Popular opinion assigns blame to greedy capitalists and a market gone wild for the financial crisis. The remedy for those who hold that view is government bailouts, fiscal stimulus and regulation. Even the head of the world's freest economy, Hong Kong Chief Executive Donald Tsang, said in his annual policy address, "When the market fails, the government should be prepared to intervene in a timely and decisive manner."
When the history of this crisis is written, it could be a story of the death of market liberalism and the ascent of market socialism. Yet the truth is that the source of the crisis was not private free markets, but markets tainted by mistaken government policies designed to satisfy special interest groups.
U.S. monetary policy was too loose for too long, an error Alan Greenspan has still not admitted; government privileges bestowed on Fannie Mae and Freddie Mac, especially the implicit (now explicit) guarantee backing their debt, politicized the flow of capital, increased risk-taking and fueled overinvestment in the housing sector; and rating agencies and regulators who were supposed to monitor risk-taking were asleep at the wheel.
Markets require an institutional framework in which private property rights are well-defined and risk is clearly assigned. The purpose of regulation should be to ensure that those who take risks bear the full cost of them and can capture the full reward from them. Competition is the best device to discipline private traders and investors. Often, however, regulation reduces or outlaws competition and imposes rules thwarting market forces and individual responsibility.
Government failure, not market failure, would be a more accurate description of the subprime/credit crisis. There would have been less risk-taking and more market discipline if Congress had not guaranteed Fannie and Freddie debt and had not passed the Community Reinvestment Act, which pressured banks to promote subprime and Alt-A mortgages. Moreover, by holding the Federal funds target rate at 1 percent from July 2003 to June 2004, the Fed fueled the housing boom.
With the large bailouts now occurring, the mistakes made in underpricing risk and overextending credit will be felt by present and future taxpayers. The socialization of risk and the privatization of profits is always a recipe for disaster. It undermines the rule of law and economic freedom by weakening private property rights. When investors believe government will bail them out, they increase their risk-taking and leverage, just as Bear Stearns and other large investment banks did. And when foreign central banks know that the U.S. Treasury stands behind the debt of government-sponsored mortgage lenders, there will be an artificially large market for their securities.
The problem with Treasury Secretary Henry Paulson's plan for resolving the subprime crisis by taking an equity stake in the troubled firms is that it substitutes public for private ownership. Hence, it shifts responsibility from those who made poor investment decisions and took on too much risk to those who did not. A little-discussed consequence is to severely undermine the moral basis of a free market — the ethic of individual accountability.
The $700 billion bailout plan — the Troubled Assets Relief Program — was planned to have the Treasury purchase toxic assets, in addition to injecting new capital into financial institutions. But why should we expect government bureaucrats or their agents — who are spending other people's money — to discover correct asset values? More likely, the Treasury will pay inflated prices and fail to maximize taxpayer wealth.
Without private ownership, there can be no real markets to determine asset values. That is a forgotten lesson Nobel laureate economist F. A. Hayek underscored in his criticism of market socialism.
The fear, of course, is that without widespread government support, capitalism would collapse. But as L. William Seidman and David Cooke, former officials at the Federal Deposit Insurance Corp., note, "In our experience, government ownership and management of assets rarely increases value. Moving assets openly, fairly, and promptly to sound private-sector owners is the best way to minimize taxpayers' losses."
To restore liquidity to markets means to restore trust — both in the actuarial models used to price complex securities and in the guarantees made in private contractual promises. Before credibility can return to financial markets, however, there must be a restoration of confidence in government as the protector and guarantor of our economic liberties. That is the real challenge — not only for president-elect Barack Obama and the incoming Congress, but for all those who wish to preserve economic and personal freedom.