Monday, October 20, 2008

Best Article on the Financial Crisis Bar None

Eamonn Butler writes, 21 October, in The Australian (Canberra) HERE:
“No such thing as a free lunch”

"WITH turmoil in the world's markets, politicians and commentators have been demanding more regulation and control of the financial sector. Kevin Rudd even says it was caused by extreme capitalism. Their reaction is predictable, but entirely wrong.

This crisis was not caused by capitalism being fatally flawed. It was caused by politicians forcing the banks to give out bad loans, monetary authorities flooding the West with cheap credit and regulators being asleep at the wheel.

Indeed, one can date its origin precisely, to October 12, 1977, when US president Jimmy Carter signed the anti-redlining law. Before then, lenders generally denied loans to people in poor neighbourhoods, believing that the local mix of low incomes and a weak housing market would lead to many people defaulting. But the politicians -with good intent - wanted to make home ownership available to all Americans. So lenders were forced into giving out risky mortgages, what we call sub-prime loans.

By 1985, this torrent of bad business had nearly bankrupted the US's savings and loan institutions. So the government took on their bad debt and encouraged them to consolidate, unwittingly making them too big to be allowed to fail.

Meanwhile, several other problems worried the monetary authorities. In 1987, the US stock market plummeted, fearing that other lenders could collapse. There have been other successive crises. Asia's markets sank. Mexico, Argentina and even Russia defaulted on their loans. Over-valued dotcom stocks crashed. Then there was 9/11. Each time, Western authorities responded by flooding the markets with cash.

After 9/11, the Federal Reserve took US interest rates down from 6.25 per cent to just 1 per cent, fearing this blow to investor confidence could sink the markets. But, again, its action boosted the wrong market by sustaining the credit bubble.
With loans six times cheaper, mortgage applications soared.

Lenders, awash with the Fed's cash, happily issued more sub-prime loans. With more people buying homes, house prices soared. Buying a house seemed a certain money-maker, so more people got more loans and bought more houses, continuing the spiral.
In London, that other great financial centre, a decade of government overspending saw public debt soaring. Private debt and house prices soared even faster.
So for 10 years, economies boomed, the champagne flowed and everyone had a great party. But it was financed by fake money, printed by the authorities solely to keep the party going. When the realisation broke, the long party turned into the inevitable hangover we suffer today.

The regulators, meanwhile, were unconscious on the floor. The US mortgage institutions, Fannie Mae and Freddie Mac, had 200 regulators on their case but still went bust for $US5 trillion. These semi-governmental companies allowed investors to believe the bad mortgages were guaranteed by government, causing credit rating agencies to give their dodgy bonds high scores.

Mortgage lenders repackaged these bad debts across the world, but nobody cried foul. Institutions were lending 30 times their asset base. Though the Bank of England knew that the huge mortgage lender Northern Rock was failing, the 2500 staff of Britain's financial regulator seemed to do nothing until it collapsed six months later. Even then, they had no coherent plan.

When the government is persuading the casino to hand out free chips and the regulators are standing drinks at the bar, you shouldn't be surprised if the customers place a few risky bets. It's the management, not the system, that deserves our scorn for breaking the basic rules of economics: there ain't no such thing as a free lunch.

Any sustainable solution has to get finance back to those basics. But the bailout package includes so many treats for special interests that it could save the culprits without helping the victims.

But it's a big world out there. China, the world's fourth biggest economy, continues to grow at nearly 10 per cent. India and other emerging economies are expanding, too. Even with the West in recession, world growth next year will probably be near 4 per cent. That's pretty good.

Western capitalism has been dealt a severe blow by inept politicians and officials. But global capitalism continues to pull hundreds of millions of people out of poverty. It's a great system. Let's not break it.”


I have reproduced it in full – risking my relations with the good folks at The Australian (er, I always support Australia against the English at Rugby…).

It summarises the current crisis and points the finger at the real culprits. Readers may wish to circulate it in their own blogs and ask their readers to do likewise (don’t forget to credit it to The Australian newspaper, among Australia's best newspapers).

Eamonn Butler is director of the Adam Smith Institute and author of Adam Smith: A Primer (2007, IEA, London), and The Best Book on the Market (2008, Profile Books, London).


Blogger Voice of the GOP Grass Roots said...

Same story, different year. 1819, 1892, 1928, 1974. Banks fail, other banks or governments bail them out, severe recession or depression follows. Also the names change, Monroe and Crawford, Norman and Strong, Bush and Paulson. If people actually understood laissez faire, this wouldn't happen.

6:09 pm  
Blogger Aran Lawrence said...

Perfect. Inept bureaucrats always blame capitalism for the problems they create.

8:02 pm  
Anonymous Anonymous said...

So the bottleneck is in defaulting loans - why not have the gov't just make the monthly payments directly on these short loans and take a percentage ownership instead? Seems to me it's better to subsidize individual people instead of big rich corporations... at least this way the wheels keep turning even if inflation goes up...

2:53 am  
Blogger Arnold Thompson said...

Capitalistic NeoCons trying to pass the blame. Any student of the markets knows that free market capitalism is fatally flawed. History is replete with booms and busts. They are all caused by the greed and fear of the market participants. No one forced anybody to create, sell and buy a Credit Default Swap.

Capitalism is inherently unstable. It is not a utopian theory of everything economic. Capitalism is sloppy and imperfect. Capitalism is a reflection of human nature and we all know the failings of man don't we?

Free Market Capitalism is an abomination to reality. In the real world, all that matters is who has the leverage. That's it, in it's simplest form. Whoever has the leverage wins. The Free Market is just there to manipulate. That is human nature as it is practiced today.

Now if you want fairness and morality, you need rules, enforced level playing fields. But NeoCons hate this. NeoCons want the law of the Jungle, a dog eat dog world. Yea, and no modern society will ever evolve out of that kind of chaos. It will be in a constant flux of destructive capitalism through booms and busts.

4:59 am  
Blogger Gavin Kennedy said...

arnold t

What again, this time on a changed horse? (see the comment on the previous Lost legacy post and my response).

You are a troll, or perhaps, being kind,a mightily confused person

Have a nice day.


7:03 am  
Blogger RD said...

The problem is investors' assuming that no matter the downside risk inherent in mortgages being issued, voters would force the government to backstop the mortgage market and industry. voters see their ability to buy a residence with borrowed money as a fundamental prerogative of contemporary life. Hence investors perceived the mortgage market as "too sacred to be allowed to fail," and therefore enjoying a tacit government guarantee. And recent events have shown that investors were partly correct. This is how I explain that banks as sophisticated as UBS got sucked into the financial maelstrom.

Two weeks ago, the Economist reported that Fannie Mae and Freddie Mac were
buying mortgages as large as 625K, and with downpayments as small as 3.5%. When will they ever learn? The financial crisis will persist until mortgage lenders go back to the situation of the 1950s and 60s, namely a minimum downpayment of 20% for the salaried and 35% for the self-employed. This and more have been the norm in continental Europe for yonks.

I have time for the aggressive use of monetary policy to blunt a recession, as was done in 1987 and 2001-03. But such lax monetary policy should be paired with the central bank having the power to set minimum downpayments on real estate and car purchases. Otherwise moral hazard will rule the roost.

The 20th century will come to be seen as the century during which the human race learned slowly and painful how to deal with fiat money. The current central banking consensus emerged around 1990, and soon thereafter this struggle appeared to have been won. The optimism was premature. The Crisis of 2008 sends at least one clear message: Back to the Drawing Board. Financial intermediation resistant to stupidity and robust to shocks still eludes us.

8:37 pm  
Anonymous Anonymous said...

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3:55 am  
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12:58 pm  

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