Government failure, not market failure

Allan Meltzer is one of the great living economists. I've been a fan of his ever since he was asked to review the first research paper that I produced for clients of the firm I worked for back in 1981. He wrote an article in the WSJ a few days ago titled "Market Failure or Government Failure." It's short, sweet and to the point: the financial crisis of 2008 was the direct result of misguided government intervention in the market.

Last year the New York Times ran several articles about the end of capitalism. Others picked up this meme and reinforced it with claims that greedy bankers and deregulated financial markets had brought the world to the brink of another Great Depression. Then— just in the nick of time—we were allegedly saved by timely, forceful and intelligent government actions. The groundwork was laid for the next phase: more government regulation of financial and economic life.

Left out of this narrative is the government's disastrous mortgage and housing policy. Without the policies followed by Fannie Mae and Freddie Mac—and the destructive changes in housing and mortgage policies, like authorizing subprime and Alt-A mortgages for impecunious borrowers—the crisis would not have happened.

How can we avoid another crisis? We need to fix the problem of government intervention in the markets. It won't help at all to increase regulation.

Regulation often fails either because regulators are better at announcing rules than at enforcing them, or because the regulated circumvent the regulations. Consider the Basel Accord, passed following bank failures in Germany and the U.S. in the 1970s. This was supposed to reduce banking risk by requiring banks to increase capital if they increased holdings of risky assets. But financial markets circumvented it by putting the risky assets off their balance sheets. Unusual? Not at all. In 1991 Congress passed the FDIC Improvement Act, which authorized regulators to close banks before they lost all their capital. Regulators ignored it. Unusual? Not at all. Bernard Madoff, Allen Stanford, AIG—regulation failed in all of these instances.

This is because regulation is static, while markets are dynamic. If markets don't circumvent costly regulation at first they will find a way later.

The answer is to use regulation to change incentives by making the bankers and their shareholders bear the losses. Beyond some minimum size, Congress should require banks to increase their capital more than in proportion to the increase in their assets. Let the bankers choose their size and asset composition. Trust stockholders' incentives, not regulators' rules.

And consider these words of eternal wisdom:

The market is not perfect. It is run by humans who make mistakes. But the same humans run government where they make different, often more costly, mistakes for which the public pays.

Capitalists make errors, but left alone, markets punish such errors.

Unfortunately there is no one except the voters to punish the irresponsibility of politicians (from both parties) who continue to make costly spending promises that the government will never keep, but for which taxpayers will ultimately pay dearly. The healthcare reform bill being discussed these days is a perfect example of a new government program that will be extraordinarily expensive and inefficient. Voters must rise up and stop this madness.

HT: Russell Redenbaugh