Part of the debate "The current financial crisis sounds the death knell for laissez-faire capitalism"
Proposer: Professor Jonathan Michie
I would argue that the recent banking crisis and looming recession are the consequence of laissez-faire policies pursued variously in the UK and globally over the past 30 years, and that to get out of our current mess, and to stay out, depends on discarding those laissez-faire policies.
But first, is there actually a problem? Or – as argued by some laissez-faire economists – are we simply witnessing the inevitable creative destruction of the business cycle? Call three witnesses: the head of the Federal Reserve during these laissez-faire years, Alan Greenspan; the Governor of the Bank of England; and the Deputy Governor. Greenspan has said that the economic model he had in mind which drove his decision making has turned out to have a flaw. The Governor of the Bank of England described the banking crisis as the worst since World War 1. And the Deputy Governor referred to it as possibly the largest financial crisis of its kind in human history. So, to paraphrase mainstream economics, let’s assume there is a problem.
What has caused this state of affairs? The past thirty years has witnessed repeated waves of deregulation. Laissez-faire economics has been imposed globally by the IMF, World Bank, and governments such as the UK’s. British 'aid' to Africa has involved funding the Adam Smith Institute to promote privatisation, deregulation and free market economics.
There have been problems along the way. The Asian financial crisis in the 1990s cast doubts on the idea that financial globalisation was all good news. Yet the IMF’s cure was more of the same. If Malaysia thought they could tackle the crisis by reintroducing exchange controls, it was argued, they were living in the past. But they did impose controls; the sky did not fall in; the controls worked fine.
Next, the 'smartest guys in the room' made Enron into a fantastically successful company, utilising utility deregulation to innovate new products and processes. But their innovatory techniques led to power cuts in California. Some at least of Enron’s behaviour turned out to be illegal. However, after a pause for reflection, the ‘greed is good' bandwagon rolled on.
The laissez-faire logic that imposed global financial deregulation on Asia and elsewhere, and that underlay the stock-option incentives that rewarded the Enron executives, survived such setbacks. The global financial system continued to be driven by the desire for more profits, new markets, and innovative 'products' – regardless of the implications for the real economy.
This was never sustainable. House prices became inflated beyond what was affordable – but with 125% mortgages, payments could be met from the additional advance. In the US the inability to repay such debts was hardly a matter of concern for the lender, since the debts were sold on to others. What are now considered 'toxic debts' were wrapped up in such innovative ways that many were unaware of what they were buying. Company Directors didn’t know, didn’t understand, or didn’t care. Failing in their fiduciary duty to shareholders, they were at least delivering high dividend payouts and rising share prices. Shareholders were happy, few questions were asked, and even fewer answered.
What’s the problem? Shareholders are rewarded for risk, and if it goes wrong, they lose their money. This much we know from the textbooks. And so it came to pass. Banks folded and shares became worthless. But at this point the laissez-faire story ended. Institutions do matter, as do human attitudes such as trust. If people stop trusting banks, or even the currency, markets cease to function. Hence the bailouts, the re-regulation, the nationalisation.
Laissez-faire policies couldn’t save the banking system. Governments had to act. Laissez-faire policies will not solve the recession. Governments will need to act. But when times are good, laissez-faire policies prove profitable – for some, at least. Once the worst is over, will we return to laissez-faire policies? Possibly – but I would argue we should not. Rather, markets and companies should be properly regulated; and incentives should encourage long-term and responsible behaviour, rather than short-term personal financial gain. That is true both nationally and globally.