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Market failure? Or policy and regulatory failure?

Thursday, 16th October 2008

The conventional wisdom is that the current financial crisis marks the failure of markets, possibly the end of capitalism. We have had Will Hutton doing the rounds of the media studios pouring scorn on anyone who has a good word for free markets. Even the very sound Roger Bootle of Capital Economics has been saying that perhaps banks are rather like public utilities, and need more government involvement.

So are we looking at market failure? Of course some institutions have behaved rashly. Of course the remuneration structures for bankers have encouraged short-termism. Of course (here comes the cliché!) lessons must be learned.

But this is not all down to the market. In many ways it reflects policy and regulation failure as much as, or more than, market failure. Which begs the question: if regulation is part of the problem, why do we think that more regulation is the solution?

Let me offer you four examples.

I have been struck by an article from 1999 by Steven A. Holmes, recently re-printed in the New York Times. He says quite explicitly that the Clinton Administration was pressuring Fannie Mae to relax lending criteria and increase housing loans to low and middle-income Americans, and minorities, who would otherwise not qualify. So at least to start with, the growth in sub-prime lending was not about spivs earning bonuses — it was the Democratic Administration’s considered policy.

There can be little doubt that the US government was behind the relaxation of credit criteria, and therefore a major driver of the housing bubble that has caused all the problems. Policy failure, not market failure. It would be interesting to know if our fresh and dewy-eyed Labour government in the UK, casting admiring glances at the Clinton phenomenon, made any similar moves at that time.

Then there was Alan Greenspan. Like most people, I regarded him as a genius who had helped the world recover from the dot.com crash. I though the US — and the world — economies were safe in his hands. Clearly Gordon Brown still thinks so. But with 20/20 hindsight, the truth is revealed. Greenspan was focussing on consumer price inflation, while letting asset price inflation rip. He believed that asset bubbles didn’t matter. We know better now. So he kept US interest rates too low for too long, another major factor in the housing bubble that has come back to haunt us. You can’t blame the bankers for that, any more than you can blame the fish for the water they swim in. Policy failure, not market failure.

Third example: marking to market. At first sight, the practice of valuing assets for accounting purposes at their actual market price on the day seems to be fair and proper and transparent. It prevents sharp bankers from over-valuing assets and presenting a false accounting picture. That’s fine, however, while there is a market. When panic grips the market as it has recently, suddenly there is no market price. No one can sell anything. The mark-to-market rule means assets must be marked down close to zero, and institutions that would probably be viable in the medium term are bankrupt in the short term Regulation was fine for the good times, but failed in a crisis. Not market failure — regulatory failure.

Then there was Northern Rock. In passing, recall that Gordon Brown constantly repeats the mantra that this was a crisis created in America, and exported to the world. The truth is different. The housing bubble in the UK developed broadly in parallel with the US, and the Northern Rock problem was home-grown. In the old days, when Britain was an independent country, the Bank of England would have called a meeting in marble halls with mahogany panelling, heads would have been banged together, Lloyds would have quietly taken over Northern Rock, and the whole affair would have been covered in one column on page seven of the FT. No panic. No queues outside the bank. No damage to the City and the country’s reputation.

So what happened in 2007? The Bank of England was uncertain how EU rules, on transparency and state aid, applied. It was impossible to sort the problem in private. Panic ensued, with the first run on a UK bank for over a century. The fumbled response was a direct result of EU regulation. Not market failure: regulatory failure.

The markets did not cover themselves in glory. But much of the blame lies with central banks, policy-makers and regulators. Do not believe for a moment that the solution is more of the same.