Saturday, December 27, 2008

"How could you believe in free-market capitalism after this financial mess ?"

In the midst of the economic crisis that we are facing today, most of the so-called pundits argued that we are witnessing a failure of free-market capitalism and this is therefore the consequences of several economic deregulations made in the past twenty to thirty years. As these pseudo-intellectuals are flooding the international mainstream media, I have lot of friends who are asking me the following question: "How could you believe in free-market capitalism after this financial mess ?"

In my native country (France), We use to see the United States as the symbol of free market capitalism and Georges W. bush is one of his ferocious proponent. We consequently associates this philosophy to his administration failures to demonstrate that capitalism does not work and should thence be tightly regulated. However, if we look back to the US history of politics, we can easily shows that this is utterly inaccurate.

The end of the 19th century and beginning of the 20th was shaped by progressivism. Followers of this philosophy pledge for a more interventionist role of the state in the economic and financial spheres, which is totally in opposition to free-market principles.
Abraham Lincoln was one of the first American president to put this doctrine in practice by increasing tariffs, leaning towards big corporations, and putting an end to the gold standard. Suspending the gold standard is indeed one of the cause of the economic booms and bursts that we faced during the 20th and the 21st century. Backing paper money by nothing leads to a vicious inflationary cycle that is lethal to the economy. Things went worse when the progressist administration of Woodrow Wilson created in 1913 the Federal Reserve (US central bank). The FED (abbreviation of Federal Reserve) was created to limit financial"panics" that occurred in the 19th and 20th century. During these tough financial periods where the amount of credit is tightened its role is to inject liquidity in the financial system, in order to dope the economy. Unfortunately, this system creates more inflationary pressure and send the wrong message to investors. To have a better understanding of this mechanism, I would recommend you to watch the video below. This video is from the most prominent libertarian and free market school of economics in the world: the Austrian School of Economics. Note that this video predates the current financial crisis

Eighty years after the great depression and ten years after the "dotcom" bubble the same kind of policy led the world to another burst.
in the the beginning of the 20th century The Fed decided to lower interest rates, that generated an economic boom as well as an era of prosperity. In this euphoria and in an attempt to pursue an interventionist agenda, the Clinton administration(policies also endorsed by the G. W. Bush Administration) decided to make housing affordable for those who cannot have access to this market. That is how para-governmental entities Fannie Mae and Freddie Mac were created and laws like the Community Reinvestment Act and the Taxpayer Relief Act were passed.
Moreover, to make Fannie and Freddie profit-making entities these organizations spread financial products based on these loans. The immediate results of these measures were successful in the sense that a lot of people were able to afford a mortgage. Regrettably, The same and predictable scenario happened. In 2004, the FED decided to increase his main interest rate. As most of these house owners contracted a variable interest rate mortgage, they progressively faced insolvency. All the financial institutions that purchased products based on those insolvent loans were in trouble and they contaminated the whole economy and the whole world. Please watch the following video for more details:

Apart from the two schools of economics cited above there are also lot of intellectuals, who are also backing this explanation (New York Times Columnist Russel Roberts, 2002 Nobel Prize of economics Vernon Smith) but the most spectacular demonstration of it was the interview of Peter Schiff (economic advisor of the Libertarian and 2008 republican candidate Ron Paul) two years before the economic meltdown on CNBC (video below):

You will understand that it is very difficult for me to say that free-market capitalism is responsible for this crisis when the US government tightly controls and regulates he financial sector. I am not denying that there was also corporate greed in this period, but this has more to do about the effects of the meltdown and not about its cause as William L. Anderson brilliantly pointed out in his article.