The Regulation of the Mixed Economy in Action
Both the highly-intelligent Martin Wolf and the highly-intelligent David Wessel, I think, overstate the importance of what has happened in financial markets this month. Both of them--very smart as they are--talk as if there has been a big shift: an end to laissez-faire in financial markets: as if the Federal Reserve's discretionary actions to try to stabilize markets mark "the day the dream of global free-market capitalism died" or "the time the U.S. government discarded a half-century of rules... [o]n the Richter scale of government activism, the government's recent actions don't (yet) register at FDR levels.... But something big just happened."
From my perspective, at least, there never was such an animal as laissez-faire in financial markets. In my first semester as a graduate student I listened to Charlie Kindleberger talk about how as long ago as 1844 it was settled doctrine that a market economy should have a central bank, and that that central bank should exercise its discretion within broad boundaries in times of financial crisis.
Consider Robert Peel, Charlie lectured. Karl Marx and Friedrich Engels hated Robert Peel:
Marx and Engels: Neue Rheinische Zeitung Revue: Peel himself has been apotheosized in the most exaggerated fashion... One thing at least distinguished him from the European 'statesmen' -- he was no mere careerist.... [T]he statesmanship of this son of the bourgeoisie... consisted in the view that there is today only one real aristocracy: the bourgeoisie.... [H]e continually used his leadership of the landed aristocracy to wring concessions from it for the bourgeoisie... Catholic emancipation... the reform of the police... the Bank Acts of 1818 and 1844, which strengthened the financial aristocracy... tariff reform... free trade... with which the aristocracy was nothing short of sacrificed to the industrial bourgeoisie.... His power over the House of Commons was based upon the extraordinary plausibility of his eloquence. If one reads his most famous speeches, one finds that they consist of a massive accumulation of commonplaces, skillfully interspersed with a large amount of statistical data...
British Prime Minister Robert Peel was--Charlies went on to say--the very creator of the "night watchman" state itself: the creator of the London police force, and thus of the idea that one could rely on the state rather than on community self-help refereed by royal judges to protect one's property (police in England are not called "Bobbies" by accident). Yet as Peel put it in 1844 in the debate over the Bank of England's Charter (Anno Septimo & Octavo Victoriae Reginae CAP XXXI), it was vitally important to set out rules for the operation of financial markets that minimized the potential for moral hazard, but equally important that it be understood that the central bank have the role of suspending those rules to take immediate action. Even though Peel was confident that the Bank Charter Act of 1844 was well-designed and "that we are taking all the precautions which legislation can prudently take against the recurrence of a monetary crisis":
Kindleberger quoting Peel: [Nevertheless, a crisis] may occur in spite of our precautions, and if it does, and if it be necessary to assume a grave responsibility for the purpose of meeting it, I dare say men will be found willing to assume such a responsibility. I would rather trust to this than impair the efficiency and probable success of those measures by which one hopes to control evil tendencies in their beginning, and to diminish the risk that extraordinary measures may be necessary...
Kindleberger characterized Britain's mid-nineteenth century handling of financial crises as a "Machiavellian device": the Bank of England would, in crisis, break the law and support the markets
but only after receiving a Letter of Indemnity from the Chancellor of the Exchequer stating that [the Bank] would not be prosecuted for its violation of the law.... As is widely known, the Letter of Indemnity in 1848 and 1866... so calmed the market that there was no need of [market support]... and... in the crisis of 1857 the excess was very small...
Thus supposing we could summon back from the grave Robert Peel himself and ask him what he thought of the Federal Reserve's actions, he would say "of course this is what you do."
Why, then, are Martin Wolf and David Wessel with their Krell-like brains surprised at the fact that the Federal Reserve is composed of men (and women) willing to "assume a grave responsibility for the purpose of meeting" a financial crisis?
I think that they are surprised because they--at some level--drank the koolaid, breathed in the miasma, were deranged by the effluvia of the vast right-wing conspiracy--the "drown the government in the bathtub" types. The argument against progressive income taxation requires a claim that the rich don't need any help from government, and is fatally undermined by any admission that the rich stand to benefit from the safety net as much--nay, enormously more in dollar terms--than the poor. But, as Robert Peel would put it, in financial matters the question is never laissez-faire vs. regulation, but always good smart regulation vs. bad stupid regulation.
Martin Wolf:
The rescue of Bear Stearns marks liberalisation's limit: Remember Friday March 14 2008: it was the day the dream of global free-market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over....
Mine is not a judgment on whether the Fed was right.... Mine is more a judgment on the implications of the Fed's decision. Put simply, Bear Stearns was deemed too systemically important to fail.... The implications of this decision are evident: there will have to be far greater regulation of such institutions.... The lobbies of Wall Street will, it is true, resist onerous regulation of capital requirements or liquidity.... But... their position is now untenable. Systemically important institutions must pay for any official protection they receive. Their ability to enjoy the upside on the risks they run, while shifting parts of the downside on to society at large, must be restricted. This is not just a matter of simple justice (although it is that, too). It is also a matter of efficiency....
I greatly regret the fact that the Fed thought it necessary to take this step. Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion....
If the US itself has passed the high water mark of financial deregulation, this will have wide global implications.... These longer-term implications for attitudes to deregulated financial markets are far from the only reason the present turmoil is so significant. We still have to get through the immediate crisis. A collapse in financial profits (so significant in the US economy), a house-price crash and a big rise in commodity prices are a combination likely to generate a long and deep recession....
These are perilous times. They are also historic times. The US is showing the limits of deregulation. Managing this unavoidable shift, without throwing away what has been gained in the past three decades, is a huge challenge. So is getting through the deleveraging ahead in anything like one piece. But we must start in the right place, by recognising that even the recent past is a foreign country.
David Wessel:
Ten Days that Changed Capitalism: The past 10 days will be remembered as the time the U.S. government discarded a half-century of rules to save American financial capitalism from collapse. On the Richter scale of government activism, the government's recent actions don't (yet) register at FDR levels. They are shrouded in technicalities and buried in a pile of new acronyms. But something big just happened... without an explicit vote by Congress... billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess. "The Government of Last Resort is working with the Lender of Last Resort to shore up the housing and credit markets to avoid Great Depression II," economist Ed Yardeni wrote to clients.
First, over St. Patrick's Day weekend, the Fed (aka the Lender of Last Resort) and the Treasury forced the sale of Bear Stearns, the fifth-largest U.S. investment bank, to J.P. Morgan Chase.... To induce J.P. Morgan to do the deal, the Fed agreed to take losses or gains, if any, on up to $29 billion of securities in Bear Stearns's portfolio.... Then the Fed lent directly to Wall Street securities firms for the first time. Until now, the Fed has lent directly only to Main Street banks.... In the first three days of this new era, securities firms borrowed an average of $31.3 billion a day from the Fed.... Republican Treasury secretary leaned on two shareholder-owned, though government-chartered, companies -- Fannie Mae and Freddie Mac -- to raise capital that their boards didn't want to raise.... Fannie and Freddie... accounted for 76% of new mortgages in the fourth quarter of last year, up from 46% in the second quarter... if Fannie or Freddie stumble, taxpayers will get stuck with the tab. And then, the federal regulator of the low-profile Federal Home Loan Banks, which are even less well capitalized than Fannie and Freddie, said they could buy twice as many Fannie and Freddie-blessed mortgage-backed securities as previously permitted -- more than $100 billion worth....
[T]he clear and present danger that the virus in the housing, mortgage and credit markets is infecting the overall economy is too great to ignore. The Great Depression was worsened because the initial government reaction was wrong-headed. Federal Reserve Chairman Ben Bernanke spent an academic career learning how to avoid repeating those mistakes.
Is it working? It is helping. One key measure is the gap between interest rates on mortgages and safe Treasury securities.... The gap remains enormous by historical standards, but has narrowed. On March 6, according to FTN Financial, 30-year fixed-rate mortgages were trading at 2.92 percentage points above the relevant Treasury rates; Wednesday the gap was down to 2.22. Normal is about 1.5 percentage points.... Is it enough? Probably not....
The case for doing more is twofold. One is to cushion the blow to families and communities, even if some are culpable. The other is to disrupt a dangerous downward spiral in which falling prices of houses and mortgage-backed securities lead lenders to pull back, hurting the economy and dragging asset prices down further, and so on.... So the next step, no matter how it is dressed up, is likely to involve the government's moving in ways that put a floor under prices, hoping that will limit the downside risks enough so more Americans are willing to buy homes and deeper-pocketed investors are willing, in effect, to lend them the money to do so.
