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Blame Bad Rules, not Capitalism

With turmoil in the world’s markets, politicians and commentators have been demanding more regulation and control of the financial sector. Their reaction is entirely predictable – but entirely wrong.

by Eamonn Butler

With turmoil in the world’s markets, politicians and commentators have been demanding more regulation and control of the financial sector. Their reaction is entirely predictable – but entirely wrong.

This crisis was not caused by capitalism being fatally flawed. It was caused by politicians forcing the banks to give out bad loans, monetary authorities flooding the West with cheap credit and regulators being asleep at the wheel.

Indeed, one can date its origin precisely, to 12 October 1977, when US President Jimmy Carter signed the “anti-redlining” law. Before then, lenders generally denied loans to people in poor neighborhoods, believing that the local mix of low incomes and a weak housing market would lead to many people defaulting. But the politicians – with good intent – wanted to make home ownership available to all Americans. Therefore, lenders were forced into giving out risky mortgages, which we now call “sub-prime” loans.

By 1985, this torrent of bad business had nearly bankrupted America’s saving and loan institutions. So the government took on their bad debt and encouraged them to consolidate – unwittingly making them too big to be allowed to fail.

Meanwhile, several other problems worried the monetary authorities. In 1987, the US stock market plummeted, fearing that other lenders could collapse. Asia’s markets sank. Mexico, Argentina and even Russia defaulted on their loans. Over-valued dotcom stocks crashed and then the 9/11 incident occurred. Each time, the Western authorities responded by flooding the markets with cash.

After 9/11, the Federal Reserve took US interest rates down from 6.25 per cent to just 1 per cent; fearing this blow to investor confidence could sink the markets. But again, their action boosted the wrong market by sustaining the credit bubble. With loans now six times cheaper, mortgage applications soared. Lenders, awash with the Fed’s cash, happily issued more sub-prime loans. With more people buying homes, house prices soared. Buying a house seemed a certain money-maker, so more people got more loans and bought more houses, continuing the spiral.

In London, that other great financial centre, a decade of government overspending saw public debt soaring. Private debt, and house prices, soared even faster.

So for ten years, economies boomed. But it was financed by fake money – printed by the authorities solely to keep the economy in a boom. When the dawn of realisation broke, the long boom turned into the inevitable setback, which we still suffer from today.

The regulators, meanwhile, were unconscious on the floor. The US mortgage institutions, Fannie Mae and Freddie Mac, had 200 regulators on their case but still went bust for US$5 trillion. These semi-governmental companies allowed investors to believe the bad mortgages were guaranteed by government, causing credit rating agencies to give their dodgy bonds high scores.

Mortgage lenders re-packaged these bad debts round the world but nobody cried foul. Institutions were lending thirty times their asset base. Though the Bank of England knew that the huge mortgage lender Northern Rock was failing, the 2,500 staff of Britain’s financial regulator seemed to do nothing until it actually collapsed six months later. Even then, they had no coherent plan.

When the government is persuading the casino to hand out free chips and the regulators are standing drinks at the bar, you shouldn’t be surprised if the customers place a few risky bets. It’s the management and not the system that deserves our scorn for breaking the basic rules of economics. Any sustainable solution has to get finance back to those basics. But the bail-out package includes so many treats for special interests that it could save the culprits without helping the victims.

China, now the world’s fourth biggest economy, it continues to grow at nearly 10 per cent. India and other is an emerging economy which is also expanding. Even with the West in recession, world growth next year will probably be near 4 per cent, which has a positive outlook.

Western capitalism has been dealt with a severe blow by inept politicians and officials. But global capitalism continues to pull hundreds of millions of people out of poverty.


Dr. Eamonn Butler is Director of the Adam Smith Institute think-tank, London, and author of Adam Smith – A Primer.

This article appeared in The Frontier Post on October 08, 2008.