Unlike in the realm of physical sciences, one of the most frustrating aspects of economics is its dependency on natural experiments. Far too many hypotheses cannot be tested in sleek laboratories. As a direct result, it may take some time before anyone can comfortably pinpoint the causes of the unraveling financial crisis across the Pacific Ocean.

Yet, hunting season for a scapegoat has begun as the US government unveils the largest plan to intervene in the market since the Great Depression of the 1930s. Sweeping premature conclusions are fast becoming the preferred way of answering questions while scientific methods are thrown out of the window at a terrifying rate; centuries of scientific progress has come to naught.

As some observe the crisis with the valiant intention of pushing the boundary of ignorance outwards to populate the libraries of the world, statists have wasted no time in scapegoating and making sweeping premature conclusions. Their scapegoat: free market capitalism. Their conclusion: greater government intervention in the market.

An honest observer would recognize the fact that candidates for the cause or causes of the crisis cut beyond the rigidity of ideologies and this is where statists find themselves in trouble. While the story revolving the sub-prime mortgage crisis and the current financial crisis may have to do with lack of regulation in the proper place, two major potential causes of the crisis originated from government interventions. The two are bailouts of the past and low interest rates set by the state.

In comprehending how the two factors contributed to the whole fiasco, context is essential and it requires us to go as far back in time as the 1980s, back when another crisis was haunting the US economy.

It was the savings and loan crisis.

It is absolutely crucial to note that crises have happened in the past. Booms and busts are part of business cycles and there is really no reason to say your prayers for free market capitalism. Adherents of the Austrian school of economics may wish for a different path to be followed but the fact remains that such a business cycle is essentially the characteristic of the current setup of the system.

As proven in the past, each time the symbols of capitalism are burned to the ground, the whole system will rise up even stronger. Free market capitalism is a phoenix in the truest sense of the legend.

This is untrue for socialism or most of its variants. Once it is burned, it stays down and is forever maimed. Statists will do well to commit this to memory.

The most important aspect of the 1980s crisis is the action taken in its aftermath. The US government bailed out a number of troubled companies on the pretext that these companies were too big to fail. The idea was that these companies were too entangled in the economy and their failure would send destructive ripples throughout the system. And just before the beginning of the decade, there was the bailout of Chrysler rationalized by the same thinking.

The benefits of bailouts are immediately apparent but the side effect will pop up only later down the line: while bailouts tend to compensate downsides of the business cycle, they adversely affect the structure of the economy. It is a seed for yet another crisis in the future.

Any bailout essentially creates a problem called moral hazard. In a situation when profits are made private and losses are socialized, participants of the market have the incentive to undertake large risks incomparable to its rewards. In the case of the sub-prime mortgage crisis, the manner in which lenders of money swam in the sea of fire was indicative — no, instructive — of an awfully misaligned carrot and stick model.

Statists have called for more regulations to mitigate the effects of moral hazard but it must be highlighted that without the state-created moral hazard, there will be less requirement for regulation; the only regulation required in a situation which the state refrains from interfering in the market, with all else being equal, will be the rule of market Darwinism.

In true free market capitalism, profits and losses are internalized and thus eliminate the source for the explained moral hazard. With a more balanced risk-reward model, the severity of the crisis could have been reduced.

While moral hazard may have a role in the whole mess, an even bigger potential culprit is the low interest rates, courtesy of the state. This is so because the prevalent low interest rates environment in the early 2000s provided cheap financing which in turn fueled demand for, among others, homes. The environment was made possible as the Federal Reserve tried to maneuver the economy to a soft landing after the bust of the dotcom bubble. Needless to say, the Federal Reserve is an arm of the state and therefore, the tweaking of the interest rates is an act of intervention by the state.

If the setting of interest rates was left to the means of the market, it would have gone up and not down as lenders seek to compensate the prevailing risk.

With demand built-up fueled by cheap sources of funds, as well as several other factors which are mostly irrelevant to the issue at hand, the housing bubble grew and grew until the exuberance caused by the state was met with the cold logic of the free market. Slowly but surely the market overcame the interventions of the state, and brought about unintended consequences. The bubble burst and along with it the inability of borrowers to repay their mortgage loans.

The sub-prime borrowers were the first to suffer and as the borrowers defaulted on their loans, the lenders who suffered from moral hazard — no thanks to the actions by the state — began to realize the gravity of the crisis.

With the two factors considered, would it be fair to make free market capitalism a scapegoat and call for greater government intervention in the market?

In any case, it is unlikely that Malaysia will suffer the full brunt of the crisis. That, however, does not mean that there is nothing to learn from land of the free.

First, it is that past interventions have the potential of adversely affecting the future. Malaysia has had its fair share of bailouts and the fact that a majority of large companies in Malaysia are owned by state-sponsored enterprises offers many with an exciting if not scary natural experiment in a case of system-wide crisis. It would definitely be interesting to measure the moral hazard co-efficient in this country.

Secondly is the independence of Bank Negara. It is unclear how independent the technocrats on Jalan Dato’ Onn are from the politicians in Putrajaya. If Putrajaya has considerable influence over the central bank, the pressure to lower interest rates when it should be high would be present. With that possibility comes the possibility of a bubble.

Even more important is the requirement for Bank Negara to refrain from tweaking various interest rates and instead to let those rates float to their free market levels. Only the market has the processing capability to calculate the right interest rates for a particular environment while considering all variables.

Mohd Hafiz Noor Shams. Some rights reserved Mohd Hafiz Noor Shams. Some rights reserved Mohd Hafiz Noor Shams. Some rights reserved

A version of this article was published in The Malaysian Insider.

14 Responses to “[1787] Of do not blame free market capitalism too fast”

  1. on 23 Sep 2008 at 16:25 sigma

    Good article. Read it on Malaysian Insider.

    Two things though. The agency problem presents a real problem for corporate capitalism.

    And deregulation will always mean companies will skirt away as much as they can in revealing their financial health and conduct.

    Ross Gittins of the Sydney Morning Herald recently wrote an article pertaining to why govts bail out bankshere.

  2. on 23 Sep 2008 at 16:34 anon

    Maybe it’s time to take Friedman’s proposal to replace the Fed with a computer – increasing the money supply by, say, 2-3% per annum.

    It saddens me that the mainstream view seems to be that the fault main perpetrators are the “filthy rich”, perhaps abetted by misguided monetary policy – and the appropriate response should be greater, ‘updated’, regulation by government.

    The problem was precisely with GOVERNMENT REGULATION ITSELF. Both the Fed, the Treasury, the Securities and Exchange Commission, together with a myriad of other commissions/boards – almost every aspect involved in this financial crisis was REGULATED.

    Regulation and government intervention are two titles for the same thing, and they yield the same results i.e. throw things out of whack.

    The abscence of government regulation doesn’t mean that there would be none – things would then be regulated by private individuals i.e. market regulation, which is the BEST thing out there. Increased government regulation only prevents this from taking place.

    Despite the cries of ‘The End of Raw Capitalism’, ‘The Failure of Capitalism’ – no no, the problem is that there was NO REAL ECONOMIC FREEDOM, NO REAL CAPITALISM. What is behind the mess is really CENTRAL PLANNING (central banks, government) and SOCIALISM (Fannie, Freddie).

    You reap what you sow. Defy the laws of economics, and you suffer the consequences.

    Sure, people can flirt with central planning and run a command economy for a while – but eventual failure will always result, leading to enormous pain and suffering for all (rioting, looting, collapse of social order, wars).

    Of course, not all forms of government intervention are bad per se – but these days hardly anyone has a clue what the proper role of government should be.

    The Treasury bailout proposal is staggering – $700 billion is only a balance sheet figure (potentially the Treasury could spend infinite amount of money on bailouts). What is really scary is that it endows the Treasury with tremendous power with little accountability – fascism, anyone?

    But all these measures are only deferring the inevitable collapse – probably prolonging the pain and making it worse.

    The masses are deluded if they believe greater government control is the key to salvation, when in fact that’s the road to hell.

    Please, America – stop going down the path to fascism!

  3. on 23 Sep 2008 at 16:40 anon

    re: the Ross Gittins article

    Those could be some of the reasons, but search the backgrounds of those who control the Fed and the American political establishment – and you’d know why they like bailouts ;)

  4. on 23 Sep 2008 at 22:53 anon

    > The masses are deluded if they believe greater
    > government control is the key to salvation, when in
    > fact that’s the road to hell.

    Oh, it’s started!

    “Angry voters back Obama to fix crisis”

    “Barack Obama’s Six Point Plan to Fix Wall Street’s Financial Mess”

    “McCain, Obama Call for More Oversight, Limits on Executive Pay”

    “Obama, McCain back bailout, with caveats”

    Sheeple to the slaughter!

  5. on 23 Sep 2008 at 22:54 Hafiz Noor Shams


  6. on 23 Sep 2008 at 23:40 zewt

    gotta come back and read this tomm… too long for late night reading.

    thanks for the tips… i am truly out of date.

  7. on 24 Sep 2008 at 18:37 Rajan R

    Well, Bank Negara doesn’t dictate interest rates, but influences them. And considering that 1) it’s a fiat currency, and 2) Bank Negara issues it, I don’t think it is illegitimate. Suppliers influence market price, after all.

    But yes, the independence of the central bank is important, but it is just as important to set targets for an independent central bank. There is a reason why the European Central Bank is a lot more successful in controlling inflation in the Eurozone than the Federal Reserve: it is given a clear task and goal.

    The purpose of monetary policy is to ensure stability, and therefore, minimal inflation and no deflation. Yet Bank Negara considers growth and development in its decision-making – things that ought to be handled by fiscal policy.

  8. on 25 Sep 2008 at 09:45 anon

    To claim that the mandate of central bankers is to maintain price stability is to assume they know what prices ought to be.

    I’m not at all convinced that mild inflation is ok, while deflation is bad. Inflation in the U.S. remained low for the past few decades largely in part due to increased productivity and competing imports – but there were still ‘bubbles’ rearing their heads. The trend of the Industrial Revolution was falling prices, which resulted in higher standards of living for everyone. And to target ‘consumer spending’ is absurd, because spending/investment and savings are really opposite sides of the same coin.

    The Blessings of Deflation


  9. on 25 Sep 2008 at 12:39 anon

    Nicer article on Deflation:


  10. on 27 Sep 2008 at 14:02 Hafiz Noor Shams

    I don’t know. There are several kinds of deflation, just as there are several kinds of inflation. The “deflation” due to increased productivity is not really the issue which anti-deflationists (for the lack of better term) are highlighting.

    Rather, anti-deflationists are worried about the deflation caused by falling aggregate demand.

  11. on 27 Sep 2008 at 18:08 anon

    My point was that while it’s nice to have some macro-statistical measures (e.g. CPI, GDP) around – I question the wisdom of using them to target inflation/deflation (if it should be targeted at all).

    I don’t understand the reasoning behind targeting aggregate demand either. Monetary expansion artificially increases aggregate demand, but this has to be reversed when this expansion eventually stops resulting in falling aggregate demand. If people should choose to save – then by all means that should be respected; this would eventually lead to falling interest rates, which is conducive to economic growth. Real economic growth can only come from savings too, so savings is indeed a virtue to be encouraged.

  12. on 30 Sep 2008 at 11:07 anon

    Was reminded of this post while reading this:

    Meet the Doctor (the late Richebacher – Volcker & Exter’s good friend)
    Part I: http://www.dailyreckoning.com/RudeAwake/Articles/RA102505.html
    Part II: http://www.dailyreckoning.com/RudeAwake/Articles/RA102605.html

    “There are, of course, people in America, including many of my readers, who are old-fashioned, economically speaking. Paul Volcker, for example, who is an old friend of mine. But he held these basic economic concepts that I write about in his gut. All these things that I write about used to be in the gut of every economist.

    The Americans I knew thirty years ago saved money. They didn’t save as much as the Europeans, but they held the same attitude, at least. The fundamentals were never questioned. No economist questioned the idea that a nation needs savings. They never questioned that investment is crucial for prosperity. It was never questioned that a developed country should have a surplus in its current account. This was never questioned! It was never a topic of discussion!

    But all of a sudden, the Americans have rewritten economics…because it suits them…Saving money used to be instinctive in people, even without any economic theories. Classic economic theory is absent in America. It does not exist.”

    “We are at an inflection point in thinking…The big change begun in the 1980s. In the ’80s, Americans continued to save, but it was the government that began to dis-save. And at the time, there was a lively debate among economists about the wisdom and benefits of deficit-spending by the government. There was a very lively debate about this topic. Today there is no debate. There is no longer any economic discussion. American economists are silent, deeply silent.

    Do you know why they are quiet? Because academic America, like all of America, believes that consumer spending is the key to prosperity. The high esteem of consumer spending is implanted in every American, including its academics.

    There are many who say that deficit spending by the
    government is bad. But they don’t say that deficit spending by the consumer is equally bad, or worse. The American idea that everything good comes from consumer spending is preposterous. And that is the key fallacy in America today.”

  13. […] however is not to say that the whole crisis is caused by the market. The US government has blood on its hand. Government interference in the market has caused a cascading effect through the US economy, […]

  14. […] decisions made by actors as market failure. Bad decisions made by actors are actors’ failure, not market’s. This is applicable to the bubble bursting. The market is merely turning around and saying, hey, […]

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