Government Intervention Into Financial Markets Caused the Economic Crisis
By Shane Flait © 2010

 

The recent boom and bust crisis of our financial markets is not the failure of free market capitalism. It's a result of government intervention into the financial markets. It's this intervention that prevents the free market forces from bringing markets into balance to offset the possibility of runaway booms or busts.

 

The changing price for any commodity, good, or service in a free market supplies information about the markets associated with that product, coordinates the supply and demand for that product, and supplies incentives or de-incentives about supplying or demanding more of that product.

 

The financial markets are driven by interest rates which is the price of money. The interest rates determine the matching of the supply of money from savings with the demand for money in the investment and debt-related markets.

 

Increasing interest rates favor the supply of saving but makes investing more expensive. Lower interest rates frustrate the supply of savings but makes investing cheaper. There's a rate that matches these markets under prevailing conditions of institutional incentives and responsibility.

 

Government intervenes and interferes in the financial markets - undermining free market forces - through its monetary policies. Such policies control the supply of money which, in turn, effects the interest rate. Increasing the supply of money can force down the interest rate (money's price) - just like the over abundance of any product, and vice versa.

 

But making too much money available in the hands of consumers and government without a commensurate increase in goods and services will bid up the price of those goods and services. This results in inflation - a lowering of the dollar's purchasing power.  Too much inflation will force savers and lenders to demand higher interest rates to offset their money's loss of purchasing power during the time they lend it.

 

Government regulates the money supply to foster growth in the markets to increase productivity and employment, especially to offset current or impending recessions that result in reduced productivity and rising unemployment. Yet at the same time, it tries to minimize too much inflation from occurring. But this perverts and destabilizes the markets.

 

It regulates lending institutions, guarantees home mortgage loans - under Fannie Mae and Freddie Mac type investment agencies - presumably to protect bank consumers and help citizens acquire homes.

 

Unfortunately, by trying to regulate the money supply to government’s purposes, regulating the banks, and guaranteeing loans, the government undermines or destroys the free market forces that keep the markets balanced with appropriate incentives, de-incentives and responsibilities for savings and investments.

 

Without free market forces operating, the markets move away from equilibrium and have nothing to keep them from a running away toward boom or bust.

 

From 2003 to 2007, the government, to offset the recessionary fears from the end of the century equity market bust, expanded the money by 50% through its monetary polices to stimulate investment through 'easy available money or credit'. This unnaturally forced down interest rates to near zero levels and created enormous money availability for investing.

 

Such low interest rates made direct saving pay very little return, while making investment and borrowing very inexpensive. The result was an enormous housing boom as people - nervous about the recently busted equity markets - invested in real estate. It also frustrated normal savings rates, and highly aggravated the amount of debt consumers incurred.

 

Booming real estate investments fostered an explosion in mortgages. These were funded by banks, government agencies' guaranteed loans through Freddie Mac and Fannie Mae, and newly created mortgage-backed investments.    

 

For lending institutions and other money suppliers to compete and remain in business under the demands for mortgages with unnaturally low interest rates and rising house prices, they lowered their loan qualifications - and thereby increased the risk to future investors in all mortgage-backed investments.

 

Lending institutions- along with the government-related agencies Freddie Mac and Fannie Mae lowered their loan application requirements so even the noncreditworthy borrowers got loans.

 

And of course, the government guaranteed those loans which certainly enhanced risk-taking since the government would be picking up the 'check' under any defaults.  Mortgage-backed investments packages obscured the underlying loan risks to better compete for offering higher interest rates to investors. 

 

So, the result of the government forcing low interest rates through over expansion of the money supply was to destroy the free market forces resulting in runaway booms driven by 'easy money'. The booms included the mortgage-backed real estate boom, the boom in all the financial investment supporting it, and the debt boom for consumers.

 

But of course, all booms end when the missing benefits that a free market would supply becomes apparent. What was missing in this government fostered financial crisis was the natural de-incentive for lending - i.e. defaults and the associated investment losses. The bust began in 2008 when the overabundance of noncreditworthy borrowers began defaulting on their loans.

 

By this time, the money and mortgaged-based investment boom had infiltrated the investments of most of the major financial institutions. Many of these 'default-related' investments became next to worthless causing them enormous losses. Such investment were called 'toxic asset'. With such assets, many large financial institutions, themselves, began to fail. The financial crisis instigated in the U.S. put additional countries into recession.

 

The recession then made financial institutions wary of lending any money they had for fear of further loan defaults and loss.

 

And so we're brought back into recession again with productivity down and employment high, after government's interference in the financial markets. But the boom and bust economy has been with us for the last 100 years that the Federal Reserve System has regulated the money supply.

 

What's government's position?

'Capitalism - i.e. the free market - doesn't quite work'.

 

It needs more regulation by government. They say that the whole crisis is the fault of 'greedy lenders' who made irresponsible loans for profits. 

 

Of course, the government prevented the free market from working with the natural market forces that would have held lenders to responsible standards. Government forced irresponsible lending by perverting the markets and interest rates by infusion of available money.

 

What's government's solution?

'Get us out of recession by expanding the money supply to keep rates low and promote lending' - as usual.

 

They’re bailing out banks with an expansion of the money supply and forcing bankers to lend when they don't feel responsible lending. They want to regulate the banks more and determine what they can and cannot invest in. They even want to regulate how bankers can actually pay themselves salaries and bonuses. 

 

That surely will throw more ‘wrenches’ into the workings of our institutions.

 

Slowly we should come out of recession. Business will pick up and depressed housing prices may slowly work their way up. Down the line we can anticipate more booms and busts.

 

How would Capitalism - i.e. a free market - handle the economy?

I guess we won't know. That's because of several circumstances.

 

The government wants to be in control of the economy as much as it can so politicians and regulators can take credit whenever things improve and further blame others and grab more control when things get worse. That’s where their power and benefits reside.

 

And worst still is that there are special interest groups that depend on government intervention. They will push to keep more government intervention since they that's how they make money their money too. All this happens when government just gets to big.

 

Get the word out.

End