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