The Fed Bails Out the Free Marketeers
The policy of slashing rates
to rescue big finance is
both flawed and fraught with risk
The big flaw in the cheap money approach
is that it was too much cheap money
that got the US (and Britain, for that matter)
into difficulties in the first place
George Soros
The current crisis is the culmination of a super-boom that has lasted for more than 60 years."
It has been fueled by a steady expansion of credit availability to individuals and institutions.
Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy.
That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion.
The system was so successful that people came to believe in what former U.S. president Ronald Reagan called the magic of the marketplace and I call market fundamentalism.
Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest.
It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves.
Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalized and the U.S. started to run a current account deficit.
The Fed's interest rate-slashing response to this
inevitable crisis is flawed and fraught with risk
Davos is in a state of shock. Regulars at the talkfest in the snow in Switzerland are accustomed to turning up for a few days of mutual back-slapping, congratulating themselves on the robust state of the global economy and its potential for limitless expansion.
This year the talk is of falling asset prices, of murky financial instruments that have burrowed their way deep into the system, and of the possibility - horror of horrors - that the global economy might be on the brink of a full-scale crisis.
In truth, the sense of surprise is hard to credit, since everything that has happened was entirely predictable.
For 25 years or more, the great and the good of the financial markets have been chipping away at the constraints that were put on them the last time they brought the global economy to its knees, ably aided and abetted by politicians, the international institutions and a battery of thinktanks supported by corporate interests.
Get the government off our backs, they said. Let the markets work, they said. Regulation is the enemy of innovation and efficiency, they said. Politicians duly obliged and now, according to George Soros, there is a systemic problem the like of which we have not seen for 60 years.
And now what do we find? Those self-same financial institutions, having made a colossal mess of things, are relying on the forces of darkness to bail them out. We're hurting, they say. Our losses are enormous, they say. We're too big to fail, they say.
Sadly, the latter point is absolutely true. The reason the Federal Reserve announced an emergency cut in interest rates this week was that it feared a global crash in stock markets would clobber Wall Street just at the moment the dire financial consequences of the sub-prime fiasco were becoming evident.
The Fed is Wall Street's poodle, but - as the US central bank saw it - the choice was between taking a risk with inflation or having collapsing banks deflating asset prices and rocketing unemployment.
But make no mistake, the policy of slashing rates to rescue big finance is both flawed and fraught with risk.
The big flaw in the cheap money approach is that it was too much cheap money that got the US (and Britain, for that matter) into difficulties in the first place.
If the policy response to the collapse of one bubble is to blow up another one, then that's an indication of intellectual bankruptcy.
To that extent, the more cautious approach to monetary easing adopted by the European Central Bank is rather more coherent.
The ECB is concerned about inflation, perhaps obsessively so, but its refusal to be dragooned into cutting rates is at least coherent.
The Fed's strategy - that a problem deferred is a problem solved - is not. Under Alan Greenspan, the Fed left rates too low for too long.
Under Ben Bernanke it left them too high for too long. It takes a mighty leap of faith to assume that it will get it just right this time.
The big risk is that the impact of lower interest rates will make little difference to consumers up to their eyeballs in debt, but will instead lead to a collapse in the dollar which in turn will lead to higher imported inflation.
The Fed cut interest rates with the headline rate of inflation above 4%; in the event that price pressure intensifies and the dollar's decline accelerates, its freedom of action will be seriously compromised.
But the really central issue is the one known as moral hazard. The reason Mervyn King has been taking a tough line with the City is that he doesn't want to be seen to be rewarding those who have taken dumb decisions.
Doing so, the Bank of England's governor believes, simply encourages them to carry on doing dumb things, resulting in a still bigger crisis at some point in the future.
King is absolutely right. By cutting rates to bail out Wall Street, the Fed has created a colossal moral hazard problem.
If - and it's an extremely big if - the financial markets ride out the current crisis, and anxiety about recession proves ill-founded, then it doesn't take a genius to see what will happen next.
The big financial institutions will be back taking the same reckless gambles and insisting that they should be entirely free to do so.
This, though, is an entirely unsustainable position. Either the banks and the hedge funds accept that the flipside to deregulation is that they take their losses stoically when times get rough.
Or they accept that the price of government bailouts is that their activities are more closely monitored and regulated. They really can't have it both ways.
Faced with that choice, it's not hard to see which way Wall Street and the City would jump. These institutions think free markets are a great idea - but only for other people, not themselves.
This is a chance, perhaps a once in a lifetime chance, to break the dependency culture by forcing big finance to be more transparent, having a clearly defined separation between commercial and investment banking, and by banning some of the more toxic products.
Over the past few years, there has been much talk about how poor welfare claimants have responsibilities as well as rights. Now is the time to apply the same tough love principle to rich bankers.