The Free Market Fails

If there was one mantra of the past 2 decades it was 'free markets, deregulation and privatisation.' It is impossible to read any edition of the economist, without reading that the solution to every economic problem seemed to be simply - deregulation, flexible labour markets and more extensive free markets.

This ideology of deregulation was no more sacrosanct than in financial markets. Yet, the problem with giving the finance markets a free hand has been an unprecedented necessity for expensive and difficult government intervention to rescue the mistakes and disasters of unbridled free markets.

The Dot Com Bubble of 2000-01. You might have thought the Dot Com bubble would have sent warning signals about the irrationality of financial speculators. But, it was just seen as an unfortunate, one off event. The US government reacted by doing everything it could to avoid any problem. Interest rates were slashed to 1% - thereby sowing the seeds for the next boom and bust in housing. - A classic case of Moral Hazard.

Sub Prime Mortgage Debt. Remember the days when mortgage lending was backed by deposits and you actually had to prove a decent income. US mortgage salesman working for bonuses sold mortgages to all and sundry. The consequence was an unprecedented rise in mortgage defaults. Yet, the whole banking system seems to have not taken much concern about the level of risks. This toxic subprime debt was happily bought by banks around the world - rather ironically, transforming high risk debt into supposedly A+ safe loans. The fall out from the Credit crunch has led to many banks going bankrupt or needing a bailout.

Victims of Credit Crunch so Far

  • Subprime mortgage companies filing for bankruptcy - New Century Financial, Net Bank, American Home Mortgages, American Freedom Homes e.t.c.
  • Bear Sterns gets bought for $2 a share, with backing from government
  • Merrill Lynch sold to Bank of America over fears of cash shortage
  • Freddie Mac, Fannie Mae - nationalised by US Government
  • Lehman Brothers - bankrupt
  • AIG Insurance - required $85 billion loan from US government
  • House builders in UK and US suffering grave difficulties.
  • Northern Rock - ran out of funds required rescuing by Government
  • HBOS - target of short sellers, needed unprecedented takeover by Lloyds TSB breaking up competition commission rules.

Government Intervention in Markets

  • Government loans to banks in trouble
  • Nationalisation of key banks like Freddie Mac
  • New regulations to stop 'short selling'
  • Governments pumping money into financial markets.
  • Tax cuts to try reflationary stimulus. - Economic Stimulus Pact only partially successful.
  • 31 March 2008 Sweeping range of regulatory changes gives the Federal Reserve the right to regulate financial institutions and intervene in financial crisis.
  • New regulation on non-depository banks
  • New regulations on mortgage lending
The amount of money the Fed has committed to underpinning the financial system is staggering. The 2 large Mortgage companies Freddie Mac and Fannie Mae have balance sheet obligations of $5bn alone. If these loans and guarantees are included as part of US National debt, it pushes up national debt from around 65% of GDP to 85% of GDP.
Perma Link | By: T Pettinger | Friday, September 19, 2008
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1 Comments:

Anonymous Anonymous said...

I see a problem with this statement:

" Yet, the problem with giving the finance markets a free hand has been an unprecedented necessity for expensive and difficult government intervention to rescue the mistakes and disasters of unbridled free markets."

Government intervention is not necessary because it reprieves the moral hazard. Corporations must be held responsible for their mistakes the same way individuals are. Smaller companies with sound financial policies will then thrive.

February 3, 2010 6:52 PM  

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