Opinion & Commentary
Beware political saviours
According to Prime Minister Kevin Rudd, the global financial crisis is the outcome of ‘a culture of greed.' In the world according to Rudd, ‘this culture was never challenged by a political and economic ideology of extreme capitalism.’ The credit crisis ‘bears the fingerprints of the extreme free market ideologues who influence much of the neo-liberal economic elite.’
The Prime Minister almost sounds like a conspiracy theorist, blaming the world’s problems on shadowy elites and greedy capitalists. Unfortunately, Kevin Rudd is not alone in this. Politicians around the world have been quick to point the finger at financial markets and the executives who preside over financial institutions. Even US Republican Presidential candidate John McCain has sought to blame ‘Wall Street’, which he describes as a ‘casino’.
It is not surprising that politicians seek to scapegoat capitalism in general and financial markets in particular. Capitalism and free markets have always been objects of popular suspicion, even in a notionally free market country like the US. Politicians pander to these popular prejudices, not least because focusing attention on supposed market failures diverts attention from their own policy failings.
Far from being an unregulated free-for-all, financial markets are in fact heavily regulated by a plethora of government agencies, both in the US and around the world. Not only did these regulatory institutions fail to foresee or prevent the problems in US housing and global credit markets, they arguably played a significant causal role in the crisis.
Given the extent of regulation and government intervention in the world’s developed economies, a financial crisis must involve profound regulatory failure. This is not to say that mistakes have not been made by private market participants. It is simply to acknowledge the reality that governments and regulators are also deeply implicated in these problems.
Politicians and pundits like to blame both greed and irrationality for the financial crisis as part of their appeal to popular prejudice. Yet these same critics often oppose these two aspects of human nature. On the one hand, capitalism is accused of elevating self-interest above all other considerations, such as altruism. On the other hand, we are also asked to believe that financial market participants are driven by irrational sentiment that ultimately harms their own interests.
Whatever one’s view of human motivation and individual rationality, one needs to make consistent assumptions about human behaviour. People are not altruistic or rational one day and then greedy or irrational the next.
The Scottish Enlightenment philosopher David Hume noted as long ago as 1741 that ‘Avarice, or the desire of gain, is a universal passion, which operates at all times, in all places, and upon all persons.’
One cannot explain episodic phenomena like financial crises with reference to a constant like human nature or rationality.
The principal mistake the critics of free markets make is to assume that self-interest, greed and irrationality only affects private sector decisionmakers.
Politicians and regulators are just as prone to self-interested behaviour and do not become saints by virtue of elected or unelected office. The public sector and regulators are populated by the same species that is found in the private sector and financial markets. We should always be suspicious of claims to superior moral virtue coming from politicians.
The advocates of free markets seek to make consistent assumptions about human behaviour and argue that all people respond to incentives. Good people can be led to do bad things, and bad people can be led to good things, depending on the institutional setting in which they are located.
If we are distrustful of the motivations of people in the private sector, we should be just as wary of the motivations of those in the public sector, not least because the latter have considerably more power over the rest of us. Their mistakes can consequently prove much more costly.
These considerations highlight the important role of sound regulatory and institutional design. Regulatory frameworks that substitute public for private sector decisionmaking are likely to be no less error prone, because the public sector is no less fallible. What we need are institutions that are robust to the inevitable errors of both public and private actors.
The financial crisis is widely seen as a repudiation of the idea that markets are efficient in allocating capital and pricing assets.
The efficient markets hypothesis is analogous to the idea of perfect competition in markets for goods and services. No one believes that any real-world market for goods and services is perfectly competitive, but that does not invalidate the model’s usefulness as an approximation of real world behaviour. The same is true of the efficient markets hypothesis.
The routine violations of perfect competition are often viewed as automatically justifying government intervention to correct market failure. The inevitable violations of the efficient markets hypothesis have also been used to argue that free markets deliver inefficient outcomes, without bothering to establish whether proposed regulatory interventions are likely to improve on these outcomes.
Governments and regulators for the most part rely on the same information and the same methods for analysing that information as the private sector. This is why regulators and governments are no better at avoiding mistakes than the private sector. Neither elected nor unelected office confers special insight or wisdom. But the private sector has the distinct advantage of a focus on the bottom-line. This is a powerful incentive to avoid mistakes, but only when the costs of those mistakes are borne privately rather than publicly.
Markets also have the advantage that they are self-correcting. Falling US house prices are the market’s way of correcting the over-supply in US housing. US house prices began responding to this over-supply well before the problem was recognised by regulators or by government. No government intervention was required to facilitate this process.
In credit and other financial markets, the current crisis can be interpreted as a global re-pricing of risk following an extended period in which risk was incorrectly priced. Again, no government or regulatory intervention was required to set in train this market correction.
We may not particularly like the price signals generated by markets in the context of the credit crisis, but that does not mean that the market is not working or that the price signals are wrong.
The biggest problem in financial markets right now stems from the fact that the markets for some assets have essentially shut down. If there is a role for government, it is in getting these markets working again. The danger is that governments may crowd out rather than facilitate the re-emergence of private markets or stand in the way of the market’s adjustment process, rather than facilitating it.
The current financial crisis tells us as much about the failures of regulation and government intervention as it does about the limitations of markets. Governments and regulators are far from infallible and certainly no more virtuous than private actors.
The crisis should be a humbling experience for governments and regulators, no less than for market participants. A little more humility and less moral superiority on the part of politicians would help ensure that the regulatory responses to the crisis don’t do more harm than good.
Dr Stephen Kirchner is a Research Fellow at the Centre for Independent Studies.
