Wednesday, July 23, 2008

The Market and the Crash

I have been reading several articles, and comments, over the last couple of months in which 'the market' is being blamed for the mess that the world economy has fallen into. There are calls from every direction for more regulation of markets in general, and the banking system in particular.

The first problem with such calls is that they start from false assumptions. For example, many people suggest that the current problems originate in the sub-prime crisis in the USA. The interesting thing here is that the US market for mortgages is not a free market at all. As anyone reading the unfolding Fannie Mae and Freddie Mac story will know, these two US mortgage giants have benefited from an implicit government guarantee of their security. In particular that guarantee has allowed them to raise money in the market place at cheaper rates, as well as allowing them to operate with levels of capital that would otherwise have rung alarm bells.

One interesting part of this story, which I have not yet read in any of the commentary, is that the presence of these two state guaranteed mortgage lenders may be one of the reasons for the sub-prime crisis. The interesting thing is that the market for non sub-prime markets was dominated by these two institutions due to their ability to raise finance cheaply. Financial institutions that wanted to compete with these two institutions could not raise money as cheaply, and would therefore find it difficult to compete in this market. In this situation, the only mortgage market that was open to genuine competition was the sub-prime market. For financial institutions wishing to enter the mortgage market, the only place to go was therefore markets that were not dominated by these institutions - sub-prime (the story is complicated by the fact that Fannie Mae and Freddie Mac were also indirectly buying into the sub-prime market, but that is not the issue here).

The important point to note is that there was no free market in mortgages in the United States, and that the presence of Fannie Mae and Freddie Mac may have indirectly been a push for lending into sub-prime.

What of the banking crisis in broad terms? Surely this is a case of the free market getting it wrong?

Once again, if we look at the current crisis we see that it has taken place in a time when the banking system has been highly regulated. It is not a free market, but a highly regulated market. All of the current problems have taken place under the regulatory environment created by the Basel Accords, which required banks to meet capital adequacy ratios. These accords were inspired by a bank failure, and were supposed to make the banking system safer. They were all about regulation of risk, and the calculation of capital adequacy, which was supposed to prevent banks getting into trouble.

So how is it, in the most stringent regulatory regime in history, that there is now a banking crisis unfolding? The first problem is that the regulations were, in part, responsible for the emergence of SPVs, SIVs and CDOs, which were very useful ways for the banking system to take high risk positions, whilst still meeting the capital adequacy ratios. In other words, the regulatory regime was one of the main reasons for the emergence of new methods, which were actively used to bypass the regulations, and led to the current crisis.

There is a fundamental problem with regulation. It is always going to be an unequal battle. On the one hand you have the banks able to recruit and finance the best and brightest, and on the other you have the regulators endlessly trying to keep up with (and regulate) the innovations of these agile and clever banks. Whatever regulations are created, there will always be ways around them. Furthermore, there is also a fundamental problem with regulation in any event. How do you value assets and risk? Two years ago, property was a safe investment. Today it is not. Who decides what is safe and unsafe? And how?

The trouble with regulation is that it creates a false sense of security, and this false sense of security encourages complacency. If a bank meets the regulators requirements, then it must be sound, right?.....right up to the point where it falls over....

The fundamental problem is that, whatever system is created, someone will find ways to game the system. The more secure that everyone feels, the less everyone looks at the fundamentals of the activity. In such a system, there is more likely to be a major crisis, as everyone believes that the system is under control.

There have always been bad investments, such as the 'Tulip Mania' or the 'South Sea Bubble'. The single defining commonality of bubbles is 'money for nothing', 'no risk' and old fashioned greed. As long as their is a lust for money for nothing and greed, nothing will ever stop such bubbles occurring. Any capitalist system will allow bubbles to form in some way or another. There is always someone out there finding new ways to exploit greed, offering high returns for 'no risk'. Regulation offers banks the opportunity of suggesting that they are safe, and 'no risk' institutions, and that false confidence has allowed the banks to reach the current point of crisis.

Today, rather than accepting that regulation does not work, there are now cries for more regulation. However, if we look at the history of regulation, we find that for each crisis, there are proposals for more regulation. Despite this, crises continue to occur.

At what point will there be sufficient regulation for the avoidance of another crisis? How many new and complex rules will it take?

This is not to say that a light regulatory regime will avoid crises. The difference is that, in a light regulatory regime, people are more likely to heed the ancient advice of 'buyer beware', and scrutinise their investments more carefully. Whilst, inevitably, there will still be crises, they are more likely to be found sooner, rather than later. The crises will be more frequent but of less severity. Each small crisis would be a reminder that there is no such thing as 'risk free' investment.

If we look at the current problems, it is not the free market that has created the problems, but rather it is the regulation that has largely caused the problems. The underlying greed that always causes problems is a factor, but the degree of this particular crisis has been magnified by the false confidence of regulation.

This idea can be summarised as follows:

The more free the market, the less the likelihood of systemic risk.

Note: Much more could be said on this subject but, as ever, I am forced into a short post due to time constraints. If you doubt what I am saying, then take a look at the history of Basel, and regulation in general, and just keep asking yourself why it is that we keep on having crises when there is more and more regulation. In other words, if regulation stops crises, then why do they keep on occurring?

1 comment:

  1. Yes, but I can still imagine the ultimate free marketeer. He would be the businessman who finally managed to 'own' everything: all the land, all the houses, all the water, all the fuel. The people would have to do whatever he required in order to survive. Isn't that the logical conclusion of an unregulated free market?

    The ultimate free marketeer doesn't exist, but in recent years, miniature versions have engineered a situation where young people start their working lives in debt, with no prospect other than toiling for the rest of their days for a worthless, parasitic landlord class. And even if the market somehow accidentally 'corrects' that situation in the future, the damage caused to some people's lives will never be repaired. In the UK we had a situation where a person who hesitated to buy a typical first house in 2000, and waited until 2005, say, was faced with the prospect of paying an extra £300 a month in mortgage costs for the next 25 years. Their friends would discuss retiring at 50, based on their housing bonanza, while the unfortunate late purchaser would contemplate working until they were 70. Quite a punishment for perhaps being *more* perceptive than their friends and working out that a recession was about to strike, which the government merely postponed until shortly after they *did* buy that house 5 years later (because they couldn't stand not having a home of their own any longer and nothing to do with 'investing')

    Even if a different system (real progressive taxation?) meant that we were all a little poorer on average, I am sure we would be a better society.

    Rant over!


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