Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of After The Fall: Saving Capitalism from Wall Street – and Washington (Encounter Books, November 2009), from which this article is excerpted.
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The popular narrative after the financial system’s 2008 collapse held that capitalism had failed. But capitalism didn’t fail.
The meltdown was a result of 25 years’ worth of government failure to understand its proper role in markets. Since the early 1980s, government hasn’t been a fair regulator but an arbitrary rescuer.
In 2008, the markets finally forced the government’s hand, exposing the whole state-subsidized, too-big-to-fail financial sector, built up over a quarter-century of bailouts, as impossible. Without adequate market discipline — including regulation of exotic financial instruments so that markets could discipline financial firms without causing economic disaster — the nation got the opposite of free markets: wholesale socialization of the financial industry to prevent a replay of the 1930s.
Could free markets have sorted out the mess without extraordinary government action? Only by destroying the remains of the financial system and putting tens of millions of people out of work.
The government may have staved off depression, but it severely damaged elements upon which free markets depend, including failure and fairness.
Federal overseers have never made it clear whether companies like AIG and Citigroup, each a recipient of multiple, multi-hundred-billion-dollar bailouts, should live or die. A vibrant free-market economy needs a clear dividing line between viability and failure, so that bad companies and bad ideas don’t crowd out good ones.
When a company fails, a successful firm can purchase its good assets, improving economic efficiency by releasing them from incompetent management and putting them back to work. Failed firms’ workers (even those who made the mistakes that led to the failure) can find more useful outlets for their labor.
Government money has instead created a risk that failed institutions will survive into the future, sucking capital and talent from the vital parts of the economy. Firing the top management of bailed-out companies, as the government directed at AIG, doesn’t lessen this risk. The failure is institutional, not personal.
The highest price that America might pay for subverting market principles to save failing financial firms over more than two decades became clear in early 2009: a poisonous mob mentality seeping into the American spirit as citizens perceived that big government was letting big business unfairly escape the consequences of failure while many ordinary people suffered losses. AIG executives paid security guards to stand outside their mansions and protect them from angry trespassers.
Congress was content to stir up the anger, deflecting its responsibility for the financial crisis toward AIG’s useful caricatures of corporate America. As rage mounted, many AIG employees gave back their bonuses. But they made their decisions out of fear. Bankruptcy, by contrast, enables a consistent, transparent treatment of contracts, even in an environment of anger.
In its arbitrary, unpredictable efforts, Washington risked sacrificing the public’s confidence that the government can act fairly in serving as a referee and regulator of free markets, not an active chooser of winners and losers. Such lost confidence would be catastrophic not just for the nation but for the world.
Washington must reassert the core principles by which the government regulated the financial world from the Depression until the 1980s. Otherwise, its reaction to this crisis will prove to be an even stronger precedent than its previous legacy of panicked bailouts.
The story of the past 25 years is that Washington has created a financial system that cannot withstand the destructive part of creative destruction — necessary for free markets — without destroying the economy.
We’ve grown so accustomed to government-subsidized failure in finance that we feel we have no choice. In accepting subsidized failure, we harm America’s trust in free markets, we harm the world’s trust in American markets, and we harm the financial innovation that advances the economy rather than smothers it.
The good news is that we know how to fix it. As 2007 and 2008 unfolded, conventional wisdom held that the financial crisis was a “black swan,” a term popularized by Nassim Nicholas Taleb to denote a “highly improbable” event that nobody could have anticipated because nobody had ever seen it before. People who’d only seen white swans, Taleb pointed out, couldn’t imagine that black swans existed before their discovery.
Given the slow erosion of almost all reasonable limits on the financial system by 2007, the black-swan event would have been the absence of a historic financial crisis. Washington’s too-big-to-fail policy had insulated financial firms from market discipline, distorting financial markets for a quarter of a century.
Meanwhile, every regulation protecting the economy’s money and credit supplies from twenties-style speculative forces had become inadequate, allowing financial firms a unique opportunity to create great wealth for themselves while creating great risk for society.
The first step to restoring the robust financial markets that can support global capitalism is to reassert the market’s ability to discipline itself without endangering the economy. Bad companies, including big, bad financial companies, must be allowed to fail through a formal, consistent system, so that their bad ideas can have a chance of dying with them.
Unless Washington credibly repudiates its too-big-to-fail policy, any other worthy regulations it enacts won’t matter. The lack of market discipline that the doctrine promotes will guarantee that big financial firms continue to have the cheap money and the motive to find their way around such rules.
Washington can credibly enforce a not-too-big-to-fail policy for financial firms only if it strengthens financial markets so that they can withstand such failure. As recently as 1995, Barings could go bankrupt without crippling the economy.
But in the years between Continental Illinois and AIG, presidents, congressmen, and regulators let financiers quietly and gradually introduce such scale and scope of brittle risk that a similar failure could bring the most sophisticated, most robust markets in the world crashing down.
The White House and Congress can strengthen markets by applying core regulatory principles to new markets and instruments, current and future, that represent the same systemic risk to the economy that the old ones do. The principles are just as they were in the thirties: limiting speculative borrowing, circumscribing reckless exposure, and requiring disclosure.
The unregulated credit-default-swap market is a prime example of current fragility. Within less than a decade, the financial institutions that traded in credit derivatives grew the market from nothing to $29 trillion.
No government regulations limited borrowing, or required investors and speculators to limit exposure or even to disclose activity. Exploiting these loopholes, AIG, with negligible money down, made $500 billion in promises that it couldn’t keep — and nobody knew to whom the promises were made.