The View From 1776

Is Laissez-Faire Finished?

The free marketplace was the antidote to toxic securitized assets created by government’s socialistic interventions that distorted economic judgment.

French President Sarkozy, along with many other political leaders, gleefully declared that free-market capitalism is dead.  In their view, only the centrally-planned economy, regulated by welfare-state bureaucrats, can function effectively; only the socialized political state can support the life, liberty, and pursuit of happiness proclaimed by the Declaration of Independence.

Liberal-progressive pundits tell us that banking deregulation caused the subprime meltdown, though none of them can demonstrate cause and effect between the two.  The collapse of much of the banking community is said by liberal-progressives to reflect a fatal theoretical flaw in capitalism and to justify, indeed to demand, its replacement by a socialist, managed economy. 

What liberal-progressives fail to recognize is that the free marketplace did very well what it is supposed to do: assess the goodness of products and price them appropriately.  This interplay between demand and prices is the most effective mechanism in economic history for efficiently allocating scarce economic resources. 

As economist Joseph Schumpater famously said, an essential aspect of capitalism is creative destruction.  When an economic process is deeply flawed, or when a better economic process is developed, rejection by the free market economy destroys the old.  The example of buggy whip producers being run over by Henry Ford’s Model T is overworked, but apt.

Lost in the panic is the fundamental fact that the market mechanisms supporting the housing boom and the proliferation of non-creditworthy debt were planned and mandated by the Federal government.  The free market merely responded for a time to the Federal bureaucracies’ interventions.

When it became apparent, however, that the structured investment vehicles and huge pools of securitized mortgages and other debt instruments were composed of rotten assets, the free market did its job.  It sharply reduced the prices of poor quality securitized debt and punished the most egregious of their non-government structurers and purveyors.

Contrast this to government anointed and government-run programs.  No matter how unnecessary or grossly inefficient, it is almost impossible to kill a government program once initiated.  Government programs exist to buy votes.  They are impervious to rational analysis and heedless of efficiency.

The centerpiece exhibits are Fannie Mae and Freddie Mac.  As quasi-Federal institutions with an implicit Federal guarantee of their debt obligations, Fannie and Freddie were able to grow unchecked to mammoth proportions.  Until the final market collapse, they were protected by Democrat/Socialists in Congress against all scrutiny.

When free-market credit analysts questioned Fannie’s and Freddie’s lending and accounting practices, Congress refused to listen.  Even after government investigators uncovered fraudulent accounting and highly risky balance sheet maneuvers, Democrat/Socialist congressional leaders stiff-armed Republicans who demanded corrective action.

Without the ability to offload bad mortgage loans into the Fannie Mae and Freddie Mac secondary market, banks would have carried the loans on their own books, and they would have been considerably more prudent in judging risk.  But government intervention in the free market wildly distorted economic incentives by making it both highly profitable and necessary to generate and package subprime mortgage loans. 

The 1977 Community Reinvestment Act compelled banks to make mortgage loans to unqualified borrowers.  Before that legislative act, banks confined their lending to creditworthy borrowers with documentable jobs and incomes sufficient to service their debt.  But with Federal regulators threatening economic punishment for failure to make risky mortgage loans to uncreditworthy borrowers, banks complied and sold those loans to Fannie and Freddie.

The subprime meltdown and financial collapse thus were the product of socialist government, not the free marketplace.  The root of the subprime meltdown and financial collapse was the Fed’s over-expansion of the money supply.  Coupled with it, the government’s socialistic intervention with Fannie, Freddie, and the Community Reinvestment Act’s mandate for uncreditworthy mortgages in high-risk neighborhoods, gave us today’s fiasco.

It was free-market capitalism that finally opened the barn doors and began the process of shoveling out government-produced financial excrement.  The Federal government meanwhile is considering perfuming socialist labor union outhouses that don’t deserve to survive.