In recent months, we’ve all been treated to a steady diet of sermons from those who would have us believe that the international financial crisis is all the result of the banking industry being “free and unregulated”. The former Vice Chancellor of Waikato University, Bryan Gould, is one who has made this accusation, and Australian Prime Minister Kevin Rudd has generalized the accusation by a broad attack on what he terms “neo-liberalism”. Others have demonstrated how weak Kevin Rudd’s position is, so let me focus on the kind of arguments which Bryan Gould makes.
Let’s first concede that many mistakes were made by many people in the years preceding the current crisis: irrational exuberance extended well beyond the dot.com stocks in the nineties into the residential property market and the financial sector in this decade, and many bankers seem to have assumed that, because house prices in the US had been rising strongly for years, this increase would inevitably continue. (Plenty of people made the same erroneous assumption in New Zealand.) Moreover, in retrospect, both monetary policy and fiscal policy were too loose, in the United States at least. And of course, in some cases there was criminal fraud (Bernard Madoff being the best known example).
But critics like Gould imply that the crisis was caused by “free and unregulated markets”, especially in the financial sector. This is quite simply nonsense. Banks may be relatively lightly regulated in New Zealand (where there is no banking crisis), but they have been highly regulated in the United States and Europe for many years. Government agencies have stipulated minimum capital levels that banks must maintain, and have enforced a wide range of rules and restrictions, including limits on concentration of credit risk, limits on net foreign exchange positions and much more. They have monitored those rules by regular on-site inspections.
In many ways, this intensive supervision by official agencies made matters worse by leading bank customers to assume that banks were effectively “guaranteed” by government, thereby enabling banks to operate with levels of capital well below those regarded as prudent in earlier decades. Perhaps even more serious, intensive supervision led even some bank directors to suspend their own judgement, and believe that they were behaving prudently provided they were observing all the official rules.
I well recall meeting a man who had just joined the board of one of Britain’s largest banks in the early nineties. He had spent most of his career in the British Treasury. I asked him how he found switching from the Treasury to the board of a bank. His reply was profoundly disturbing. He said that he had always assumed that banking was largely about measuring and pricing risk, and of course he had not been involved in that in the Treasury. He said he was greatly relieved to discover that all he had to worry about was whether his bank was complying with the Bank of England’s rules.
Critics like Gould seem not to have noticed that the crisis emerged not in the essentially unregulated hedge fund industry, or even among private equity funds, but in the most highly regulated part of the financial sector, namely banking.
Gould has argued that “government involvement in the management of the economy is essential”, implying that that has not been the case in recent decades. Again, that could hardly be further from the truth. Government taxation and spending make up some 40% of total economic activity in most developed countries, and in all developed countries regulations of one kind or another tightly control what businesses can do.
Even in monetary policy – where Gould has argued that central banks are a law unto themselves, operated by bankers primarily for the benefit of other banks – governments ultimately hold the whip handle. In the United States, the Federal Reserve Board operates under a statute dating back to early last century, and the chairman of the Fed gives a regular account of his activities to a Congressional committee. He is free of direct political involvement in day to day decision-making, but that has not changed to any appreciable extent in the last 100 years. The current chairman of the Fed has never been a banker.
In New Zealand, the Reserve Bank has to aim monetary policy at an inflation band agreed with the government of the day, must publish the way it sees monetary policy operating in the immediate future at regular three monthly intervals, appears before the Finance and Expenditure Committee of Parliament to be cross-examined every three months, and is subject to a potential “override” of its decisions by the Minister of Finance. The current Governor has never been a banker.
The United Kingdom adopted a very similar structure to that in New Zealand for the Bank of England in 1997, immediately after a new government was formed by the Labour Party – of which Gould had been a senior member for many years! The current Governor has never been a banker.
Ironically, a case can be made that the present crisis was caused not by too little official intervention in the market place but by too much. I have already alluded to the fact that, with the benefit of hindsight, monetary policy was probably too loose in recent years, in some major countries at least, while intensive supervision of the banking sector led many customers and bank directors to assume that official agencies were keeping the banks solvent.
We also know that, in the nineties, the United States government started putting pressure on American banks to lend to borrowers of quite marginal creditworthiness to prove that they were not discriminating on the basis of race.
And driving the housing bubble in many markets, in the English-speaking world at least, were the highly restrictive zoning policies of local governments – policies which sharply increased the price of residential land and led both borrowers and lenders to assume that the price of housing would increase forever. They were clearly wrong, but they were hardly operating in the “free and unregulated” markets which Gould imagines.
Copyright © 2024 Don Brash.