The economic crash and free markets

December 4th, 2008 at 8:37 am

I’m having a hard time understanding why many people are blaming the free markets for the recent economic crash. The most popular opinion is that the government has let the markets “run wild”, and it should now regulate them more instead. But IMHO, this is the exact opposite of the truth!

If anything, this economic crash happened because of too much regulation, not too few. The mortgage loopholes, the whole subprime business, was made possible by governmental intervention into the free market. This resulted in a bubble, and now the bubble has burst and pulls down the whole economy.

Circa seven years ago the dot-com bubble has burst and caused a short period of recession, which hurt most badly the industry that originated it – the hi-tech, software and internet businesses. This makes lots of sense, and I don’t think anyone serious blamed the free markets for the crash. The free markets (like most economic theories) work over prolonged periods of time, not over short few-year spans. The dot-com bubble burst made lots of investors cautious, and a similar burst is very unlikely any time soon (though it will happen eventually, since people have short memories. See the tulip mania, for example). A few months ago (before the big crash) the NASDAQ index was at 60% of its value in the peak of the bubble. This is the free market’s way of correcting itself. Some business model seemed successful at one period of time, but (again, as happens a lot in economics) most investors didn’t really know that it was shaky – a bubble. So the market crashed – it makes sense.

The same can be said about the latest crisis. Yes, it’s deeper, because the financial and banking industry is much larger and affects much more people than the internet business. But it was a bubble none-the-less. And moreover, it was aided caused by the government’s regulation of the loaning business. And eventually (in a few years, it seems) – the free market will correct itself, and people will just be more cautious in the future.

But the government tries to solve the problem by even more intervention. My opinion may be unpopular on this subject, but I’m not sure that bailing out banks is a good idea. It’s an incentive to err again in the future, and that worries me. Brokers who went loose with the inverstors’ money that was based on shaky foundations, and those bankers who’ve lent money knowing that it won’t be paid, but that they will get the bonus for the deal, won’t be careful next time, because the government has intervened. “The fed will save us again” they’re now saying, and as soon as the crisis ends they’ll be back.

Recently I’ve heard that the incentives programs of the big governments include not only saving banks but also real economic incentives for returning to growth. This is great, but I’m still concerned about the ratio of these expenditures. Saving banks won’t help the economy recover, incentives to the industry and to consumers will.

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5 Responses to “The economic crash and free markets”

  1. abelNo Gravatar Says:

    Hi Eli,
    “The mortgage loopholes, the whole subprime business, was made possible by governmental intervention into the free market”

    Could you elaborate what interventions made the subprimes business and its loopholes possible. How did the government’s regulation aid in the bubble’s creation and it consequently bursting.

    Below, I have included some interesting links, which deal directly with the sub prime mortgage.
    Mark of Good Math Bad Math, has written a series of articles on the subprimes mortgages — a mathematician’s analysis of the situation. Here is a google search of his blog with subprime as search term.
    http://www.google.com/cse?cx=017254414699180528062%3Auyrcvn__yd0&q=subprime+site%3Ahttp%3A%2F%2Fscienceblogs.com%2Fgoodmath%2F&sa=Search

    This American life is am excellent public radio program that elaborates on people’s lives in America. Last year, they had a program called global pool of money which mortgage crisis.
    http://www.thislife.org/radio_episode.aspx?episode=355

    and finally, the infamous, Peter Schiff video collection, the guy who foresaw it all –
    http://andrewsullivan.theatlantic.com/the_daily_dish/2008/11/vindication.html

  2. elibenNo Gravatar Says:

    @abel,

    Thanks for the comment. The link to “Good math bad math” is very interesting. In its explanations of the whole subprime business it lacks one important point. There are clear indications (though I don’t have direct sources) that the govenment encouraged banks and other financial instutitions, using incentives, to loan out to badly-rated borrowers. This was driven by the more leftist parts of the congress in order to allow people with weak credits to buy homes too.

    A couple of interesting (though I suspect quite extreme for socialistically leaning individuals) articles on the topic are here and here.

  3. abelNo Gravatar Says:

    Eli, the allusion that the government allowed banks to give mortgages to credit risky individuals is false. The government plays one and only one important role to influence decisions that banks make. Interest Rates or in financial parlance Fed Funds.

    “…This was driven by the more leftist parts of the congress in order to allow people with weak credits to buy homes too.”

    You must be unfamiliar with the credit process. In the US, we use Fico Score which is a numerical value on your credit worthiness.

    Through out this sub prime underwriting process this number must always have been higher than the banks required minimum score for that particular loan package. For example, if I was to borrow $500000 mortgage in a NINA loan my credit worthiness couldn’t be any less than what the bank’s requirements are.

    The problem is Fico score tells that you pay your bills on time. Except it doesnt tell, any thing about how much you can afford to pay monthly.

    So, it is important to understand that the loans were made to credit worthy people but very POOR people.

    And my above rant is not some leftist idiosyncrasy. While I do not agree to your view that government regulation is the issue, I do not like the way the current and the coming governments are handling the situation. Instead of helping the people –john mcain’s approach– it is helping the corporations which is the obama policy.

    PS. Please when you get a chance listen to the global pool of money episode of TAL –link on above post– it is an eye opener.

  4. abelNo Gravatar Says:

    More evidence to show that regulations are necessary is Madoff’s 50 billion fraud. The news, including SECs failure in monitoring this guy is everywhere.

    The idea that “less regulation”, meaning, relying on the rich to play by the rules (for their own sake) is utterly and completely false and being debunked on a daily basis.

    when a market maker , first let me explain to you the amount of money that market makers have

    Take all the money that Citi, JP Morgan Chase, Bank of America and the rest of all US financial institutions and combine their money and market makers still have more than that. Liquid. (this information comes from a reliable source :) in the finance industry). The Liquid part is very important. that’s what makes you and me able to buy and sell a single or a million share with a clck.

    so When a market maker swindles you — I rather keep my dollars under my bed and let the rodents eat it.

  5. elibenNo Gravatar Says:

    @abel,

    It is a very common mistake to think that market regulations by government are meant to cause people play by the rules. There are laws for that, and the commiters of fraud are outlaws, in either a socialistic or a capitalistic society. If anything, government regulations usually result in more fraud, and not less. Take the Soviet Union for one notable example.