Don't knock the system: politics caused this crisis of capitalism

Published on 05/10/2008 21:32

Market-driven economies will flourish, if politicians and regulators act responsibly writes, 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 the then US president, Jimmy Carter, signed the "anti-redlining" law. Before then, lenders generally denied loans to people in poor neighbourhoods, believing 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. So lenders were forced into giving out risky mortgages: what we now call "subprime" loans.

By 1985, this torrent of bad business had nearly bankrupted America's savings 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, sparking fears other lenders could collapse. Asia's markets sank. Mexico, Argentina and even Russia defaulted on their loans. Overvalued dotcom stocks crashed. And then there was 9/11. 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 only 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 public money, happily issued more subprime loans. With more people buying homes, prices soared. Buying a house seemed a certain money-maker, so more people got more loans and bought more houses, continuing the spiral.

Over the past ten years, Gordon Brown's government has been spending well beyond its means. The difference has been funded by borrowing – an extra 280 billion of it injected into our economy, equivalent to 10,000 per household.

Meanwhile, with China and other parts of the newly globalised world sending us cheap goods, prices should have been falling. But the Bank of England has kept interest rates low, happy to see inflation at its 2 per cent target. This prompted us all to take out mortgages and buy houses, which then went up in price, making us think we were rich and could afford even bigger credit-card bills. Personal indebtedness soared.

So, for ten years, economies boomed, the champagne flowed and everyone had a great party. But it was financed by fake money – printed by the authorities solely to keep the party going. When the dawn of realisation broke, the long party turned into the inevitable hangover we suffer 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 $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 repackaged these bad debts round the world, but nobody cried foul. Institutions were lending 30 times their asset base. Though the Bank of England knew that the huge mortgage lender Northern Rock was failing, the 2,500 staff of the Financial Services Authority seemed to do nothing until it actually collapsed six months later. Even then, the FSA, the Treasury and the Bank 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: there ain't no such thing as a free lunch.

Any sustainable solution has to get finance back to those basics. But the US bailout package includes so many treats for special interests that it could save the culprits without helping the victims.

However, it's a big world out there. China, now the world's fourth biggest economy, continues to grow at nearly 10 per cent. India and other emerging economies are expanding too. Even with the West in recession, world growth next year will probably be near 4 per cent. That's pretty good.

Western capitalism has been dealt a severe blow by inept politicians and officials. But global capitalism continues to pull hundreds of millions of people out of poverty. It's a great system. Let's not break it.

&#149 Eamonn Butler is director of the Adam Smith Institute think tank in London and the author of Adam Smith – A Primer.