Decoding the Credit Crisis

Spring 2009 -- Are libertarians blindly faithful? Do they hew to ideology not because of, but despite the facts?

That’s the charge that Newsweek columnist and Slate Magazine editor Jacob Weisberg  has laid against the advocates of markets in a recent commentary: “Like all true ideologues, [libertarians] find a way to interpret mounting evidence of error as proof that they were right all along.” Weisberg equates contemporary defenses of the free market to the intellectual gyrations of academic Marxists after the fall of the Communism in 1989. “Utopians of the right, libertarians are just as convinced that their ideas have yet to be tried, and that they would work beautifully if we could only just have a do-over of human history.”

Some libertarians have tried to blame the crash of 2008 directly on government policies. It is true that congressional mandates pushed banks to take on risky, sub-prime debtors. And Congress did create mortgage financiers Freddie Mac and Fannie Mae. Over the years, Freddie and Fannie were mandated to try to relieve social differences in ownership with preferential lending practices. And over the years Congress ignored the mounting debt the two semi-private companies were racking up, even though everyone knew that if the companies failed, the taxpayers would be stuck holding the bill. I would also lay some blame for the mess at the Federal Reserve Bank’s door, as both Alan Greenspan and his successor Ben Bernanke worried too much about goosing economic growth with low interest rates, and too little about the inflation and debt bubbles those low rates were causing.

But the derivatives markets weren’t created by government fiat, and there wasn’t an international conspiracy to buy up sub-prime mortgage debt instruments. American International Group’s (AIG) debt insurance crisis was the product of private-market, unregulated contractual exchange on a massive scale. Bernard Madoff’s $50-billion Ponzi scheme was a strictly private swindle. The investment banks that collapsed under unimaginable amounts debt—Bear Stearns, Lehman Brothers—had not been forced to gamble wildly on the markets. And those investment banks were struggling to survive in a deregulated environment, after the repeal of the Glass-Steagall partition between commercial and investment banking. I don’t recall any free-market advocates complaining in 1999 when Glass-Steagall was repealed.

These are the kinds of facts that lead former Fed Chairman and former Ayn Rand follower Greenspan to admit to Congress  that he was “distressed” at having seen a “flaw” in what he’d taken to be the overwhelming evidence in favor of the free market and against regulation. And his admission has the enemies of the market baying at the moon, and growling that somehow Greenspan or George W. Bush or congressional Republicans should have known and should have foreseen and should have done something. Certainly, the Bush administration and Congress have now done something, by investing hundreds of billions of government dollars in the financial sector. This could either turn out to be a neat piece of market stabilization by the creditor-of-last-resort, or the biggest act of nationalization since Nixon’s price controls.

Given what is known about the sources of the current crisis, I am embarrassed by free-market advocates who leap to pin all the blame on the government. In the end, our politics—including our view of free markets, regulation, and taxation—should derive from antecedent conclusions we’ve reached about the facts of human nature and how humans ought to live.

So in what follows, I would like to take Weisberg’s challenge seriously. I would like to offer more than a knee-jerk ideological reaction. I would like to give an Objectivist view of the current crisis; if it isn’t a libertarian view as well, so be it.  

RATIONALITY IS A VIRTUE FOR A REASON

All human institutions have their ups and downs. The crash of 2008 is one of many market panics that extend back to tulip-mania and the South Sea Bubble. But government institutions have their crashes, too. The Vietnam War and the bungled 2003 occupation of Iraq are just two of the many cock-ups the U.S. military has engaged in. We’ve had a “war on poverty” that, well, didn’t do much to alleviate poverty. We have Amtrak, a kind of living museum that keeps the trains and work practices of 1968 alive unto this day. We have massive recent subsidies for ethanol, that —oops!—caused a world-wide corn shortage. And let’s not dwell too long on the many other governmental monuments to murderous irrationality.

The derivative markets weren't created by government fiat.

One big reason that human institutions have fads and failings is that humans live by the use of our individual minds. Our thinking isn’t automatic. We don’t know automatically how to continually improve a railroad; it’s much easier to just do what you’ve always done. Hence, Amtrak. We don’t automatically know what percentage of mortgage holders will default in this or any future year; it’s easiest to assume that what happened in the past will continue to happen. But when it looks like the past is no guide, it’s hard to figure out what the truth is or will be. Hence, market turmoil and panic: 2008 edition.

Ayn Rand named rationality as the primary virtue. For humans, it is the policy of action we most need to deal with the facts and know how to reach our goals. We need it to survive. We need it to have a hope of being happy. It cashes out in all our other virtues.

But to say that rationality is a virtue is to say it’s something we need to learn. We need to teach it, to practice it. It’s a struggle. To say rationality is a virtue is to say that irrationality is a common vice. It’s easy to be thoughtless. It’s easy to give in to prejudice, or be swayed by emotion. It’s easy to live in the moment or go with the crowd. It’s easy to join an investment fad: tulips, tech stocks, Florida condos. And it’s easy to join a selling panic.

Free markets promote individual responsibility: you bear the most brunt from your own choices, and you therefore feel the need to be rational more directly than you would if a social welfare net were there to pick you up every time you needed help. And economic freedom does tend to promote wealth and human welfare. Just look at the results from the Freedom in the World studies: the freest countries grow faster economically and are richer on average than the less free.

But markets don’t guarantee that people will be rational, or that a free society will become wealthy. In fact, we can be pretty sure that irrationality will still be with us, come what may. It’s a basic human vice.

Free markets help reveal irrational judgments quickly, and they make the irrational bear the burden of their own errors—unlike government. Investment bankers are not partying in New York this year, yet things remain pretty cozy at the Department of Energy. Free markets give each person the most incentive to be creative, productive, and to work with others to mutual benefit. But let’s be very clear: markets never have guaranteed wealth without effort or progress without hiccups—and they never will.

DISCOVERY REQUIRES BEING SURPRISED

One of the problems in the market for mortgage debt today is that many creditors can’t make a deal with their borrowers. Mortgage debt was bundled, and the obligations from a single mortgage were divided out into multiple securities. The buyers of these securities got a steady income stream that flowed in from all across the mortgage market. In a healthy property market, a certain number of foreclosures was predictable and manageable. These innovative financial instruments deepened and extended the capital markets and they made credit more widely available in the mortgage market than ever before.

I'm embarassed by free-market advocates who leap to pin all the blame on government.

But now the property markets are in a state of shock: foreclosure rates in some areas have gone through the roof, and the number of unsold houses continues to mount. Reading the newspaper, you might imagine that bankers like to foreclose on debtors. They don’t: foreclosure is never a profit center. In depressed markets like today’s, each foreclosure is a small financial suicide. Creditors would gain by writing off ten or twenty percent of the value of loans to “underwater” debtors, rather than losing practically the whole value of the loan in a foreclosure or bankruptcy. They need to offer their borrowers a write-down. And this is happening: JP Morgan-Chase and Citigroup, for example, have launched initiatives to reduce the debt balance and ease the terms of thousands of financially pressed borrowers. But the holders of bundled, sliced-up mortgage debt cannot do this in many cases: to restructure just one mortgage would take a huge, unique consortium of creditors. The international creditors holding these instruments don’t even know where to begin. So the foreclosures pile up, and the bundled mortgage debt becomes “toxic”: no one wants to touch it.

Well, now we know.

Perhaps this problem should have been foreseen, but most financial structures are not well-designed to handle the kind of hiccups that hit major markets but once in a generation.

In any case, this is a kind of problem that is typical of new technologies. With the best will in the world, the clearest thinking, and the best models, it is hard to foresee all the problems and all the potential a new technology will have. When cable television rolled out, did we know it would end up posing direct competition for the telephone companies? Has any airplane ever performed flawlessly in flight testing? Has any medicine performed in the body just as predicted? The big market for cell phones is in the Third World: who’d a thunk it?

It isn’t new technology if we already understand all the effects it will have and how it will perform under every conceivable situation. With some technologies, especially broad social technologies like those of finance, it is impossible to see the full effects except in action. It isn’t pretty when a major unforeseen flaw crops up. But human progress depends on our developing and trying new technologies.

The first pressurized jet passenger plane was the de Havilland Comet. It had a full set of flight tests in 1949. But because no had thought, in the testing, to depressurize and re-pressurize the aluminum in the hull hundreds of times, it came as a surprise five years later when Comets began disintegrating in flight due to metal fatigue. In 1954, with the Comet disaster splashed all over headlines, many thought that there was no future in high-altitude pressurized aircraft. In fact, the de Havilland Aircraft Company would never recover. But now we know different: with the right design adjustments, aluminum-hull pressurized jets fill the skies, and are the safest way to travel today.

After the financial crash of 1987, there was a witch-hunt aimed at the leading figures of the “junk-bond” market.  A new innovation, “junk” bonds were blamed for risky lending, a splurge of buyouts and takeovers, and general financial over-expansion. The investment bank Drexel-Burnham-Lambert collapsed amid charges of insider trading and unethical dealings. But today, high-risk, high yield corporate securities are a standard piece of the financial menu, and huge markets deal in them. Today, we see “junk” as a common-sense option, and we appreciate the financial discipline that the possibility of buy-outs brings to American corporate governance.

Twenty years from now, there will be a huge and thriving market for complex financial instruments. Among those instruments will be bundled mortgage securities, with their kinks worked out. Our children will see them as commonsensical and natural. Like jet planes and junk bonds. Our kids will be looking for new technologies to help them live better lives: they will be looking for their own chance to be surprised.

A MIXED-UP ECONOMY

The U.S. economy today is pervaded by government ownership of assets, governmental monopolies and oligopolies, and government regulation of market institutions. Often, this government presence goes relatively unremarked. Consider some of the more obvious examples that touch practically everyone. Our education system is distorted by a massive system of free school districts supported by local taxes. How bad is the distortion? In the United States, where a family lives is often driven by what the local school district is like. Isn’t that absurd, when you think about it? Our housing market is distorted by a huge tax subsidy for mortgage debt and a capital gains tax exemption for primary residences. Millions of people, who in a sane world would rent, instead own homes and today use their home as a primary investment asset because of these distortions.

Markets don't guarantee that people will act rationally.

The mixed economy has mixed-up the financial markets generally. Just to note a few examples: the poster children of the crash of 2008 were the investment banks. But these banks would never have existed in the form they did had the Glass-Steagall Act not split them off from their commercial bank parents in 1933 and created an artificial market niche that lasted 66 years. The same act created the FDIC, which in effect taxes banks and relies on the tax powers of the federal government to insure bank deposits and reassure bank customers in times of crisis. Today, banking itself is a crazy-quilt of odd institutions created by regulation: thrifts, bank-holding companies, hedge funds, and credit unions.

Any libertarian can point out that regulated commercial institutions only survive because they develop a political constituency. How many congressmen would lose votes if they attempted to repeal the mortgage interest deduction, for example? A larger number than would gain, of that you can be sure. Given this, however, regulated institutions sometimes also serve a laudable goal. Deposit insurance is an example: even in a free market, it would be good to have a compact among responsible banks to fund a deposit insurance system and subject themselves to reasonable oversight of their financial soundness. I know I would prefer to bank with firms like that.

What are we to make, then, of the hundreds of billions the U.S. Treasury is pouring into the financial markets? In a time of market crisis, the price of tradable goods can fall far below their long-term value. There are huge deals to be had, but nobody has the resources to take advantage of the situation. To stem the panic, someone needs to show that long-term value still matters. Before the creation of the Federal Reserve, leaders of the financial world would try to cobble-together a buyers’ consortium in moments of crisis, as J.P. Morgan did personally in the panic of 1907. In 2008, Treasury Secretary Henry Paulson was aping Morgan both in the kind of rescue plan he promoted and in how he organized it. In our mixed economy today, when all the actors look to the government to provide them with security, Paulson’s plan at least has the form of a temporary private market intervention. In fact, with the surge of private money flooding into Treasury bills, the government has plenty of ready finance at its command, provided voluntarily. (Of course, government debt is considered safe because it is backed by taxation, but that’s another matter.) Whether Paulson’s intervention will play out like a private one, or instead become a scene of corruption and Congressional meddling, remains to be seen.

In a free market, individual responsibility would be the watch-word of all dealings. But market failures and institutional crises would not disappear. The technology to resolve them would have to be developed by individuals working together in voluntary concert, and it would develop over generations. In our mixed economy today, we have instead social mores conditioned by the idea that the government is our insurer and nanny. Even titans of the “private sector” look to the government as the means of arranging solutions to social problems. And many businesspeople develop an amoral pragmatism that assumes that what is not banned by law is therefore permitted. In this context, it isn’t obvious how our current institutions differ from what a free society would create, and the behavior of the “private sector” isn’t always a good model of how free people would conduct themselves in a culture based in liberty.

WHO FAILED?

So, in the end, who is to blame for this mess?

It’s true that the financial institutions at the heart of the crisis failed. They failed themselves most of all, and they failed their shareholders and investors. Many house buyers failed as well, irresponsibly loading up on debt they couldn’t reasonably expect to service, gambling that property markets would go up, up, and away forever.

But for the general public, the institutions that most failed were those providing us with information and advice: The Wall Street Journal and other financial news reporting outlets; Moody’s and Standard & Poor’s; Consumer Reports… These are the private organizations we pay to provide us with critical analysis and hard-hitting investigations into the real state of affairs in the business world. In the run-up to the Iraq war, the news reporters failed to look hard enough into the claims that Iraq had weapons of mass destruction. Now, in the run-up to the crash of 2008, the reporters failed to report on the dangerous over-leveraging of the investment banks and the tremendous obligations that insurers of commercial debt were taking on. Most news sources failed, even, to call the property or commodity bubbles what they were.

But alas, perhaps because we really need to be more rational, most people seem to prefer entertaining writing to a strong track record in diagnosing the markets. Better business news reporting would require a sea-change in how business journalists are trained and in what their subscribers expect of their product. It would require that journalists receive significant training in finance and economics, rather than just in politics and history, for example. It would require an outlook that doesn’t see government action as a panacea.

The fact about markets is that they are human institutions. They have much to recommend them, but they will never eliminate risk, ban irrationality, or remove the surprises from new technologies. The fact about the mixed economy is that it contributed to the crash in certain ways, and is being used to ameliorate it in certain ways: as usual, it is all mixed up.

The crash of 2008 shook Alan Greenspan’s world-view. For my part, it shook my cultural view. I regularly expect more rationality out of the markets than they really provide. I expect more perspicacity of journalists than they really have. What this crash has taught us is that more than ever we need a culture that values reason and achievement, a culture that sees the market for what it is: the free cooperation of individuals, not a social deus ex machina.

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