The Next Economic Meltdown

“Economists: Another Financial Crisis on the Way” read a recent ABC News headline. The headline was occasioned by a report from an elite group of economists, financiers and former federal regulators headed by the Nobel Prize winner Joseph Stiglitz. The report warned that the American economy and the financial system are in danger of descending into another crisis. The fault, according to the authors, lies with “our government leaders,” who “have shown little capacity to fix the flaws in our market system.” This lack, they urged, should be remedied by more regulation.

Even though the recommendation may sound superficially reasonable, the advice is not only badly flawed, but it is a prescription for more trouble. To see why, we only need to ask this question: When have our government leaders managed to fix any problem in the market place? The market may not always produce the kind of results we like, but we have a long history of experience to show that attempts to correct it almost invariably produce more bad than good. Even in those cases where politicians’ intent is pure, the interference tends to produce unforeseen consequences that are nearly always detrimental.

In the real world, however, politicians’ regulatory motives are seldom chaste. The financial-reform bill which was passed by the House of Representatives at the end of 2009 is a case in point. Advertised as a measure that would curb excesses on Wall Street, it was the brainchild of Financial Services Committee Chairman Barney Frank. But there is a problem with Frank’s involvement with this legislation. Since becoming the committee’s chairman in 2006, almost half of his campaign contributions have come from the finance, insurance and real estate industries. In other words, Barney Frank is regulating companies and institutions that bankroll his political career. The money they have invested in him has not gone to waste. Frank’s financial-reform bill includes a provision for $4 trillion in emergency funding for Wall Street the next time things come crashing down.

It’s fruitless to expect politicians to come up with the kind of regulation that would cure our economic and financial systems. After all, they cannot even balance the federal budget, which should not be all that difficult. All they need to do is not to spend more than they take in. For some reason, however, our leaders cannot live up to this very simple principle. Every year they run up large deficits which have produced a national debt that the federal government will never be able to honestly discharge.

Failing to address this troubling concern, the report goes on to note:

[T]he country is now immersed in a doomsday cycle wherein banks use borrowed money to take massive risks in an attempt to pay big dividends to shareholders and big bonuses to management – and when the risks go wrong, the banks receive taxpayer bailouts from the government… Risk-taking at banks will soon be larger than ever.

This is correct. But it should be pointed out that this situation is largely due to government action. Banks take undue risks, because they know they will be bailed out if they fail. We should not be indignant at this, since their behavior is completely rational under the circumstances. The system is set up in such a way that even those who would like to play responsibly cannot do so. If they did, their earnings would lag behind those of their more aggressive competitors and the management would be pilloried for “substandard” performance. Thus the only real choice is to run with the herd and take the risks regardless of how excessive they may be.

But notice what is behind this. It is the government’s implicit guarantee of bailouts, which has given rise to a situation economists refer to as “moral hazard.” Moral hazard occurs when a player – in this case a bank – becomes fully or partially insulated from risk and as a result behaves differently that it would have if it were forced to bear the consequences of its actions. Here is a good description of this phenomenon:

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its doings, and therefore has a tendency to act less carefully than it alternately would, leaving another party to hold some responsibility for the consequences of those actions.

With its “too big to fail” approach, the government has infused systemic moral hazard throughout the financial system. The party that now ultimately holds responsibility for the consequences of the banks’ undue risk-taking is, of course, the US taxpayer. What we must never forget is that this state of affairs has been brought about by government intervention. The answer is not more regulation restricting banks’ risky behavior, but the removal of bail out guarantees. Once that happens banks will be far more careful about how they manage their risk portfolios, knowing there will be a real price to pay for reckless choices.

The report’s call for “Congress to enact reforms strong enough to prevent another meltdown” is only to ask for more problems down the line. Whether we are faced with a financial, economic or any other crisis, we would do well to remember Ronald Reagan’s famous dictum: “Government is not the solution to our problem; government is the problem.” The present crisis is no exception.

  • gamalpha

    There is a very interesting principle here that applies to more than just banks. The more the government applies a safety net the more the economy collapses. The more medical care the government provides the greater the more medical care costs escalate, the more unemployment benefits the government provides the less incentive there is to go to work and so on.

    • Art Gallery

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  • therealend

    If only we did the opposite and developed an environment which would create more wealth instead of more entitlements.

  • Mik

    This really does apply to all areas of finance. The student loan revolution, which began during the Carter administration is yet another example. Loans are now assumed to be part of the financial aid package that students receive. The universities now assume a certain level of indebtedness upon graduation and have raised tuition to match that increase. Since the late 70's the rate of tuition increase has greatly exceeded inflation. The loans function in the same way that the guaranteed bailouts do.

    • Rifleman

      You may also notice DC is now trying to completely take over student loans, so the government is the only place they can be obtained.

  • deleted5525157

    "Frank’s financial-reform bill includes a provision for $4 trillion in emergency funding for Wall Street the next time things come crashing down."

    May God help us, and whoever thought that giving Barney Frank a $4 trillion dollar slush fund was a good idea.

    The problem, in many senses, is the neo-feudalism which has perpetuated the Democratic Party since FDR. The bottom line is American politicians, especially Democrats because they are in the cities, get elected on the dollars they bring home, not on the best interest of America. If it was me, I would do my best to allow for Congressional redistricting across state lines and really wreck havoc with politicians' lives.

  • johncarens

    …Which also points out one of the great paradoxes of the modern political framework: The axiom that only conservative Republicans are the representatives of "Fat-Cat Bankers". In reality, though, Radical Democrats have spouted a neo-Marxist line vis-a-vis the Financial Services sector for three generation, but notwithstanding their rhetoric, it is they who have promoted policies that explicitly remove the Moral Hazard from financial transactions. They've done this with everything from underwriting Mexico's national debt in the early 1990's, to collateralizing SBA loans to non-performing small businesses, and everything in between.

    Of course, this fits into their hedonistic world-view that insists that no one is responsible for their actions, and that the world is a chaotic mish-mash of circumstances beyond anyone's control– except, that is, the liberal utopian that can perfect the situation by the coercive force of government.

    To them, a Wall Street Fat Cat is just another welfare-mother in a Brooks Brothers suit. The environment made them do it.

    • eerieSteve

      As conservatives, it is important for us to be optimistic. Doom and gloom is good now, but this is America.

      What we need is a new Manifest destiny. What better land than our own back yards?

  • gpcase

    Moral Hazard will necessarily pervade any society who gives up its liberty for government largesse. From the welfare mom to the entitlement-protected middle class to the investment banker, their decision-making is corrupted by the understanding that they will be recused if they fail, and thus take on more risk than if they were to suffer the consequences alone. Once the progressive ethic convinced us that we had the "right" to someone else's money, it turned us all into looters and thieves, and not just from each other but from our children.

    A return to the Constitution's enumerated powers is the only antidote. But we must teach the great midde class not only the benefits of free markets (it simultaneously institutionalizes freedom, responsibility and accountability to produce prosperity) but why this is the only moral system ever devised. Its morality is based on man's natural right (whether by God or objectively deduced) to life, liberty and property to pursue his happiness.

    • coyote3

      Whether is is an antidote or not, we shouldn't have to "return" to the Constitution's enumerated powers. Fact is government is acting without power, i.e., illegally if acts outside those enumerated powers. If they want to give more enumerated powers to the government, they can, rightly or wrongly, propose a constitutional amendment(s).

  • Gary

    "When buying and selling are controlled by legislation, the first things to be bought and sold are legislators." – P. J. O'Rourke


    Still beatin that old 'laissez faire' bush, I see

    • eerieSteve

      I don't know what you are talking about. Bush was anything but Laissez faire, and his tax cuts worked.

      • coyote3

        Actually, in legislation that was actually signed into law, in some areas, Bush was even less laissez faire than the current administration.

        • eerieSteve

          Yes. Sarbanes Oaxley was probably the most restrictive legislation passed in recent history.

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  • Club Penguin

    It is painstakingly brutal to see that politicians could not even balance the federal budget, which should not be too difficult at all.

  • Orris

    There is one thing the government does better than anything else – spend money. If anyone is going to get out of debt they have to do it themselves. The government isn't going to bail out individuals.

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    I don't think the government officials really know much about the market sector . Thanks for this great post

  • chrise

    I don't share the opinion of the doomsday sayers. Tough times call for tough measures and Obama is, in all fairnes,s doing his best to fix the unprecedented mess he inherited.

  • rhonda

    If this is true, the looming financial crisis should call for more, not less regulation of the banking, insurance and healthcare industries.

  • spreadbetting

    Even though the recommendation may sound superficially reasonable, the advice is not only badly flawed, but it is a prescription for more trouble.

  • Emeric28

    Business bankruptcies and personal bankruptcies have spiraled upward over the past two years, as the housing and credit crises have snared the economy.

    Gift Ideas for Men

  • morten

    I absolutely agree that bail-outs for banks and wallstreet is a really bad idea and such
    things cause moral hazard. However, I just wanted to point out that regulation is not the problem. In fact deregulation leads to disasters such as the savings and loan crisis… which gave banks the freedom
    to gamble with everyone's savings and general deposits.
    Before this deregulatory move there was a successful firewall inplace,
    due to regulation, which prevented them from doing this.

    As some people have hinted at in this thread I think the bigger problem is that we essentially have legalized corruption in this country in the form of campaign contributions.
    In addition to this those who make such contributions have interests which
    align with the few who control mainstream media. In other words politicians who don't play ball will never make it through an election even if they wanted to turn down highly influential interest groups. By design our government is not built to do what is best for main street.

  • Madonna

    Still beatin that old 'laissez faire' bush, I see

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  • jenny

    i want to add one more thing if people work smart we can handle this situation . otherwise we hay no way to escape

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    Informative blog. I am also agree with all these financial crisis. There are always much side effect of it. Thanks for sharing such a great knowledge.Thanks.
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