Central Planning has Failed

by Moe Kinney

In the months following the peak of the so-called “financial crisis” of 2007-2008, a popular meme emanating from the political left was “capitalism has failed”. The argument being that a series of changes to financial laws in the late 1990s, had ushered in a new era of laissez faire capitalism on Wall Street. This in turn caused the housing bubble, the over-leveraging of financial institutions and the creation of exotic derivatives which ultimately brought turmoil to the financial markets and an economic recession. Thus demonstrating that “capitalism” had somehow “failed”. This simplistic conclusion has little merit from a causal perspective, and furthermore, the unprecedented intervention of the federal government and the federal reserve to deal with the so called “crisis” deprived us of the observations and information necessary to draw a valid conclusion.

There are justifiable criticisms of the aforementioned “de-regulation” in the 1990s. When commercial bank deposits are insured by government, removing the barriers between commercial banking, investment banking and insurance creates systemic risk as well as moral hazard. The trading of derivatives instruments without margin requirements (i.e. no “proof” that the seller can make good on the contract) and without open exchanges likewise spread the risk across what were previously unrelated businesses. Rather than being a “cause”, these behaviors merely served to make the problem “contagious” across both companies and business sectors.

When looking for “causes”, it is impossible to overlook the “easy money” policies of the Alan Greenspan Federal Reserve, the government-backed mortgage companies Fannie Mae and Freddie Mac and other government policies as the primary enablers of the “crisis”. With this in mind, it’s easy to see that the 2007-2008 crisis, contrary to being an indictment of “capitalism”, was yet another failure of central economic planning.

How does a “capitalist” system determine interest rates? Very simply. When people are engaging in “saving” behavior they are putting off current consumption for future consumption. When this becomes pervasive in the economy, interest rates go down because there is ample “capital” available. By contrast, when there is a propensity to borrow or consume in the present (The American way), capital is scarce and interest rates increase. Any tendency for the formation of an excessive debt bubble is held in check by rising interest rates and a scarcity of capital.

Enter the central planners at the Federal Reserve. Having a virtual printing press at their fingertips, a small group of central bankers decide that only THEY have the wisdom to set interest rates. With a few keystrokes, they create as much cheap money as the banks can possibly lend, setting up a situation of near zero interest rates in a market with little genuine savings. A capitalist recoils in horror at the co-existence of these conditions.

Even with cheap money from the Fed, bankers would normally have underwriting standards out of concern for the recovery of principal and to minimize risk of default. When government decides that everyone must have a home however, banks are coerced into relaxing these standards. When two giant “Government Sponsored Entities”(GSEs) are willing to guarantee the mortgages, the bankers have every incentive to collect their fees, pass off the risk and move on to the next sub-prime borrower. This behavior is only exacerbated by the mania of perpetual increases in real estate prices. Make a loan, get a few payments from the unqualified borrower and foreclose on an asset which has appreciated in value. Rinse and repeat. We all know the end result. Real estate prices cannot go higher in perpetuity. People working minimum wage can’t afford $250K mortgages, the illusion of wealth in home equity ultimately disappears and the impact on the economy is disastrous.

How does a capitalist system deal with the collapse of a speculative bubble and a massive misallocation of resources into housing? Obviously interest rates would have risen long before such a bubble formed, but assuming the central planners could be removed, higher interest rates would prevail. People that speculated on housing, including the exotic “Mortgage Backed Securities” take the loss. Banks that made excessive amounts of real estate loans to unqualified borrowers take huge losses and most of the big ones must declare bankruptcy. Contrary to the “Financial Armageddon” rhetoric, this is a healthy thing for the economy. When a firm goes bankrupt, it’s assets(for a bank, this means mortgages) are sold off at MARKET value. A $250,000 loan on a house that has depreciated to a value of $150K does not get sold at face value and certainly doesn’t get sold for a price greater than the house value. In the presence of uncertainty in the market, it likely sells at an even deeper discount. The bad debt is cleared from the system and only the bankrupt bank and its shareholders eat the loss. The new owner of this mortgage loan then re-finances with the borrower at a substantial principle reduction and still profits on the purchase.

How do the central planners deal with such a collapse? They respond with trillions of dollars in bailout funds from the federal government to the big banks and with further trillions in cheap loans from the Federal Reserve. Insolvent firms remain in business, the losses are spread to taxpayers, the de-valuation of assets is prevented and trillions of dollars in bad loans remain in the economy. Nothing is fixed, nothing is solved. The underlying problems remain unaddressed. How can capitalism have failed when it was never even given the opportunity to succeed?

For over four years now, the central planners in government and at The Fed have attempted to circumvent and delay the fallout from the collapse of the housing bubble. Over ten million mortgage holders remain underwater. The major banks remain technically insolvent, but are now allowed to use government-approved accounting fraud to hide this fact. The federal government has borrowed and spent over $5 trillion to artificially “stimulate” the economy and create the illusion of recovery. The Federal Reserve continues its insane policies of near-zero interest rates and has engaged in trillions of dollars of what it terms “Quantitative Easing”. The latter practice amounts to buying hundreds of billions of dollars worth of U.S. Treasury debt AND even buying massive quantities of Mortgage Backed Securities as a further handout to the big banks. This is not a “capitalist” approach, and the policies of debt-financed stimulus and loose money are doomed to failure, resulting in a replay of the 2008 crisis. When this failure becomes readily apparent a cacophony of voices will once again attempt to blame the evils of “capitalism” even when the unavoidable conclusion is that “central planning has failed”. Capitalism was forsaken long ago.



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