The credit crunch, libertarians and smoking guns

 A few days ago Charlotte Gore wrote, “If Libertarians and free markets are to blame, please point to the regulation that was blocked by Libertarians that would have prevented the Credit Crunch.  The answer is simple: such regulation was never proposed.” 

Oh! Yes it was, and repeatedly – but for various reasons no-one wanted to know.  

I agree with her about Gordon Brown’s reason for not wanting to know (“Brown was thrilled with the ‘boom’ and enjoyed his reputation as the miracle chancellor, the one who had ended boom and bust.  He had no desire to highlight flaws in the system”).   But the wider context was the all-conquering neo-liberal world-view variously expressed as, for instance, ‘government is not the answer – it’s the problem’ (Reagan), and that ‘the market is always right’ (Thatcher). 

After 1979 and the Winter of Discontent, socialism as a philosophy with anything useful to say about economics was washed-up so New Labour adopted the neo-liberal world-view to a large extent and it filtered down to the ‘great and the good’ and thence to much of the administrative hierarchy.  

Some people did know that there was a problem but by this point swimming against the tide became difficult for even the most determined individual and neo-liberalism become the ruling cognitive policy.  A better opposition might have evolved a coherent alternative but tragically, none did.  From there on, and in the absence of any rival world-view, the die was cast.  Of course, there were many brave and insightful individuals who did what they could but, as individuals, that is not much in the final analysis. 

Some of the ensuing missteps are documented in this recent piece from the New York Times on the Greenspan legacy.  As former Chaiman of the Federal Reserve, Alan Greenspan championed the ruling view that  any sort of regulation is bad, an unnecessary and unwarranted cost for business, that businesses including banks would naturally self-regulate in their own interest and that Wall Street had tamed risk.  A professed libertarian, Greenspan counted among his formative influences the novelist Ayn Rand who portrayed collective power as an evil force set against the enlightened self-interest of individuals.  

Just to summarize a few threads from the NYT article:

  • In 1997 Brooksley Born, then head of the Commodity Futures and Trading Commission, a federal agency that regulates options and futures began exploring derivatives regulation – contracts like the now notorious credit default swops.  She was concerned that unfettered opaque trading could “threaten our regulated markets or, indeed, our economy without any federal agency knowing about it”.  Prescient indeed!  However, she ran into fierce and concerted opposition from Greenspan and others who asserted that she didn’t know what she was doing and that too many rules would damage Wall Street, prompting traders to take their business elsewhere.  Despite the fact that the very next year the collapse of the massive hedge fund LTCM vindicated her view and almost caused a systemic crisis, she was sidelined and eventually forced out.
  • Greenspan and allies persuaded Congress to repeal the Glass-Steagall Act – a depression era law that had kept commercial and investment banking separate – in effect creating a firebreak – to reduce the systemic risk of a failure in one part of the banking system spreading to the rest.
  • As the size and importance of the derivatives market grew, Greenspan repeatedly rebuffed attempts to bring in even minimalist regulation.  For instance, congressman Ed Markey asked the General Accounting Office to study derivative risks as far back as 1992.  The GAO’s subsequent report identified “significant gaps and weaknesses” in derivative regulation.  They saw that the sudden failure of any large US dealers could pose risks to the financial system as a whole.   Despite this Markey’s subsequent bill was never passed.

Although not strictly part of the current financial collapse, the Enron debacle shares root causes and many of the same cast of characters as this posting by Public Citizen shows.  It documents how the Gramms – Senator Phil and wife Wendy – played a central role. 

In 2000 Gramm engineered a provision in a bill that exempted Enron’s energy trading from regulation and disclosure which enabled Enron to manipulate the electricity market, especially in California in such as way as to reap a vast profit immediately after the deregulation took effect – up 400% from the previous year in 2001 Q1.  The cost to Californians was in billions until regulators belatedly moved to restore some order in June 2001.  Subsequent investigations concluded that “power generators and power marketers intentionally withheld electricity, creating artificial shortages in order to increase the cost of power“.

Is it possible that market manipulations are in some way behind the soaring cost in energy in Britain compared with the Continent?  I think it likely.

More recently, in 2004 the SEC agreed to a plea by the big banks (including Goldman Sachs then led by Hank Paulson) to unshackle them from the traditional rules that limited the amount of debt they could take on in relation to their equity.  With little discussion the change was agreed.  This is hubris of the highest order; it flies in the face of all previous experience and was undoubtedly the proximate cause of the credit crunch – the smoking gun.  Its immediate result was to kick start the huge boom in debt that is now collapsing.

Traditionally, banks have been required to keep their capital ratios at around 10:1 yet by the time Bear Stearns collapsed its ratio had risen to 33:1.  The SEC had become aware of “numerous red flags” regarding Bear Stearns activities yet so great was the presumption against regulatory intervention that no action was taken (just as with Northern Rock).  (The significance of this ratio is that the higher it is, the more profitable the bank – provided markets are rising.  However, the risk increases in parallel so that even the slightest market fall can cause the whole house of cards to tumble). 

Moreover, with the development and growth of the hedge funds, governmental and regulatory negligence have allowed the emergence of a shadow banking system completely outside of the formal banking system and its associated regulatory control.  This again defies all historical experience and is now tottering under the weight of its greed and is about to collapse causing immense ‘collateral damage’.

I could go on, but no doubt there will soon be a tidal wave of books documenting the many and various ways in which warnings were dismissed, regulatory interventions stymied and existing regulations sidelined and not enforced.

However, despite all this sad history, I believe it would be wrong to frame this simply as a issue of libertarian vs non-libertarian or some such; to do so would be to throw the baby out with the bathwater.   There are problems with the extreme libertarian position which is why I do not describe myself as such.  Conversely, there are also great merits in a more nuanced semi-libertarian position which is where I place myself on the political spectrum.

I suggest that there are two common errors with the more extreme versions.

Firstly, the tendency to forget that anything involving human beings has to have a pretty huge behavioural element.  It is all very well for Greenspan and others to argue for instance that market participants would act responsibly (an absolutely fundamental part of his belief-system).  Unfortunately, this assumes that everyone involved is some sort of secular saint which is dead wrong.  There are a fair few spiv-bankers out there and the way that capitalism works is that those who make higher profits eat up those making lower profits.  No morals are involved so – absent imposed boundaries – the result is a race to the bottom and indeed that is precisely the term applied to recent events in several recent press reports.

The behavioural dimension is important in another way – the cock-eyed bonus culture in finance.  If people are paid huge amounts on the basis of short-term measures why would they care if the long-term consequence of their deal making is to bankrupt the firm?  They will be long gone when it unravels.  It’s just a twist on the classic Ponzi Scheme.  This problem completely short-circuits the libertarian logic of enlightened self-interest enforcing discipline.  It has been known about for just about ever – but no-one did anything.  (In contrast, note that the libertarian self-regulation meme can work well for self-employed people embedded in their local community, alert to the reputational dimension and thinking long-term for themselves and their families).

Secondly, some libertarian ideas can, with the slightest nudge, morph from being a benign and positive proposal into a cancerous travesty that is nevertheless so close to the original as to escape detection by the media or Parliament.  Dissenters can easily be dismissed as ‘special pleading’, ‘ill-informed’ etc.  This is just wonderful for powerful corporations who have the lobbying power to do all the nudging they want, especially when their ‘friends’ are in power.

Thus, deregulation – which can certainly be a good thing in many circumstances – can, in other instances, become cover for a power grab as in the Enron case.  I submit that one of the underlying trends that so disfigures contemporary society is the rise of the Corporate State seen in everything from clone towns to soaring energy prices to disenfranchised citizens. (There has to be a better term than ‘Corporate State’ – any suggestions?)  Carnivorous companies can and do see themselves as being above the law, not subject to it.

So I conclude that for liberals everywhere, it’s time to do some pretty serious thinking about the political economy of regulation, competition and consumer protection.  Somewhere in there is a new, exciting and immensely powerful narrative struggling to be free from the wreckage of the neo-liberal view.

Postscript: Since I roughed out most of the above Greenspan has recanted – sort of.  He has admitted that he made a “partially” wrong decision in thinking that relying on banks to use their self-interest would be enough to protect shareholders and their equity.  Hmm – not much ‘”partial” about it!


4 responses to this post.

  1. I don’t understand what you mean by “extreme libertarian” and “semi-libertarian”.

    I’m in touch with lots of other libertarians and I don’t know one of us who are randroid objectivists. Most libertarians I can think of rail against protected big capital. Even the ones calling themselves anarcho-capitalists do not envisage the sort of corporatism we see today in “neo-liberalism” which I would suggest is a corruption of both liberalism and libertarianism.

    The Austrians have long been forthright in their criticism of the Ponzi scheme that is the entire fractional reserve banking system, with or without regulation (indeed outside the Mises Institute yours is the first time I’ve seen anyone else use the phrase, albeit to describe something subtly different).

    I agree that there is an opportunity for a “new, exciting and immensely powerful narrative struggling to be free from the wreckage of the neo-liberal view” but not that the “neo-liberal view” equates to libertarianism any more than it equates to some peoples’ idea of plain “liberalism” – eg the Tories.


  2. Thank you for this, very interesting.

    Sadly the banking system as it is currently set up has systemic imbalances and inherent moral hazard. I think that it’s easy, with the benefit of hindsight, to regulate for previous problems but by then it’s too late – banks will not repeat the same mistakes. While a few individuals may spot the risks in advance of problems manifesting, I can never see a situation where Governments will interfere while the system is ‘working’.. because they are not bankers and do not really have the expertise to make the decisions.

    My point, really, is that it is best not to imbalance systems in the first place.

    Ironically the only way that regulation would have helped in this particular situation would have been to prevent securitisation, full stop – because to cut it off once it was ‘in action’ would have caused the same result as we’ve seen from it being cut off for other reasons. But then.. regulation created securitization so.. you see how there’s no easy answers here, no obvious culprits.

    I still contend that Government involvement here has not helped, at all, and to choose to rely on it more as a result isn’t helpful :S


  3. Posted by liberaleye on 25 October 2008 at 6:00 pm


    Probably “extreme libertarian” is not the best term for what I had in mind – the sort which emphasises a certain philosophical view but forgets or downplays other factors – apparently including in Greenspan’s case human nature. It reminds me of why communism is doomed to failure. By “semi”, I meant the more sensible majority who do integrate other considerations – including human nature – into their philosophies.

    Certainly “neo-liberal” and “libertarian” are different but by aligning himself with the neo-liberals Greenspan has effectively contaminated the ‘brand’. The fact that his version of it is ‘eccentric’ will be lost on most people.


  4. Posted by liberaleye on 25 October 2008 at 6:21 pm


    They say that armies are always trained and equipped to fight the last war, not the next one which I think is what you are saying about governments’ recent involvement in bank regulation.

    I agree that this is a problem as far as securitised derivatives are concerned. Moreover, it’s always difficult to see even the most obvious bubbles when caught up in them.

    However this is NOT true of allowing banks to set their own capital ratios then and allowing them to balloon out. That is ‘Bank Regulation 101’ and as just about old as banking so no excuse is possible.

    As to the government not having the expertise etc, that is transparently true but the solution is not/cannot be to let govt off the hook. Regulation is one of the oldest tasks of govt (think weights and measures) but it’s got far more complex along with society. And it’s not just banking; what about nuclear? That’s where it gets really serious!

    The choice I believe is a simple one. Go back to the middle ages or find better ways to run things. How to make govt work better is the greatest challenge facing us. Let’s not throw in the towel at the outset.


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