The Rule of Men

Farewell to the Free Market?

Western governments have compounded the economic crisis by rejecting the one force that can end it.

By NICOLE GELINAS

In the years leading up to 2007, the rules necessary to govern a flourishing market economy broke down, producing a financial and economic crisis. Rather than responding to the crisis by fixing those rules, the West aggressively repudiated market economics, and the repudiation continues to this day. Through their actions, which have lately involved everything from European debt to the American financial system to house prices in Britain, government officials around the world have revealed a disturbing assumption: that they can decide how to allocate resources better than markets can. No longer, it seems, do Western governments use investor signals as valuable feedback in devising effective policies; instead, they ignore those signals and plow ahead with their policymaking, leaving chaos in their wake. Often, in fact, public officials actively mute market signals in a vain but destructive attempt to impose their own will on struggling economies.

The rejection of markets helps explain the strange inertia of 2011. Across the free world, the year went out just the way it had come in. In December, German chancellor Angela Merkel and French president Nicolas Sarkozy convened a breakthrough summit to rescue Europe’s single currency and its debt-crushed nations from speculators—just as they had done a year earlier. President Barack Obama ended the year bickering with Congress over short-term stimulus measures to jump-start recovery—just as he had done a year earlier. British prime minister David Cameron concluded 2011 promising to do something about bank executives’ rewarding themselves with massive bonuses while refusing to lend to home buyers and small businesses . . . just as he had done in late 2010. Global stock indices were stuck in limbo, at best, with the Dow Jones Industrial Average listlessly flirting with 12,000 as 2011 came to a close, just as it had 12 months previously.

Western leaders’ attack on free markets has made perfect sense to them. After all, the dominant narrative of the crisis has described the alleged failure of capitalism. As Obama put it in a December speech, the Great Recession struck because “everybody [was] left to fend for themselves and play by their own rules.” Sarkozy lamented back in 2008 that “financial capitalism” had “imposed its logic on the whole economy.” People close to Merkel tell reporters that she feels “duped” by investors. Yet free markets aren’t to blame for the various problems threatening Europe, America, and Britain, and abandoning market economics will weaken the West in ways that will be hard to reverse.

Start with the ongoing euro crisis. Before its 1999 debut, national leaders had pitched a single European currency as a way to improve private-sector efficiency across the Continent. A French carmaker ordering German auto supplies would no longer need to protect itself from the risk that the franc would decline in value before the purchase was complete, requiring the company to pay more. A Spanish family traveling to Greece could now skip its visit to a money exchange, whose fee would eat into holiday spending.

Yet the euro, whatever efficiencies it achieved, introduced a deep corruption into the world’s capital markets. Investors understood that the euro’s architects saw it as a way to forge a grand postnational European Union. These investors, as they bought bonds from individual European nations, assumed that the euro’s sturdiest economies and most ardent champions—above all, Germany and France—would never let a weaker eurozone country default on its obligations, for fear of derailing the political union of Europe. This belief enabled such countries as Greece, Ireland, Italy, Portugal, and Spain—as well as their nominally private-sector banks—to borrow too much money too cheaply.

By February 2010, though, the investors and credit-rating analysts were starting to question whether lending money to these nations was really riskless. Greece had borrowed too much, the investors worried, and was unlikely to repay its debt without a big bailout. So they demanded higher and higher interest rates on Greek bonds to make up for the risk they were taking. Throughout the 2000s, investors had bought ten-year bonds from Greece while demanding only an average 5 percent return—not much more than Germany paid back then. By mid-2010, Greek bond yields had more than doubled, even as German interest rates declined. The message was clear: Greek finances were in serious trouble.

But European officials, rather than listen to the alarms that the market was raising about Greece, promptly began to deny that the country needed a bailout. Greece’s prime minister at the time, George Papandreou, began a global trip to whip up new bond buyers by insisting that “we will not be needing help.” In February, at the first of many summits, Merkel flatly refused to discuss a bailout, noting that “Greece has never asked us for support.” Papandreou also claimed that “traders and speculators” had unfairly ignored Greece’s “deep” fiscal reforms. The prime minister’s European counterparts backed him up.

Of course, Greece did need a bailout and got it. Yet even as a $15 billion support package from other European countries grew tenfold between 2010 and 2011, rates on Greek bonds kept rising. The investors were sending a powerful message: limited rescues aren’t enough to restore our confidence in weak countries’ bonds. Investors understood that two ways existed to resolve the euro crisis without destroying the currency altogether. Europe could make explicit the euro’s long-implied guarantee of sovereign debt, issuing bonds backed by the entire Continent’s full faith and credit—meaning, in essence, that if Greeks and Italians failed to pay their debts, Germans would do it for them. Or Europe could create an orderly way through which its overleveraged nations could default, lightening their debt burdens. Once such defaults became a possibility, potential investors in bonds would understand that their prospects for repayment rested not with Europe’s strongest nations but with whatever country had issued the bonds.

European leaders kept their ears stopped to the market’s message. In the summer of 2010, instead of guaranteeing sovereign debt or allowing overindebted countries to default, they conjured up the European Financial Stability Facility, a dubious structured-finance vehicle through which Europe would pretend to spin a few hundred billion dollars’ worth of funds from stronger euro countries into more than a trillion dollars’ worth of sovereign-debt guarantees. Investors swiftly saw through the EFSF, and interest rates for weaker European nations’ bonds shot up higher still. The European Central Bank also tried to trick the markets, buying just enough bonds from weak nations to blur what their real price, absent such artificial demand, would be—but not enough to convince investors that it would secure all the debt, if necessary.

After a year of this standoff, an even stronger effort to suppress market signals came in the summer of 2011. When Europe finally announced that Greece wouldn’t pay back its debt on time, in full, and at the interest rates to which it had previously agreed, European leaders pretended that this wouldn’t constitute a default. Rather, officials insisted absurdly, investors would take a “voluntary” hit. But the lenders who held much of the Greek debt were big banks with their own histories of relying on government aid in times of trouble, so how voluntary their actions were is open to doubt. Moreover, global-bank representatives are voting members of the International Swaps and Derivatives Association, the private-sector group that determines whether a sovereign entity has defaulted. Simply by refusing to admit what had happened, these representatives turned what is obviously a Greek default into a supposedly voluntary loss for investors. The banks had a big incentive to deny the facts: many had sold “insurance” on Greek debt to their customers, which would have added to the banks’ losses if the country officially defaulted. All this distortion further worried investors, who hadn’t realized the risk that Europe would pretend that a default hadn’t happened. Interest rates on European bonds again rose higher.

But European officials remained willfully deaf. By the end of 2011, they were resorting to centrally enforced discipline for Greece and other indebted nations. Germany and France sent experts to Greece to impose an austerity plan, a model that they promised to institutionalize throughout Europe by changing the terms of the European Union. The Greeks responded to their minders with resentment. In the fall, capturing the general mood, a Greek newspaper ran cartoons of European technocrats dressed as Nazis. Horst Reichenbach, the head of the European Union’s task force for Greece, has suggested that Europe set a time limit on the foreign experts’ presence in the country to weaken the perception that they are an “occupation force.” The longer the technocrats try to force austerity upon Greece, the likelier it becomes that the frustrated, angry country will simply abandon the euro.

Because Europe has ignored the market’s pleas, and refused either to assume countries’ debts or to allow them to default, it has increased the chances that the euro will disintegrate. That could trigger a credit crisis more severe than the 2008 meltdown. It would be a reminder that the longer governments repress market discipline, the more painful a return to it is. But despite the pain, such a correction looks increasingly likely—and necessary. Greece, for instance, could then create a new, devalued drachma and pay back its debt more easily in the cheaper currency. That cheaper currency, coupled with the measure of certainty that comes with cutting losses, would soon attract investment and jobs. And the departure of the hated technocrats could help Greece look within and achieve the labor-force and tax reforms that it needs.

The American financial crisis was no more a failure of free markets than the European crisis was. Just as investors tried to signal that something was wrong with the euro, they tried for decades to show that something was rotten in American finance. The rot remains, but Washington has spent the past two years demonstrating that it would rather distort or block market signals than rely on them. This strategy thwarts economic recovery.

The financial system crashed in 2008 because vital checks on the financial industry had eroded long before. One of these checks was that the bondholders who lent money to banks had known that they would lose money if those banks failed and didn’t leave behind sufficient assets to pay their debt; only small depositors enjoyed government protection. But in 1984, the U.S. government saved a failing bank, Continental Illinois, from the normal bankruptcy process because its failure would have posed a threat to the global financial system. Thus was born the phenomenon popularly called “too big to fail.” Bondholders and other lenders to banks began to realize that in a crisis, they could count on intervention from the U.S. government, and they started lending to banks more and more carelessly—so banks grew still bigger and still more threatening to worldwide finance. Immunized by the government against losses, investors could no longer provide important market discipline for big banks.

The government further eroded market discipline by usurping the market’s role in deciding which kinds of investments were risky and which were not. In the eighties, for example, regulators determined that mortgage lending was safer than other investments; financial institutions that borrowed in order to buy mortgage-related securities were therefore able to borrow more heavily than they otherwise could. Regulators similarly determined that securities rated triple-A were safe and rewarded banks for buying them. By 2008, these regulatory nudges had pushed the financial industry to concentrate far too much risk—and borrowed money—in certain areas of the economy. Government intervention had encouraged the financial industry to make all its mistakes in one sector; in a free market, financiers would have spread their mistakes around, diffusing the damage.

America reaped the consequences of all this governmental meddling when its financial system collapsed in 2008. At that point, Washington had little choice but to intervene still further, using hundreds of billions of taxpayer dollars to save the banks and other financial institutions. The alternative was a replay of the 1930s, when a failing banking system sent the nation, and much of the world, into a decade-long depression.

The government’s longer-term response, though, should have been to restore clear rules to the financial system, preventing such a crisis from ever happening again by consistently limiting borrowing within the financial industry and among financial instruments. Instead, the Dodd-Frank Wall Street Reform and Consumer Protection Act that President Obama signed into law in July 2010 reinforced the government errors that precipitated the crisis. Dodd-Frank directs regulators to scrutinize “systemically important” financial institutions—that is, firms whose failure could threaten the entire system—and decide on an ongoing, case-by-case basis whether they’re overindebted or pursuing risky investments. The act also empowers regulators to require these institutions to increase their “liquid” investments, which theoretically can be sold quickly in the event of a crisis, raising needed cash. (The law is self-serving: since the government considers its own bonds to be among the most liquid securities, regulators will favor investments in that debt for overleveraged institutions.)

Finally, if a “systemically important” institution fails, regulators have vast and arbitrary power to protect some of its investors; for example, they can use taxpayer money to guarantee the company’s short-term debt or its derivatives bets. In essence, Dodd-Frank codifies into law the government’s practice of picking and favoring firms that are “too big to fail.” The companies that succeed will be not those chosen by the market but those chosen by politicians and regulators.

Wall Streeters recognize that finance has become a political game. When former New Jersey governor Jon Corzine took the helm of smallish brokerage firm MF Global in 2010, he hired—for six figures a month—a consulting firm whose board members included former president Bill Clinton. Corzine’s purpose was transparent: to make sure that he would get a friendly hearing in Washington whenever he needed it. After all, regulators could use their discretion either to help him or to hurt him. In the end, Corzine didn’t succeed in making his firm important enough, so when it failed in October, he found himself without a helping hand from government and now faces a lengthy investigation into possible wrongdoing. Still, Corzine’s look-to-Washington impulse is increasingly the norm in the financial world.

Washington, for its part, understands equally well that it now matters more than markets do in determining the fate of “systemically important” financial institutions. The Economist recently hosted a panel of experts who pretended to be top Washington officials acting for the first time under Dodd-Frank’s authority to wind down failing financial institutions. Larry Summers, who played the Treasury secretary (his real-life role under President Clinton), concluded that all he could advise a president to tell the public in a new crisis was that “the financial authorities are meeting,” that “they’re very focused on the situation,” and that “there’s going to need to be some substantial government direction-setting and control.” In other words, what would govern the financial industry in a future crisis—just as in the last one—would be the panicked, unpredictable rule of men, not a calm, predictable rule of law.

The United Kingdom, like Europe and America, is in deep economic trouble. Though Britain was wise enough to steer clear of the euro long ago, its economy is growing feebly and teeters on the brink of recession. In 2010, David Cameron’s new coalition government rolled out what it said was a credible plan to balance the budget. Doing so, the government claimed, would bolster Britain’s international credibility and attract private-sector investment, igniting economic recovery. The truth, however, is that the plan offers no real foundation for recovery—in large part because Cameron, like his counterparts in Europe and America, thinks that the cure for government distortion is more government distortion.

The problem with the British economy, Cameron and his advisors believe, is that a dysfunctional private sector is stifling economic revival. Banks, they say, won’t lend to small and medium-size businesses, which prevents such firms from creating and expanding jobs. Banks also won’t lend to first-time home buyers without a hefty down payment. This credit freeze keeps young buyers off Britain’s property ladder and prevents older homeowners, who would have sold their houses to those younger buyers, from ascending to the next rung. With housing prices stagnant, people feel less wealthy and less inclined to spend.

Nearly a year ago, the Cameron government prodded the banks to sign an agreement called Project Merlin, under which they committed to increase lending. They didn’t deliver—at least not enough to boost Britain’s economy. So in November 2011, the government proposed a scheme that would help make the “dream of homeownership” a reality for would-be home- owners: a sort of mini–Fannie Mae to guarantee mortgages for at least 100,000 borrowers who put down as little as 5 percent. A few days later, Cameron announced a new National Loan Guarantee program, which encourages banks to lend to small and medium-size businesses by letting those that do so benefit from the British government’s triple-A sovereign rating when borrowing money.

Supporters of these plans understand that they distort markets. The mortgage-guarantee program, for example, if it “succeeds,” will keep the price of real estate artificially high. But the aggressive planning is necessary, many argue, to right the economy’s wrongs. Patrick Jenkins, the banking editor of the Financial Times, noted that the National Loan Guarantee program “amounts to more manipulation than proper free-marketeers can stomach.” But “we are still in a crisis,” he added, “and if the economy is to have any hope of growing it needs artificial stimulus.”

Britain, like its Western allies, continues to ignore potentially helpful market signals. If banks aren’t lending sufficiently, Britain should ask: What’s wrong with them? The answer is clear. Since 2008, the government has issued multiple reports on how to regulate British banks in the wake of the financial crisis, but it has dithered on taking action. Cameron’s government wants to settle the question during the current Parliament—that is, before 2015—but even if it manages to make that deadline, notes the Wall Street Journal, “full implementation might not come until later.” Meantime, as it tries to cut its budget deficit, Britain has slapped a new tax on the banks—and because that tax hasn’t raised the expected $4 billion in annual revenue, the government now wants to hike it by another 28 percent. Britain’s banking industry simply has no idea what to expect from government regulations for the next decade. No wonder the banks are being so miserly with their lending, especially as they’re being milked for cash.

The banks also have a good reason to demand those big down payments: though the Cameron government thinks otherwise, home prices are too high. The banks understand that it’s risky to lend so much money to young buyers, especially in the current economic climate; the down payments provide a cushion against potential losses. Another factor in the credit freeze is that Britain’s “austerity” measures—including, among other new levies, a 14 percent hike in its value-added tax—have snatched money out of consumers’ pockets, reducing the profits of businesses, which in consequence can’t borrow as confidently.

In the middle of the worst economic slump since before World War II, the British government should stop trying to balance its budget on the backs of current taxpayers; consumers could then spend more, giving businesses new profits against which they could borrow. The government should also settle on bank regulations in a matter of months, not years. And it should let house prices fall—as they will, absent goosed-up demand.

Poisoned by government prescriptions, sick Western markets are growing even sicker—yet many think that the remedy is an even higher dose of the wrong medicine. Andy Stern, a former president of the Service Employees International Union, wrote in the Wall Street Journal in December that the “conservative-preferred, free-market fundamentalist” model was “being thrown onto the trash heap of history.” For a better model, Stern argued, America should look to China—a nation that had supposedly planned its way to prosperity.

The natural defenders of free markets haven’t pushed back against the rise of the new planners, especially in America, traditionally the champion of political and economic freedom worldwide. Republican presidential candidates have mostly remained silent about the American financial bailouts and their role in distorting free-market capitalism. At one debate, former Massachusetts governor Mitt Romney, the establishment’s favored candidate for the nomination, deflected questions about what he would do in a financial crisis by saying that it was a hypothetical situation. In the years leading up to 2008, former House speaker Newt Gingrich took a seven-figure payout from Freddie Mac, a company that exemplifies the failures of government meddling in the market. Only Jon Huntsman, languishing in the polls, has spoken clearly about the need to end the “too big to fail” model.

What advocates of free markets should be saying is that the free movement of capital hasn’t failed in the current crisis. What has failed is the West’s ongoing misdirection of capital. China’s misdirection of capital will eventually fail, too—and when it does, the West had better have an alternative to which the world can turn.