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Saturday, October 25, 2008

Who Needs Evidence?

Around the corner from FEE’s offices, on Main Street in Irvington, N.Y., there’s a life-size statue of Rip Van Winkle awakening from his 20-year slumber. After reading Jacob Weisberg’s Newsweek and Slate columns this week, I feel as though I must have been asleep for an equally long time.

According to Weisberg, editor in chief of Slate, the financial turmoil taking place worldwide is the fault of . . . libertarians. That must mean libertarians have been in a position to repeal generations of deep-seated government intervention in the financial and related industries, including the Federal Reserve system. That would have taken a long time, yet I don’t recall reading that a libertarian revolution occurred in the United States. Surely it would have been in the newspapers. Hence, I must conclude that I, like old Rip, was slumbering all those years. I missed the revolution! It’s the only possible explanation.

Unless Weisberg is wrong.

But let Weisberg speak for himself: “We have narrowly avoided a global depression and are mercifully pointed toward merely the worst recession in a long while. This is thanks to an economic meltdown made possible by libertarian ideas.”

Stop laughing! As my old friend Dave Barry would say, I’m not making this up.

Weisberg thinks we need to “figure out how we got into this mess,” and I agree with him. As with any failure, he goes on, “inquest is central to improvement. And any competent forensic work has to put the libertarian theory of self-regulating financial markets at the scene of the crime.”

So Weisberg says. And now we see that Alan Greenspan agrees with him, though why we should credit the perhaps self-serving word of the man who ran the biggest anti-free-market institution imaginable — the monopoly central bank — is a mystery to me. (As for Greenspan’s allegedly laissez-faire views, see Murray Rothbard’s 1987 assessment here.)

But did self-regulating financial markets exist and hence fail? It begs the question to assume this was the case. Weisberg has to prove it. He does not even try.

No Deregulation

He shows a glimmer of perceptiveness when he writes, ” Neglecting to prevent the Crash of ’08 was a sin of omission — less the result of deregulation, per se, than of disbelief in financial regulation as a legitimate mechanism.” Actually this is the third theory floated by those who wish to blame the free market for our problems. First they blamed deregulation. When they couldn’t come up with an actual relevant example, they switched to lax regulation. And when that fell through, they turned to a failure to anticipate the need for new regulation.

Weisberg is right about there being no deregulation. The last remotely relevant act of deregulation was signed by Bill Clinton in 1999 — no libertarian revolutionary, he — repealing parts of the Depression-era Glass-Steagall Act and permitting combined investment-and-commercial banking. As others have pointed out, without this repeal, the financial markets would be worse off today.

So what is the act of omission Weisberg wishes to indict? The failure to regulate the derivatives market and the investment banks. The culprits are the allegedly libertarian ideologues Greenspan, former Senator Phil Gramm, and Securities and Exchange Commission chairman Christopher Cox.

Weisberg attributes their refusal to regulate to “market fundamentalism” (George Soros’s term). But Weisberg’s own government fundamentalism shouldn’t go unnoticed. He’s saying: If only derivatives and investment banks had been regulated, we would have avoided these problems. But as I’ve written before, what makes the pro-regulation crowd think the regulators would know what to do? Financial markets are fast-moving and extremely complex, beyond the ken of a few mortals. What are the regulators to do, dumb the markets down so the regulators can keep up? How could they do that without diminishing or destroying the good things markets provide?

One can always say there wasn’t enough regulation. Cracks in the regulatory regime and “regulatory arbitrage” (gaming the system) will always exist. By that logic, we should dispense with markets altogether and let government administrators run everything. Of course we’d then have to appoint overseers to check up on the administrators, and super-overseers to check up on the overseers, ad infinitum. Since “greed” (however defined) and corruption are human traits, regulators are as prone to them as market actors are. So the government offers us no way out of the problem. In fact, it holds its own dangers. The perception of regulatory oversight, with its implied guarantees, makes people more open to undue risk. A false sense of security is worse than none at all.

Where’s the Case?

Weisberg is a proud journalist, but he certainly did no digging in mounting his case against libertarian theory. Here’s what he writes:

A source of mild entertainment amid the financial carnage has been watching libertarians scurry to explain how the financial crisis is the result of too much government intervention, not too little. One line of argument casts as villain the Community Reinvestment Act, which prevents banks from redlining minority neighborhoods as not creditworthy. Another theory blames Fannie Mae and Freddie Mac for subsidizing and securitizing mortgages with an implicit government guarantee. An alternate thesis is that past bailouts encouraged investors to behave recklessly in anticipation of a taxpayer rescue. But libertarian apologists fall wildly short of providing any convincing explanation for what went wrong.

But wait a minute. Libertarians have sprayed a lot of electrons in cyberspace explaining how moral hazard, Freddie and Fannie, and the Community Reinvestment Act (along with other things, such as the Basel Committee on Banking Supervision) combined to create the mortgage breakdown. (Here’s a good summary by David Henderson.) The analysis has been detailed and painstaking. Yet Weisberg casually dismisses it all in this one paragraph. On what grounds does he claim that these critics have fallen wildly short of providing a convincing explanation?

Convincing to whom? Economics-impaired government fundamentalists such as himself.

Weisberg obviously hasn’t been paying attention. For him the Community Reinvestment Act, Fannie and Freddie, and past bailouts make up three separate libertarian explanations, when in fact they are all parts of a single integrated explanation of how government intervention created the problem. That he doesn’t know this suggests that he doesn’t understand the libertarian case. One ought to understand something before dismissing it.

Here’s more evidence of his lack of understanding. He correctly writes that the rigorous libertarians outside the government “are just as consistent in their opposition to government bailouts as to the kind of regulation that might have prevented one from being necessary. ‘Let failed banks fail’ is the purist line. This approach would deliver a wonderful lesson in personal responsibility, creating thousands of new jobs in the soup kitchen and food-pantry industry.”

But the libertarian argument is that if financial institutions knew that no taxpayer bailouts would be forthcoming, they would have behaved differently. Incentives matter, a point Weisberg seems ignorant of. At least he makes no attempt to refute it. (He’s also wrong to think that without the bailouts, we’d suffer another Great Depression. See this and this.)

Free Means Privilege-Free

Weisberg makes the same mistake that superficial free-market advocates make. He believes that markets, to qualify as free in libertarian theory, need only be free of government restrictions (regulation). But that is only half the story. Truly free markets are also free of privilege — guarantees, bailouts, Fed-provided liquidity, taxpayers as lenders of last resort, and so on. If you have unregulated markets but privileged, too-big-to-fail institutions, you do not have free markets. A market without full market discipline (the threat of losses and bankruptcy) is a contradiction in terms. So much for Cox’s voluntary regulation. No guarantees were withdrawn from the firms that were expected to regulate themselves. That’s phony free-market-ism.

As a matter of fact, genuinely free markets are not really unregulated. They are strictly regulated by the need to avoid losses. Thus the socialization of loss, which is what government guarantees create, is anti-market deregulation because it removes the natural incentive system that tames recklessness and the spillover harms it can produce.

Blaming the derivatives market shows the shallowness of Weisberg’s analysis. Assume that without any help from government, dubious mortgage loans were bundled along with good loans into securities and sold to investors. Assume further that some of these securities were themselves bundled to create further derivatives and that instruments (credit default swaps) insuring against losses from those derivatives were also offered for sale. Why would large numbers of investors who knew they had to absorb their own losses buy those securities without investigating their soundness? Greed is no explanation. Greedy people presumably don’t want to lose their money. There has to be a deeper explanation: the myriad government guarantees summed up by the phrase too big to fail.

Weisberg is not the only writer who has declared the free market and libertarianism dead in the wake of the subprime collapse. One sees a certain desperation in such declarations — as though those issuing them fear that people might start realizing that today’s economic turmoil is not a market failure but a government failure.

  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.