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Free market defenders need to find their voice
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"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

The author of those words was himself both academic scribbler and practical man - John Maynard Keynes. And how right he was. For the past 30 years, the dominant intellectual tide in politics and economics has been the view that the role of governments in the economy needs to be kept to a minimum. Free markets work best. They are certainly not perfect but they are much less imperfect than the alternative.

This belief underpinned the sharp change of direction in this country under Baroness Thatcher, and more widely, the collapse of communism and the recent embrace of markets and involvement in trade across the developing world. But now the intellectual tide is turning. If we are not careful it could swamp us.

As the shenanigans connected with mortgage lending and its repackaging and redistribution around the system have become apparent, it has emerged that this particular bit of our economic system is very far from perfect. It looks as though banks have landed themselves, and the rest of us, in a pretty pickle.

One response would be to let them take the consequences, even if that means letting some go bust. That is the pure free market position. But it was not what the authorities here and elsewhere have done. In this country, Northern Rock was nationalised and all deposits of the banking system were guaranteed by the British government. In America, the investment bank Bear Stearns has been bailed out by the Fed.

And in just about all monetary areas, central banks have altered not only their monetary policies, but also the way in which they provide support to the markets, in order to save banks from the consequences of their own folly.

But the acceptance of a legitimate role for the state in forestalling a systemic crisis carries an important corollary: the banking system cannot be allowed to do whatever it might like without interference. It cannot have it both ways - complete freedom of action in pursuit of profits - and taxpayer support to cushion losses.

At a minimum, banks will soon, rightly in my view, be required to have more capital and to hold more liquid assets. Both of these measures will reduce their return on capital employed.

Pressure emanating from this factor, combined with lower activity in financial markets, might put downward pressure on the level of typical remuneration in banks. This, plus the experiences of the last year, might persuade banks to reform the ludicrous structure of remuneration packages, which encourages the taking of risks with massive rewards for success but little personal downside if the bets go wrong. I hope so. The alternative of public regulation of banks' remuneration structures is not a happy prospect.

But I am worried. There is a danger that we rush in regulations that restrict the activities of banks at just the time that, frightened by recent events and belatedly under pressure from shareholders, they are restricting their own activities. This could create a worse crunch and greatly increase the cost of financial operations.

It was both fully predictable and yet also deeply depressing that the FSA's response to its own failure in the Northern Rock episode was to demand more staff. This prompted a wicked thought in my mind: could the FSA also have had a hand in the Terminal 5 fiasco?

Before we rush into new regulations controlling banks, as though they alone were responsible for what has gone wrong, we should not forget the role of public policy. In both the US and the UK, rampant lending was not an accident. It was the direct result of a deliberate policy of boosting domestic demand via low interest rates. This was bound to lead to a surge in lending and associated financial activities. How else did policymakers think they would boost demand? By osmosis?

From the very beginning, critics argued that this policy risked creating massive financial distortions which would have real economic costs. In the extreme, it would inflate bubbles whose subsequent deflation, as in the Japanese case, would prove to be extremely damaging.

The response on both sides of the Atlantic was that bubbles were so difficult to spot in advance that the best policy was just to let the private sector get on with it. If it turned out that a bubble had been created and it burst, the authorities would then simply have to clear up the mess afterwards.

As it becomes plain just how extensive the mess is, and how expensive it will be to clear up, that line is looking far less credible. So one of the consequences of these events will probably be a shift in policy regimes that will make a recurrence of these events much less likely.

What makes the change in the intellectual climate with regard to the financial system more worrying is that it coincides with growing acceptance of the case for public action to restrict or even forbid individuals and companies from a wide range of activities in order to prevent global warming.

Add to this, widespread misconceptions about the role of international trade in causing poverty in the third world and you have a strong intellectual tide running against free markets and in favour of increased state action.

The history of the past 50 years has made it abundantly clear that markets provide the basis of our prosperity and hopes for advancement. Admittedly, the tendency towards herd behaviour, the prevalence of extremely short time horizons even when dealing with assets whose life stretches many years into the future, and the ubiquity of overwhelming uncertainty, mean that financial markets are prone to behave in ways that can pose grave dangers. Accordingly, financial markets and financial institutions need regulation. But they need better regulation - not necessarily more of it. After all, it wasn't as though Northern Rock was unregulated. It was just badly regulated.

What we must not allow to happen is for disgust at the activities of bankers and their absurd rewards to prompt disillusion with the market system in general. That would take us on an extremely dangerous journey. The next stop would be the embrace of protectionist trade policies. And the final destination would be impoverishment.


by Roger Bootle

Roger Bootle is managing director of Capital Economics and economic adviser to Deloitte.


Source >
  Telegraph



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