Thursday, December 04, 2008

Government to blame for market turndown

There really is nothing new under the sun.  So too with the current financial crisis.  But moralists are making hay while the sun shines.  Prime Minister Kevin Rudd has blamed the financial crisis on "extreme free market ideologues" who have "resisted the regulation of financial markets".

In contrast to what Kevin Rudd has argued it is a failure of regulatory capitalism.  The causes of the current crisis are not "greed and fear";  but rather the unintended consequences of do-gooders, bureaucratic intervention, and anti-capitalistic prejudice.

To be perfectly blunt, greed and fear are a constant in financial markets.  Indeed they are well understood and modelled in the finance literature under the terms "return" and "risk".  Moralists need to explain why greed and fear manifest itself the way it did in the current crisis.  Of course, they can't.

The immediate causes of the US meltdown are inappropriate government intervention in the US housing markets, and loose monetary policy after 2003.  In other words, government.  Some economists have tagged macroeconomic imbalances as having contributed to the crisis.  That may even be true.  But again, that argument points to government failure not market failure.

So what was happening in markets?  Those financial institutions that had previously been criticised for not lending to low-income households are now being pilloried for "predatory lending".  But it was the Boston Federal Reserve that published a document warning banks against underwriting standards that are "arbitrary or unreasonable".  Indeed, "Policies regarding applicants with no credit history or problem credit history should be reviewed.  Lack of credit history should not be seen as a negative factor".  So the NINJA loan (no income, no job, no assets) was born.

Banks started making a lot of loans that they would otherwise not have made and some poor people probably now own homes they otherwise never would have.  There was substantial democratisation in credit markets with more and more low-income individuals accessing credit.  The ability to borrow money increases the choices that individuals can make and improves their life experiences.

Financial innovation in the housing market led to securitisation of loans.  This was not new, indeed Fannie Mae and Freddie Mae had been established to do just that.  The use of ratings agencies to certify junk bonds (an honourable source of financing) as investment grade finance, however, was new.  Don't expect anything much to come of that.  The ratings agencies make it very clear that they are providing "opinions" -- they do not guarantee the value of the assets they rate.  What that means, however, is that the regulators shouldn't have relied as heavily on the ratings agencies as they did.  But that's just more government failure.

So there were a whole lot of fractures and inefficiencies in the market.  But the spark to the crisis came through monetary policy.  In the early 2000s following the dot.com collapse, and the September 11 terrorist attacks, US jnterest rates remained too low for too long leading to over-investment in the housing market, and over-pricing of the housing stock.

During a financial crisis those firms with poor st ategy and non-viable business models are exposed.  Many fail.  While that may sound somewhat harsh, that is what is supposed to happen during a crisis.  Assets are re-organised and restructured into new configurations, new business models are developed and the market moves on.

We here in Australia would have been buffeted by the economic turbulence.  That is the price we pay for the immense benefits and wealth we enjoy being part of a highly globalised economy.  Things, however, have suddenly deteriorated.  Again, the finger of blame is pointing to government.

Both Mr Rudd and Treasurer Wayne Swan, correctly, argued that Australia banks and the Australian financial system are sound.  They then contradicted that argument by introducing an immediate guarantee on all bank funds.  Since then they have spent a great deal of time chasing their tails dealing with the unintended consequences of that policy.  If they had understood more about risk and return and less about greed and fear, they would have quickly realised that the guarantee fundamentally changed the risk profile of Australian assets and would lead to massive cash transfers.

Blowing half the budget surplus is just vandalism.  It's all very well for Ken Henry to want to "go hard, go early, go household" but whatever happened to the Productivity, Population, Participation mantra that he was preaching just last year?  If the Government wanted to stimulate the economy, why not "go tax cuts"?

To sum up; there is plenty of blame to go around.  While anti-capitalists enjoy their schadefreude the fact remains that financial crises are nothing more than the market at work.  Lots of people like to talk about creative destruction, now they have experienced it.

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