corporate governance. Bankers played recklessly with depositors’ money, even taking contradictory positions within the same institution—buying subprime bonds, for instance, that the bank was simultaneously trying to sell off, with different executives in the bank pursuing different interests. Shareholders could do little to stop such recklessness. Further, U.S. law forbids hostile takeovers of banks by larger investor groups and the concentration of bank capital in a few hands, so banks have few external market checks. This regulatory environment “gives too much power to the bank CEOs,” Calomiris says. Felix Rohatyn, a former partner of and now advisor to the Lazard bank, thinks that financial institutions should be required by law to recruit “at least one competent supervisor for their boards, drawn from a state list of legitimate administrators.”

But Scheinkman disagrees with the thesis that better corporate governance is the Holy Grail. “Shareholders did exert pressures on CEOs—in order to get maximum returns,” he points out. “And maximum returns required maximum risk exposure.” After all, before the bubble burst, many shareholders profited from the banks’ high-risk strategies. “In a bubble, very few people keep their common sense,” Scheinkman goes on. “Even those who know that they are in a bubble think that they will be smart enough to get out just before the bubble bursts.”

To what extent did “moral hazard”—the belief that the government would bail out institutions if they got into deep trouble—lead bankers and traders to take excessive risks? That expectation may explain some of the careless risk-taking, Scheinkman thinks, “but even without moral hazard, a bubble creates risky behavior.” As for the common criticism that the massive size of the leading U.S. banks made them “too big to fail,” Scheinkman says that the banks are too large, even apart from the way they worsen moral hazard. “We do not need big banks because they do not bring any economy of scale,” he says. “A big bank is not more useful to the economy than a small one.” And the big banks certainly should not enjoy taxpayer protection, he adds, because that harms free competition, putting smaller banks at a disadvantage in competing for customers.

One proposal that seems to be becoming a consensus view among free-market economists is to prepare emergency plans for future crises. “While it would be another case of hubris for the government to think that it could stop a bubble before it starts expanding, we can ask who the victims will be when a bubble bursts,” says Luigi Zingales of the University of Chicago (and a City Journal contributing editor). Those who knowingly took risks should take their lumps, he says. But mechanisms should be in place to keep a burst bubble from threatening the entire financial system. Contingency plans could help financial firms get through a crisis or, if necessary, be dismantled in an orderly fashion.

It is in the long-run interest of the economy—and consumers—for lawmakers to protect the institutions of the market against businesses seeking to game the system in their own favor. “Too often, because of lobbying, the defense of the market gets confused with the defense of business, but they can be in conflict,” says Zingales. Since the Democrats seem more pro-business than pro-market, he would like the Republican Party to stand up more forcefully for markets.

Another lesson of the crisis that most of the free-marketeers agreed with is that the teaching of economics needs revision. An excess of specialization in research and in curricula has kept many scholars, to say nothing of their students, in the dark about the big economic picture. The crisis has shown how everything we know about markets interacts in complex ways, requiring a global intellectual approach. “We have discovered that all the elements of our sophisticated modern economies need to work properly—one dysfunction in one part of the system can disrupt the entire system,” says Cochrane.

Every economist I interviewed agreed that ballooning American and European debt poses a huge threat to long-term prosperity. The debt will be paid either through inflation, which would make everyone poorer, or—a far better scenario—through economic growth that would increase both individual and government revenues. Unfortunately, by increasing taxes and imposing the wrong regulations, Western governments are hindering entrepreneurship and hence growth, Cochrane says.

As in the 1930s and 1970s, so today: crises are a serious problem, but misguided economic policy makes them worse. After the 1930s, only war production could overcome the negative economic consequences of the New Deal. After the stagflation of the 1970s, it took the bold leadership of Margaret Thatcher and Ronald Reagan to reorient the West toward free markets and prosperity. How long will it take this time before governments understand that overreacting to the crisis and imposing disproved Keynesian remedies will dampen and delay economic recovery?

The answer depends on the ability of free-market economists and commentators to communicate their narrative of the crisis. We sadly lack someone like Milton Friedman, who could effortlessly convey complex theories to a large audience. Enough talented economists are on hand, however, to build the platform that we need for a free-market revival.

Guy Sorman, a City Journal contributing editor, is the author of Economics Does Not Lie and other books.

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