Does the financial crisis discredit libertarianism?

Ilya says no; others say yes. The question is not a good one, however, because libertarianism, in any meaningful philosophical sense, hasn’t influenced financial policy in decades. One might as well ask whether the financial crisis has discredited Jeffersonian republicanism or nineteenth century rural populism.

The real question is whether the financial crisis has discredited the pro-market, deregulatory movement in a general sense, or banking deregulation in particular. Neither Weisberg nor Huffington know enough to answer this question, which is extremely complicated, and will be the subject of debate for decades. A few preliminary thoughts here:

1. Americans reject unregulated banking, as have people in every country around the world. A truly “libertarian” or free market system would lack deposit insurance and a central bank—a system that existed in the United States in the nineteenth century. Such a system is certainly possible—it did exist—and it may even be optimal in some long-term-we’ll-all-be-dead sense. But it creates extraordinary volatility that people greatly dislike. If you lend to (that is, deposit with) an unregulated bank, you might get a good interest rate, but you have no remedy if the bank becomes insolvent. This gives rise to bank runs, financial contagion, and panic. Most people simply don’t want to take the chance that the place where they park their money will vanish and take their funds with it; hence the popularity of the government guarantee. In addition, because banks borrow from each other, the collapse of one can lead to the collapse of others, drying out credit, and harming the real economy. A government backstop is and has been political bedrock for decades. The government acts as lender of last resort through a central bank, depository insurance, and the rest. No serious person rejects this system in any modern economy.

2. If you have government-supplied insurance, then you have to have government regulation of people’s financial activities. There is no way to avoid this conclusion. In a world without such regulation, banks would make excessively risk loans because they get the upside and the taxpayer bears the cost of the downside. Banks would also keep insufficient capital on hand to pay off depositors. And depositors, unlike ordinary creditors, would have no reason to investigate banks and ensure that they are operated safely. Although many people have criticized Depression era banking regulation—especially the constraints on the geographic reach of banks and the division between regular and investment banking—no serious person denies that if the government insures banks, then it must regulate them. The least controversial type of regulation is the minimum capital adequacy requirement, which obliges banks to keep a certain amount of cash or other liquid assets on hand to meet spikes in withdrawals. Unfortunately, there is nothing simple about these rules: in principle, the amount of capital kept on hand should be a function of the riskiness of the bank’s portfolio. In practice, this is hard to do. But the basic principle is undisputed.

3. Over the years, there has emerged an academic and political debate about the optimal amount of banking regulation. Again, no serious—or, at least, influential—person taking part in this debate has disputed the need for some kind of insurance or lender-of-last-resort function. And no serious person has disputed the need for restrictions on what banks and other financial institutions that benefit from insurance can and cannot do. The debate was about a matter of degree. One camp believed that existing regulation was excessive; another camp believed that existing regulation was either adequate or insufficient. The two sides converged on many issues: for example, geographical restrictions did not reduce the riskiness of banking but in fact made it harder for banks to spread risks. So both sides could agree on this type of “deregulation.”

4. The current financial crisis suggests, to the extent that one can draw inferences from one observation, that deregulation did go too far. Regulators and (probably) market actors appear to have overestimated the extent to which people could protect themselves from risk by purchasing various types of credit insurance on the market and in other ways diversifying their assets. Regulators may, alternatively or in addition, underestimated the extent to which government insurance caused people to engage in risky behavior by taking advantage of financial innovations that allowed them to evade minimum capital requirements and other regulations—on banks, insurance companies, and investment banks. If you are more heavily regulated if you own 30 years loans and less regulated if you own equivalent mortgage-backed securities, then you will sell the former and buy the latter, and take on more risk. There is certainly reason to think that some tweaking, perhaps serious tweaking, is in order. But it is tweaking nonetheless.

5. As Ilya notes, the Bush administration did contribute to the crisis, but not by promoting free market ideology or “libertarianism.” Instead, it foolishly advocated what it called an “ownership society,” one in which people would be encouraged to own homes (and health care accounts and retirement funds), through, as it turned out, artificially cheap credit, subsidies, and the like. There is no reason in the world to think it is better, in some abstract sense, to own your home than to rent it—any more than it is better to own DVDs than to rent them from Netflix. For some people, ownership is better; for others, renting is better. There was tremendous intellectual confusion here: there is a difference between helping the poor (for example, by giving them money) and rearranging the legal relationship between them and the goods and services they use (for example, paying them to own rather than rent). The main effect of this policy was to subject lower-income people to more risk—of the upside, to be sure, but also of the downside. When the housing bubble pops, and the economy tumbles into recession, any serious commitment to the idea of ownership requires that our new owners suffer their losses. But the Bush administration could not sustain the harsh implications of its philosophy, especially because it was complicit in encouraging people to take on risk who might otherwise have been more cautious.

The Bush administration pursued a two-track policy, then, one that both cut back on financial regulation and channeled financial activity toward the housing sector. The latter most definitely contributed to the financial crisis, though it is unclear how much. The former may well have but this question is even more difficult. Deregulation may have been hasty or ill-considered; that is not the same thing as saying that it could have been done better, and that therefore the lesson of the financial crisis is not that deregulation is bad but that the particular deregulatory approach of the Bush administration (and Congress, and the Clinton administration, etc.) was poorly thought out—a point that could be made about the deregulation of the S&L industry in the 1980s, which was also poorly thought out and disastrous as a result, and yet the more-or-less elimination of that sector was sensible. Deregulation may also have gone too far, which is not the same as saying that some degree of deregulation was sensible—a position that is held by most economists.

6. The moral of this story is that we live in a society with a highly regulated financial sector. It will remain highly regulated in the future, and the difficult problem now is to determine what the optimal type and level of regulation is. This is mostly a technocratic question that rests atop a rough social consensus that the government should trade off risk/volatility and growth. True libertarianism has made no headway against this consensus; it remains as irrelevant today as it has been since the 1930s.

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Does the Financial Crisis Discredit Libertarianism:

In my view, what we are seeing today is the unwinding of multiple bubbles, starting with the stock market bubble in the late 90s, the housing bubble of the mid-2000s, and the most recent mini-bubble in commodities. These bubbles all have a common source, which was lax monetary policy coming out of central banks. These lax policies were meant to cushion the impact of multiple crises, starting with the crisis in 1998 that arose from the Russian default and the plunge in Asian markets through 9/11. Banking authorities, most notably Alan Greenspan, thought they had inflation under control because consumer price inflation was under control (thanks, largely, to the huge boon to consumers of globalization; consider all the unbelievably cheap "made in China" products on the shelves), and came up with all sorts of rationalizations as to why ASSET price inflation was not really inflation. The incompetence of the relevant authorities in understanding asset price inflation is demonstrated by the fact that Greenspan bought into the idea that housing prices wouldn't fall nationwide because they never had before--forgetting that the underlying increase in housing prices was itself unprecedented. Greenspan obviously believed, against all relevant historical data, that the run up in prices was a natural result of market forces.

In short, we can argue from here to eternity over exactly what pro-free market or pro-regulatory U.S. government policies precipitated the crisis as it specifically developed. But if I'm right that the underlying problem was overly lax monetary policy, which sent false signals to the market regarding the true price/value of money and the amount of real wealth that was being created, it seems to me that even if financial sector/housing policy had been infinitely wise, the bubble would have developed in another sector where policy was less wise, and would have also caused serious economic dislocation when it popped.

Keep in mind also that putting aside all of the debate about what the Bush Administration, Congress, Clinton, et al., did or did not do, the housing bubble was not an American phenomenon, but was as bad or worse in various parts of Western Europe, Eastern Europe, and Asia, which, I'm guessing, have about as broad a range of regulatory policies regarding both housing and finance as one can reasonably expect. The prior stock market bubble was also a worldwide phenomenon, as was, of course, the commodities mini-bubble. This again suggests that the problem was a worldwide misapprehension by central bankers of the consequences of their actions, and not some specific pro or anti free market policies pursued by the U.S. government (not to say that wiser policies couldn't have helped mitigate the damage at some point, especially by cracking down on leverage when there was still time, one of the apparently forgotten lessons of the Great Depression...)

As Eric Posner suggests below, the pure libertarian solution--a free market in money, with no central bank intervention--is not even on the table among "serious thinkers." And I'm not even going to argue that the pure libertarian solution is the right one. But if the blame is accurately placed primarily on central bank policy, then it's rather foolish to consider this a failure of libertarianism or free markets.

It is, on the other hand, an example of the failure of a particular libertarian, Alan Greenspan. Somehow, perhaps for ideological/psychological reasons, he appears to have seen himself as a champion of an anti-regulatory ideology, even though he was the most powerful regulator in the world, and was artificially reducing the cost of money. It would be hard for even the best satirist to come up with a figure like Greenspan, an objectivist who wielded more government power over the economy than any other individual in the world, used that power incompetently, and then allowed himself to believe (at least twice) that bubbles that his policies helped create were the result of the "free market" and needed to be left alone.

UPDATE: One more thought. Libertarians of the utilitarian school often oppose government regulation not because they think that all government regulation is inherently illegitimate, or even necessarily bad, but because on balance they think that decisions made through the political process, or by regulators (like Greenspan) acting with limited information, are likely in most cases to be less sound than decisions made through decentralized market processes. It seems to me that many of the bad decisions made, both on the pro (Fannie, Freddie, Community Reinvestment Act, etc.) and anti (failure to regulate derivatives, leverage, etc.) were not the result of any particular ideology, but the natural result of the political process. One problem with the inevitable "mixed economy" that we live in, and which libertarians would predict, is that the political process will often give us the worst possible result--privatization of profit, socialization of risk.

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