Sunday, December 19, 2010

The Moral Case for the Free Market in the Light of the Financial Crisis (Part II)

In a previous article I outlined the moral basis for the premise that free market economics are the optimal option for economic development. I also argued that -in the light of the financial crisis-the rationale behind these arguments has been significantly challenged. Indeed, the solution to the crisis-that of collectivising risk-not only confirms moral hazard but actively encourages it in future.

 Capitalism doesn't work unless the capitalists and the capital issuers (the banks) are both working under competitive conditions benefitting from Adam Smith's invisible hand but always managing the risk of his slap. Unfortunately one side of the capitalist equation (the banks) has not been working under this premise in recent years.

It's time to look at the scorecard in terms of the arguments outlined earlier and, see how they have fared.

The Argument from Materialism

The strongest moral defence for bailing out the banks was that it would eventually make the environment better for everyone. I think the logic is indisputable, in that as total collapse of the banking system would shave benefitted no one. However, this argument comes with significant caveats. The principle is that all would benefit and that there would not be a significant transfer of wealth and resources from one group to another via collectivisation and redistribution. Unfortunately, this has not happened.

The reality is that significant risk has been transferred to the public from the banking system. Central \banks took on toxic assets. Sovereign Debt Fears have exposed peripheral Europe to significant drags on growth that affect everyone. Furthermore, the actions of the Central Banks have, thus far, ensured that whilst the banking sector has been recapitalised and their staff are enjoying the benefits, they feel the need to hoard cash. In a sense, the banks are doing exactly what they did before the crisis. In other words, taking the benefits and rewards whilst passing on the risk to the taxpayer. They are parlaying the system in a zero sum game that is directly hurting the populace at large.

For example, the UK banks according to the CEBR, they paid their staff £7bn in bonus. Saviles (the upmarket real estate agent) estimate that £1.6bn of this will go into the London housing market. Meanwhile, the UK has loaned the Irish £7bn in order to help out their Sovereign Debt crisis, ostensibly so that it doesn't hit the UK banks.

These actions (by the banks) are the height of irresponsibility. They know full well that the Sovereign Debt on their balance sheets (remember that the risk to public debt increased by taking on banks toxic assets) threatens their capital/asset ratio, so why are they awarding themselves bonuses?

 So, in conclusion, the UK taxpayer has increased risk, higher taxes and now higher house prices to pay thanks to a redistribution of return and risk.

The Epistemic Argument for the Market
Libertarian defenders of this argument will argue that the banks should have been allowed to fail and, that this is part of the process. However, the problem with this argument is that it doesn’t devolve the free market system from the responsibility of creating the financial crisis in the first place. Moreover, allowing the banks to go bust was simply not an option.
The banks and their employees were incentivised, under guiding principles of self interest, in order to maximise profits. Unfortunately, this profit maximisation came at the expense of the taxpayer, the shareholder and the economy at large. The people garnering excessive rewards were not exposing themselves to the risk. In fact, the greater risk was in not complying, because if the employees didn’t take part in the game, then they could have lost their jobs.
The essence of the problem is that the banks were leveraged and all following the same directional strategy. The forces of competition rely upon accountability and also on the fear of failure. It relies upon large companies acting under the same conditions of competition as the smallest entrepreneur is subject to. None of these conditions applied.
Indeed, if we go back to the arguments postulated by the Austrian School over the difficulties of simulating market pricing, we get to a curious irony. Many of the banks were arguing that they didn’t need to engage in mark-to-market pricing of their CDO’s because the market was artificially pricing them lowly and, forced selling would only exacerbate the problem. Similarly, they spent large parts of 2008, trying to justify loss provisions based on their own assumptions of the housing market. In a sense, they repeated the inevitable errors of centralised pricing.
They did so, despite being guided by market competition.

The Argument From Autonomy
As discussed previously, much of this argument is rendered complicated by definitive arguments over positive and negative liberty. Assuming that ‘autonomy’ means needs can be satiated; we see that the question posed here can be defined as, autonomous to do what?
If we accept that we can define satiable needs, and start out to do so, I think that it could be argued that employment, housing and raising a family are all essential aspects of the ‘good life’. It is hard to argue that this autonomy has increased over the last few years. Not only have the redistributive aspects of Government policy (as outlined above) reduced the material prospects for all, but they have also entrenched the vested self interests that actively deny young people the opportunity to do this.
The Government has allowed the banks to game the system and made the conscious decision that, the solution to the problem was ‘more of the same’. They have artificially supported the banking system and the UK housing market. There remains an undersupply of housing in London and South East. 
It need not have happened like this. The opportunity was there to generate growth by relaxing planning restrictions in London. Such action would have produced GDP growth, employment, and made housing more affordable in the areas where people actually want to live. Instead a decision was made to shore up the wealth of a select few in the UK by continuing to artificially rig the London housing market.
It should not be lost on the reader that the beneficiaries of these actions are-in many cases-the self same people that benefitted from the creation of the financial crisis. In 2008, a Savile’s strategist informed me that around 25% of overseas high end (houses £4m and above) where overseas bankers working in the UK.
None of these actions has increased the autonomous options available to most.

The Argument From an Increasing Intellectual Quotient
The desire of the banking industry to ‘intellectualise’ their activities in respect of replacing good ol’ fashioned lending from customer deposits, towards reliance on short term wholesale funding was a serious defect of the system. Similarly, the creation of ‘off-balance’ sheet accounting which enabled the banks to take on significant directional leverage helped create the ensuing crisis.
This ‘intellectualisation’ was anything but intellectually enhancing. In fact, it was a shabby and reckless attempt to maximise short term profits which ultimately ended up in a collectivisation of the losses due to it.
The aftermath of the crisis has brought about an increasing focus by regulators to discourage this kind of financial engineering with derivatives trading. Whether, they will be successful or not is another question.

Creation, Globalisation and the Poor
The last three arguments are best dealt with in one section. Firstly, it is undoubtedly true that free markets engender greater creativity. However, as we have seen, this creativity can sometimes be channelled towards destructive or exploitative purposes which curtail others creativity. The banks gamed the system to the taxpayers’ expense. This is not an act of ‘creativity’ worthy of the name.
Globalisation as actually made the situation worse. It has encouraged greater correlation of markets and therefore amplified the risks when things go wrong. I wonder out loud whether the Asian Financial Crisis (97-98) will be the last major regional crisis not to significantly affect the global economy in a synchronised and coordinated manner.
As for the poor, I fail to see how the redistribution of resources and wealthy that has, knowingly, taken place as a result of bailing out the banks, has in any way contributed to social mobility or advantage to the poor. On the contrary, unemployment is still very high in the States (the US is not a country structured with a welfare system to deal with these problems) and remains persistently high in Europe.

The narrative of this article has been consistently negative. I make no apologies for that. The behaviour of the banks is morally unacceptable. Moreover, regulators are at fault for not upholding the same standards of free market accountability on the banks as they would for anyone else. Whilst the libertarian approach is exposed as a fallacy, it does not mean that the morals and principles of the free market are not the optimal approach. However, they only acquire moral validity by their actions and their results.
The solution to the problems engendered by allowing banks to operate under ‘free markets’, seems to inevitably end up in collectivising and redistributing resources towards them. Therefore, it is better to take collective action before hand, in order to make them directly accountable for their actions. The libertarian approach fails and the moral arguments in favour of it are bankrupt. ‘Too Big To Fail’ is not an option anymore.

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