He does make the obvious point that the current credit crisis would never occur in a planned economy. He doesn't address that point any deeper, however. "Everyone knows" that a centrally planned economy makes the central planners responsible for whatever works or fails in the economy, but it does so in large part because the central planners cannot be aware of local economic conditions in a manner that permits them to take advantage of those conditions. The need to collect information and provide it to the decision-makers in a planned economy get bogged down in the bureaucracy that is the nature of ALL large organizations, making them quite inflexible and unable to deal with rapid market changes or with wide varieties in local markets.
The alternative, then, must be the "free Market." Individuals who collect local market information and who are able to acquire the needed capital to exploit the local conditions should not have to wait for approval from higher up in a bureaucracy. That individual is labeled an entrepreneur. That is clearly the nature of the free market. But does that mean that the entrepreneur is totally free of any regulation on his behavior? Not really.
Some products are illegal to sell, and there are many business practices which are properly prohibited by law. It is illegal to sell faulty products that injure the customers and it is illegal to sell numerous chemical products we call illegal drugs. It is illegal to lie about or misrepresent the products you sell. It is illegal to sell stock or borrow money based on fraudulently prepared financial statements. Companies cannot sell life or health insurance if they are financially unable to pay off in the event of loss. There is, in fact, a broad range of business practices that are not permitted under the Uniform Commercial Code. There are also a number of government bureaucracies that are established to enforce these laws, including the Securities and Exchange Commission (SEC), the Food and Drug Commission (FDA), The Fair Trade Commission (FTC), and a whole host of other similar organizations. Mostly they are government organizations because to have the regulated organizations fund them leads invariably to the funding organizations taking over the regulators.
Every one of the government regulator organizations have been created to prevent an existing failure of the regulated organizations to deal fairly with customers, suppliers, competitors or with the society around them. These are not organizations created for the purpose of expanding government power as the conservative free markets would have you believe. All exist to "patch" problems that the unregulated market have previously displayed. Nor do those regulator organizations work to install a centrally planned economy. Instead they each operate to regulate some element of the process of the free market in ways that both customers and most honest business people expect the businesses to operate.
With those regulatory agencies in place free market organizations are able to operate more freely than without them. For example, without the assurances provided by state insurance regulators, few individuals would risk buying life insurance from companies which they had no way of knowing could every pay off in the even of the death of the insured. The assurance provided by the state regulator greatly expand the life insurance market.
Those regulatory agencies are not central economic planners. They are instead crucial elements of the free market system. Without the assurances provided by effective regulators, many buyers would not trust the sellers enough to buy from them.
So what has happened to create the current credit crisis in which bankers do not trust other bankers to be sufficiently competent or honest to repay loans they take out?
The bankers trusted each other to be sufficiently aware of the risks they were taking in the loans they made to be reasonably sure they would be repaid for money they lent out. It turns out they were not properly evaluating the risks they were taking and there was no regulatory agency with the power to question them. The bankers trusted each other, not realizing that they were all blind to the risks they were taking. Then following the herd instinct, they did not even ask the embarrassing questions like "Are you really competent to make the kinds of decisions you are making?"
Then the loans that the mortgage bankers were making were bundled up and sold to investors world-wide, so when they were revealed to be loans that would not be repaid they could not be specifically identified and separated from the loans that would be repaid. Mortgages generally and all the bundles of investments made up of mortgages became suspected of being toxic. They are now unpricable. Not only will banks not buy the Collateralized Debt Obligations from each other, many of the banks have so many in their inventory that they cannot repay the other loans they have received.
What has happened is that the bankers lost control of the risks they were taking when they loaned money for mortgages, and the banking industry was not aware that was happening. A banker who loses control of the risk of lending is simply bankrupt.
Much of this occurred because of banker's hubris. They knew they were so smart that they did not need some regulator looking over their shoulder as the made loans and made new and different types of loans. But they were not asking each other the questions that a good regulator should have been asking, either.
Then when Alan Greenspan and his Federal Reserve lowered interest rates and expanded the money supply there was no one to question how long the party represented by the Housing Bubble Greenspan created could last. Greenspan also refused to regulate the mortgage brokers who were fraudulently faking documentation and encouraging borrowers to lie about income that got bad mortgages past the screening (what little there was of it) performed by banks before they issued a mortgage loan.
Top executives in both retail and investment banks got most of their income from bonuses. No one gets a bonus from saying "No!" to a deal. So questionable deals proliferated in part because top executives got a lot more money by pushing them through the system.
At the level of the Collateralized Debt Obligations, there was no one to blow the whistle on rating agencies who were competing with each other to offer the highest ratings for collections of junk mortgages. The bankers themselves didn't want to blow the whistle because they were making good money on every transaction they shoved through. The bankers at every level were fiddling the data that described the overall real risk of each loan, and no one was questioning that risk. The result was that the unmeasured risks were spread throughout the banking system. Unfortunately, the banking system is now globalized, so the toxic waste of bad loans was spread world wide.
Peter Bernstein discusses "Moral Hazard" - the threat that if the government will bail out banks that fail the very offer to bail them out will lead them to take on greater risk.
Then there is the failure of the SEC to properly regulate financial reporting. The SEC Chairman admits that they were trusting bankers to honestly report their own flaws, and that trust was misplaced. Not too surprising, that. Voluntary regulation only works with businesses that don't need to be regulated. The ones that do need to be regulated will not be honest. That's the first risk he discusses. But we are currently facing his second risk. Here is his discussion of that risk:
My second issue goes to the foundations of the economic system in which most Americans believe and take for granted. Though we sometimes give it more lip service than respect, it is rooted in individual decision-making in free markets. In theory, at least, the less government intervention, the better; the mantra is that markets know best.It is clear that Bernstein is blinding himself to the need of free markets to provide for appropriate regulation. No one is proposing a centrally planned economy. Such economies simply don't work well. But at the same time, the effort to do away with all regulation is exactly what has led to the current credit crisis.
We often hear this refrain, and history confirms its importance in the most profound issues of economic policy. It justifies our revulsion with Communism, our philosophical distance from the current Chinese system, and our distaste when politicians, not markets, try to shape our system.
Faith in free markets made icons of Ronald Reagan and Margaret Thatcher, who made deregulation a policy cornerstone. An echo in our own time was the 1999 repeal of the Glass-Steagall Act, legislated in 1933 to separate investment banking and commercial banks. Its repeal was a key contributor to the calamities now gripping the banking system.
TODAY’S crisis thus emerged from a combination of disasters operating in free markets, but wreaking ruin as they developed. The subprime mortgage mess, the huge leverage throughout the system, the insidious impact of new kinds of derivatives and other financial paper, and, at the roots, the vast underestimation of risk could not have happened in a planned economy. A superjumbo bailout is the inescapable result, but at some point we must confront its more profound implications.
As we move into the future, and as the crisis finally passes into history, how will we deal with this earth-shaking blow to the most basic principle of our economic system? I do not know how to answer that question. But we need to ask it.
A free market has to have some appropriate regulation. An unthinking mantra of "No Regulation!" is as bad for an economy as is a centrally planned economy. History is a guide to what regulations are necessary. An ideological mantra is not history.
History clearly shows that food and drug products must be regulated. The current credit crisis and the failure of all the separate Wall Street investment banks because the were allowed to avoid leverage regulations shows one level of regulation that was needed. And so on. Regulations are especially required when banks try to conduct business secretly. Most banking transactions need to be transparent because banking transactions are not real transactions. Lenders and credit card companies need to fully and clearly disclose true lending rates . Consumers should be able to more easily, cheaply an more frequently be able to determine theirwhat their credit ratings are. Ans so on. But these things ensure that businesses treat customers and suppliers fairly. They do not direct businesses to produce specific products or services as a centrally planned economy would do.
As to what precise regulations banks should have to undergo that should be carefully considered based on the current history of the credit crisis. But it should now be clear that the ideological mantra to eliminate government regulation was much too risky to apply to banks.
That's not a direction Peter Bernstein wants to consider, but in it is the answer to his question. "[A]s the crisis finally passes into history, how will we deal with this earth-shaking blow to the most basic principle of our economic system? I do not know how to answer that question. But we need to ask it."
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