Saturday, March 20, 2010

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


Bill said...


I wonder if all the right of center folks who voted for Obama and the Democrats really understood what they were doing in Nov. '08. It seems like they have buyer's remorse but it looks like it's too late because the Dems know this is their last chance to nationalize health care before they are wiped out in the mid-term elections.

alstry said...


I think the distinction between Wall Street and Government is really a distinction without a difference these days.

What happened over the past ten years is really pretty simple. Wall Street brokered a massive amount of debt to our retirement and savings accounts and in turn, advanced years of demand into a compressed period of time.

Government was the primary beneficiary of the massive demannd through higher tax receipts and even leveraged up against it driving more profits to Wall Street and butressing the perception of prosperity.

At this point, 50,000,000 if the highest imcome earners in America the the direct beneficiaries of government spending and tens of millions more depend on the above spending for their livlihood. It is governments' spending that drives government tax receipts.

Such tax receipts drive the 50,000,000 more depending on Social Security, 40,000,000 requiring food stamps, and almost 20,000,000 obtaining unemployment....and that is omitting children in many cases.

The America we knew no longer exists where the private entreprenueral economy drove our nation's prosperity. Now it is government, borrowing massive amounts and allocating it as it deems appropriate that drives the American economy today.

Any assertions to the contrary is simply a avoiding reality or wishful thinking.

Now the only question is how do we pay back the $55 trillion unless government devalues our currency or jubilees the debt?

brodero said...

Choices must be made homeownership,medical care,fighting two wars etc.etc.....many oxes
have to be gored....

Benjamin Cole said...
This comment has been removed by the author.
Benjamin Cole said...

I am all for phasing out Fannie and Freddie, and the homeowner's mortgage interest tax deduction (mysteriously unmentioned by even free marketeers when discussing the over-investment in housing).

But Meltzer may be out of his element in reviewing real estate.

There are commercial office buildings galore selling for half price and less in Orange County. No government entity encouraged this investment or lending. It was a free market, and it collapsed. Indeed, there are office buildings, resorts and retail space nationwide that are being turned back to lenders. There was an equal boom in commercial real estate in the 2000s, abetted by the CMBS market, but not the government.

So, simply stating that Fannie and Freddie caused our economy to sink and our financial system to collapse (including Lehman Bros. and Bear Stearns?) seems like simple, base political posturing.

What is Meltzer's explanation of the commercial real estate collapse?

Another example is Sam Zell's heavily leveraged buyout of Tribune Cos, a case with which I have some personal knowledge. Zell added $8 billion in debt onto Tribune, which owned the LA Times, Chicago Trib, the Cubs and few properties. Hardly had the ink dried before Zell defaulted on the debt, It has been in bankruptcy court for almost a year.

On a $13 billion property, Zell had only $300 million of equity in, and maybe not that, if his lawyers are crafty enough. Why did bankers lend Zell $8 billion to buy rapidly declining properties (Trib and LA Times). I don't know. No government entity was there to encourage them--they did it on their own.

Why did Zell want to buy newspapers? I don't know--he was a real estate man.

Meltzer is right in that free markets collapse from time to time, as we know from Tulip Bulbs to dot.coms to real estate markets 2008.

Greenspan testified only yesterday that larger reserve requirement and some sort of additional reserves or collateral for derivatives trading were warranted. This is Greenspan, Mr Ann Rynd talking.

I would also like to hear Meltzer's explanation how the federal government caused Long-Term Capital Management to collapse, and take down global growth with it, in 1997.

I think Greenspane and Volcker are on the right track with the type of relatively minor reforms they propose for our banking system.

Investors need confidence the system won't collapse--with derivatives, with management at Lehman Bros., with lenders giving $8 billion to Sam Zell to buy Tribune Cos., with outfits like Long Term Capital Management leveraging up 100-to-1, I am not sure that confidence is there.

Partially as a result, I have been investing in farmland in Thailand, not U.S. equities, for the past 10 years. It has been a wise decision (there are personal reasons for this choice, as well).

The DJI is still below 1999, although I hope for higher levels in a few years. I think a 15 year flat spot, akin to to 1967-1982 is in the cards and that will bring up to about 2014 or so for a renewed secular bull market--if our financial house in order.

Lastly, I wish people would remember the basics--the economy is not Wall Street and banks. Wall Street and banks should serve as transmission belts for savings into productive enterprises. When more money is made manipulating money than in productive enterprises, then we become a mandarin society,

This is what Buffett and Munger are warning about--too large a fraction of our GDP absorbed by the financial sector, rather than being transmitted to productive enterprises.

Doubly ironic, since the vast gaggle of money managers, mutual funds, investment advisers, stock analysts do not outperform the market. There are parasites.

Michael Meyers said...


It took me too long to figure out why so many smart people on Wall Street went along with the disastrous federal government housing policies for so long, and now seemingly are going along with Obama's socialism march. Being a math major, I'll put it in a formula that I think Wall Street uses:

1) The Federal government is stupid [self evident truth],
2) I'm smart [self evident truth],
3) The more the federal government does the more money I make making bets against them [self evident conclusion].

Paulson et. al. made billions on the sub-prime fiasco. Perhaps the reason that Lehman was caught was just payback for Lehman's stiffing the Long Term Capital bailout.


Scott Grannis said...

Benjamin: Re Meltzer's explanation for the problems with commercial real estate:

I have a few explanations to offer. One, the CMBS crisis has been much less severe than the housing crisis. Two, CRE loans were never as risky as subprime loans. Three, I think one could argue that what brought CRE down was the recession that in turn was provoked by the housing collapse. If you failed to see the housing crisis/collapse, then you got nailed on all fronts, for that matter--hardly anyone was spared serious losses.

Scott Grannis said...

Michael: A personal anecdote to add to your musings on why the world went along with the government's distortions of the housing market for so long:

I remember discussing the inherent dangers of Freddie, Fannie, non-recourse loans, and the tax deductibility of mortgage interest with a colleague in the early 1990s. We agreed that things would eventually blow up, but that in the meantime you almost had to play along. You can't ignore subsidized money forever. The whole thing lasted much more than we ever would have imagined. By 2005 we were talking about housing prices declining nationwide by 30-35%. We took steps to avoid any MBS or subprime loan, buying only securities that could easily withstand a 35% decline in housing prices. We thought we were in good shape. Then the crisis hit, and the confluence of factors produced a decline in prices that went far beyond our wildest imaginings. So even though we saw the bubble and we forecast the bubble popping, we still took a serious hit.

Things are not always as cut and dried as they seem.

Unknown said...


It seems that you could have a similar discussion today -- discussing the inherent dangers of fiscal stimulus and too-easy monetary policy. We could agree that things will eventually blow up, but that in the meantime you almost have to play along.

Scott Grannis said...

Shawn: You make an excellent point. I think, however, that the public anger and the degree of controversy that already exist over the attempted rapid expansion of government do not lend themselves to a protracted resolution, as was the case with housing. That was like "boiling the frog" slowly. Today it is like throwing a bucket of ice water on the voters. The Tea Party is well advanced. The internet and the bloggers are mobilized. This is going to have a fairly rapid denouement.