LOOKING FOR THE CAUSES AND CONSEQUENCES OF THE GLOBAL FINANCIAL AND BANKING CRISIS:
Neo-liberalism In The Dock
The current financial and banking crisis must not be mistaken for evidence of the impracticality of market economics, nor should the crisis be attributed to any lack of economic regulation. The message of the political centre-right to European voters must, therefore, be the following: Decentralization of political and economic power still helps society to cope with current and emergent problems and possibilities in much more efficient and humane way than centralized political decision-making. When innovation and development is encouraged far and wide, societies are likely to become less vulnerable to economic setbacks and upheavals. Market economics, combined with autonomous local self-government, represents structural sustainability in societal development.
Introduction
A financial and banking crisis is shaking the world with a vengeance. Its effects are considered eminently more drastic than those of the Great Depression of the 30’s. It is entirely possible that the crisis may deepen further and its damages go beyond human understanding.
Observers looking at the financial and banking crisis have hitherto fixed their attention on three principal aspects: Finding explanations for the crisis, attempting to understand its dimensions, and seeking to resolve the plight. Each of these aspects constitutes a vast and multi-dimensional entity, the scrutiny of which requires considerable mental and physical resources.
Indictment
This article focuses on the first conundrum, that is, the attempts to discern the reasons behind the crisis. Special weight is given on the assessment of the credibility of those theories which see neo-liberalismas a primary culprit to the crisis.
Veikko Vuorikoski writes in Aamulehti (12/10/2008) that the crisis has rendered Adam Smith’s notion of the beneficence of free market capitalism profoundly dubious. The maelstrom of economic disaster has sucked in the USA, Britain, and other countries rooted in economic liberalism where Smith’s model has been the most revered, and seen the most use.
Paavo Rautio writes in Helsingin Sanomat (12/10/2008) that the banking crisis has smothered the orthodox market liberalism into extinction. He thinks the crisis has pointed out the weak spot of market fundamentalism, translating complete freedom into complete anarchy. This anarchy has driven world economy to unthinkable problems.
Rona Foroohar writes in Newsweek (13/10/2008) that market economy is incurably unstable, and that its fundamental ideology and theory have now irredeemably come to the end of their road. As the “invisible hand” moving the markets simply has not enough knowledge and wisdom, politics must now steer the markets with a visible hand of new regulation and guidance.
In his latest book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, George Soros, who has a vast experience of financial markets, explains the global collapse with the liberation of world trade and lessening of regulation. In the new global environment, the United States consumed more than it could produce, and China together with other Asian countries produced more than they could consume. Thus the United States went into debt while other countries amassed considerable dollar reserves. World trade is, therefore, not only about free movement of goods and services, but also about countries incurring debts.
Soros has a clear idea of the consequences of the deregulation of financial markets. When banks could no longer lean on governmental regulation, they had to resort to their own internal regulative systems, which however proved deficient and too light-weight against the risks banks were taking. According to Soros, the biggest mistake of governmental regulators was failing to understand, how inept banks were in assessing their own actions in relation to the risks taken.
Neo-liberalism is particularly accused of opening the markets to insatiable greed, of destroying the natural communality of people, of rescinding regulation, of promoting science which puts a price tag on everything, and of tolerating widespread economic crime. Since many would agree upon the validity of these factors, it is worth taking them under critical scrutiny.
Neo-liberalism and greed
One thing neo-liberalism is being accused of is that it, by promoting unrestricted pursuit of individual gain, also endorses greed. Market economy not chained by political will makes a fertile breeding ground for greed. When unrestricted, there is no limit to human avarice. It therefore affords a plausible explanation for the global catastrophe which could have been avoided, had there any kind of reins to dampen such greed.
Neo-liberalism is generally seen as a theory of men seeking to rationally maximize their gains. In this pattern of thought, greed is mother to all virtues. In the Oliver Stone film Wall Street Gordon Gekko says, “Greed, for want of a better word, is good”.
The theory of a rational, gain-maximizing selection is a useful tool for analysis, but it does not follow that people act according to its requirements. In practice, people are not – and even cannot be – aware of all relevant causalities behind every issue. They will always be limited in knowledge, lacking in skills, and deficient in capabilities.
They may imagine that they are maximizing and optimizing their own choices, but in reality they are only taking unsure and tentative steps. They try, make mistakes, and learn. They cannot be sure of the success of their choices. They can only increase the probability of the success by trying to serve the needs and requirements of their fellow men. This is because, in the market conditions, people have freedom to choose.
Neo-liberalism perceives economic exchange basically as the reconcilement of innumerable interests. The markets do not offer great opportunities of maximizing one’s own interests by ignoring those of others. Thus, the most conspicuous feature of market economics is not the maximization of greed, but its unique ability to co-ordinate the efforts of innumerable market actors to conceive, develop and distribute new productive ideas.
The assertion that political decision-makers can rein greed in market is irrational for two reasons. First, they are also as limited in their knowledge as entrepreneurs and business managers. The society is irrevocably too vast and complicated for them to be capable of governing all relevant causalities in implementing political plans. They don’t know what they don’t know. They surely know something, but not everything.
Secondly, if people are capable of maximizing their greed, then, of course, politicians can and will do it. In this case, arguably, they seek ways to promote their own goals at the costs of others. Then, if this is the case, they also must be included in the equation in expounding greed.
People have steadfast ideas about right and wrong. They like to instruct each other and cry “greed” to those that do not take their advice. This is a question of tutelage curtailing opinions and choices; of paternalism, the problems of which liberal thinkers have been constantly warning their fellow men.
Paternalism is usually rampant in politics, in which it is easy for some activists and intellectuals to promote their own truths and opinions on others by legislation. These people – second-hand dealers in ideas as Friedrich Hayek calls them – are a serious threat to creative human interaction, because they are dogmatic in their thinking and unwilling to compromise. They seek to dictate what others may want and get. It is easier to negotiate and conciliate with people who know their own interests than it is with the defenders of universal virtues.
Of course greed is a human trait and it is useless to deny it. What is here denied is human beings’ ability to maximize greed and use greed as the valid explanation of global financial crisis. It is easy to speak of greed, but considerably more difficult to differentiate it from people’s other legitimate desires and hopes. It is likewise difficult to distinguish greed from other human motives such as the will to innovate, experiment, succeed, and surpassing oneself.
More important than condemning greed is to ponder what institutional arrangements could make greed benefit a society. In this role, when looking at things as a whole and in the long term, market economy – free enterprise – has hitherto succeeded better than political supervision and regulation.
Neo-liberalism and communal life
Neo-liberalism is accused of placing individualism before a natural community and of allowing individuals to seek personal gains without regard to their society. A culture endorsing individualism has less and less room for common values and joint efforts. This culture slights the state, the borough, and public services. Individualistic culture eradicates the idea and morals of the public government.
Individualism turns life into a merciless hunting ground for profits and compelling people to fight each other for their bread. Individualistic culture only values winning, but ignores the losers. Winners trample on the weak, of whom no one cares. It encourages the taking of ever bigger risks, notwithstanding the consequences.
The assertion according to which neo-liberalism is hostile to natural community cannot withstand close scrutiny. The liberal have constantly emphasized that different communities, which are close to people, can cope with their social problems much more efficient and humane than any forms of a welfare state.
For liberalism individualism is not opposite of community, because they are mutually strengthening and supporting social powers. For this reason the liberal argue that the real threat to community comes not from neo-liberalism but from the state which requires a monopoly status for itself in serving people. This policy has severely weakened communal bonds and ties in a society.
It is easy to speak of community, but considerably more difficult to define its real meaning. When there is no scientifically solid way to define it, everyone may figure it out as they please. It is probably not wrong to assume that, for many, a community means shared values, the convergence of interests, and harmony of life. An idea of a family, in which everyone strives for common good, approximates the ideal of communality.
Society, however, is no family. Although everyone in a family is concerned with the totality, this scarcely happens in society. It is easier for a family to reach consensus on the direction of effort and sacrifice, as well as on the sharing of spoils, than it is for society to do the same. A family can direct and rein the choices of its members, a society considerably less so. When a family works together, it thrives. If society should work as a family, it ceases to thrive.
If people in the society were only to do similar things, it would eventually lead to many important things being left undone. To get them done, the society would have to treat its members unequally. If the society gives its members an opportunity to do different things even against the will of the majority, we come to a situation where government will have to treat people equally leading to a marvellous liberal convention – equality before the law.
The paradox of diversity lies in that the more different people are, the more dependent they are on each other, and the more likely they will form different communities. Different pools of people – that is, communities – have survived better in such countries that have permitted continuous social development and the market economy to function.
It is wrong to brand individualism as the enemy of community, to perceive them as diametrically opposed, and describe their relation as a zero-sum game. Competition in the markets is not war, although it is often seen as such. It is imperative to understand what any community cannot achieve.
It does not provide information about people’s changing expectations. It does not allocate resources according to anticipations. It does not help to invent more efficient production techniques or provide stimulus to invest in them. It does not co-ordinate the actions of millions of consumers and enterprises in a manner that would bring prosperity to people. Community serves other human needs and endeavours than market process.
Individualism and market process of neo-liberalism are not a counter-force to communality. Perceiving them as opposed represents simplistic dualism, where the justification of one negates the other. Liberalism is opposed to action in the name of communality to restrict the freedom of markets and individuals.
Neo-liberalism and deregulation
It is argued that the global financial crisis is the direct outcome of government’s policy to give up its regulatory powers for market freedom. For very many, deregulation is the primary explanatory factor in the crisis.
The critics of neo-liberalism assume that without regulatory intervention people will always harm themselves, their fellow-men, and finally their society. According to them the theory of free market being infallible and impeccable has proved a mere fallacy. Free competition is not as beneficial as the liberal have supposed and thought. The critics think that the society can flourish when guided by government with its purposeful regulation.
In liberal thinking there is two kind of regulation: purposeful and neutral regulation. The former, called also target-oriented, is a means to promote politically defined objectives and purposes. The latter, called equality before the law provides a society with unbiased judicial framework in which people can pursue their different and conflicting plans simultaneously and peacefully.
The purpose of neo-liberalism is not to get rid of all regulation. They have never called for the abandonment of all regulation as is commonly argued. They are against purposeful regulation and favour equality before the law. They disregard purposeful regulation because it usually serves well-defined group interests. Purposeful regulation provides benefits to a small minority while their costs go to the majority. For this reason it is more detrimental to a society than neutral regulation in the long run.
On the contrary, regulation based on equality before the law, is usually beneficial to a society. or example, The Economist weekly (15/11/2008; p. 84) reports that certain states of America liberalized their banking laws in 1970 – 1994, with the consequence that the economic gap between the blacks and the whites began to narrow down. The increased supply of capital boosted entrepreneurship, jobs, and market competition. Taken together, these factors wiped off more than a fifth (22 %) of economic disparity in the states where such disparity was most glaring. This outcome is all the more remarkable because it was not a stated aim and came as a by-product.
The liberal do not claim that liberalising purposeful regulation would be easy. Several interests and requirements must be weighed. Above all, the position of the weakest must be protected in relation to the strong. Liberalism cannot be blamed, if legislators fail to correct legislation. It is not the failure of liberalism, if lawmakers listen to the voice of the strongest, and act accordingly.
It is entirely possible that the reasons behind the financial and banking crisis are to be found in former purposeful regulation and the inept efforts of legislators to fix it. Rules are not easily dispensed with, because after discarding certain rules they can be replaced with new, and possibly even more detrimental, ones.
Neo-liberalism and economic science
Neo-liberalism is being accused for its tendency to passionately measure all human action and put a price tag upon every move. In this line of thought, everything is for sale. This kind of thinking, of which there is ample evidence, is however strange to neo-liberal thinkers. On the other hand, it is the conspicuous feature of the school called neoclassical economics, which is invariably being taught in every economic institute.
Neoclassical thinking emphasizes market agents’ full knowledge of market conditions, utility maximisation, the boons of perfect competition, and the active role of the government in developing economy towards a state of equilibrium. Neo-liberalism has been perpetually blamed for these theses, although they are in many instances diametrically opposed to its teachings.
It is more than likely that public policies as well the world’s financial and banking institutions have been directed and developed according to the neoclassical theory of economics. In Finland, there is hardly any economic institution that has been researching and teaching neo-liberalism in the same sense as, say, Ludwig von Mises, Friedrich A. Hayek, Wilhelm Röpke, Ludwig von Lachmann, and Israel M. Kichner have done. Professionals in the world of financing and banking, bar George Soros perhaps, have probably not even heard of these thinkers. It is possible to graduate from the economic faculties of many universities without having heard a word about them. In these institutions, research based on neo-liberalism is scant indeed.
Neoclassical theory of economics puts a strong emphasis on economic measurement and the economic assessment of benefits. Calculations and measurement validate the choices taken. The choices are approved, when their value can be corroborated by economic measurement. Its fundamental idea is to steer development towards equilibrium, in which resources are put to optimal use.
The utility of economic measurement of things and choices is generally accepted, up to and including legislation. This is exactly the kind of thinking being used to explain the financial and banking crisis. The problem with this exegesis is to describe it neo-liberal, when it is in fact deeply rooted in neoclassical economics.
True enough, neo-liberalism does have the concept of economic calculation. It is, however, essentially different from the economic calculation emphasized by neoclassical economics. This becomes abundantly clear in, for example, Economic Calculation in the Social Commonwealth and Bureaucracy by Ludwig von Mises. In the former work he explains the basic idea of economic calculation, and in the latter he shows how private firms use it and why public organizations cannot use it in the same way.
Neo-liberalism and lawlessness
Der Spiegel (#47; 17/11/2008) features a special article on the meltdown of the capital market. It starts tracking down the causes of the crisis in 1995 and carries on to 2008. The article points out that the financial and banking crisis boils down to actions undertaken to exploit the possibilities afforded by the law, even though these were actually contradictory to its spirit.
Der Spiegel shows how loopholes are being searched to promote personal interests. Laws are being interpreted to best suit personal ends. Legislation is, for a number of reasons, vulnerable against this kind of activity, which can even twist the lawmakers’ designs to something quite different from what was originally intended.
Der Spiegel points out how hard and time-consuming it is for the lawmakers to keep track with the developments. They also tend to disagree on the nature of the problems and how to address them. Thus, activity in the so-called grey zone can continue almost without impediment. When different affairs are taken into court, they call for high expertise and zeal to delve into most difficult technicalities. This is why it is difficult to recognize certain important fundamentals embedded in seemingly minor and trivial matters.
Financing and banking affairs are about considerable sums of money and the complexity of systems needed to handle them. It is therefore likely that people involved in these matters cannot fully comprehend what they are doing, and what the repercussions may be. Unwanted consequences, thus, tend to accumulate with time.
Der Spiegel believes that sinister and underhand activity explains the collapse of capital assets (Das Kapital), but not that of capitalism as market economy. It is, however, difficult for public authorities to recognize and eliminate activities in conflict with the law. It seems to be that every piece of legislation and regulation may provide an enterprising mind with new opportunities to exploit, with the repercussions becoming apparent only later – often after a long time indeed.
The crisis according to neo-liberalism
If neo-liberalism cannot be held responsible for the financial and banking crisis, how then does it explain the emergence of this crisis? From the liberal point of view, it is possible to highlight two factors, which are mutually entwined in many ways. They are the manipulation of economy by the government and the centralization of political power; both of which have various manifestations.
First, however, we must refute an oft-recited claim of neo-liberalism having been ignorant of the looming crisis. Liberal thinkers have been uttering words of warning since as early as the 1990’s, but unfortunately they spoke to deaf ears. They were brushed aside as persons, who dogmatically defend the priority and the ascendancy of the markets, failing to see the public government’s possibilities in promoting general prosperity in society.
Public government as manipulator of the economy
One of the most topical explanations to the financial and banking crisis is the decision of the US president Bill Clinton to legally oblige two government sponsored financers, Fannie Mae and Freddy Mac, to grant mortgages to people who did not normally qualify for such loans. Clinton’s political aim was to provide own housing to as many as possible. A federal decree compelled Fannie Mae and Freddie Mac to purchase sub-prime loans from banks.
According to the data collected by Samuli Leppälä (Turun Sanomat 28/10/2008), federal policy led to the increase of sub-prime loans from 25 billion to 600 billion dollars in 1994 – 2006. Contradictory to common belief, market economy had obviously nothing to do with this process.
It seems likely that without federal intervention, the credit crisis could have been avoided. It is also possible that people, who were in no condition to take a mortgage a few years ago, could have been so later. The moral is what political influencers are loath to hear: Markets can, in time, implement many of the things politicians themselves think well.
It is – erroneously – claimed that the markets in United States were wholly deregulated. According to David Henderson (Cato Policy Report November/December 2008) this assertion cannot withstand critical assessment. The laws of the United States are found in the Federal Register, the number of whose pages rose on average by 75,526 per year during President George W. Bush’s time in office. In Clinton’s time the average annual increase was 71,590. It is also worth noting that from 1980 to 2007 the expenditure in finance and banking regulation rose from 725 million to about two billion dollars. Only state regulation of internal security called for more expenditure. Put together, these two areas account to more than half of the total cost of regulation in the federal budget.
Hendersonargues that the deregulation of banking and financial institutions is fiction. These fields are, and have been, very much regulated. Although there has been an amount of deregulation, new regulation has been put in place. Regulation has had two effects pertaining to the crisis. The first is that regulation burdens official decision-making and sets requirements which go beyond the cognitive capacity of the officials. The second is that regulation does not add to rationality in economic decision-making. It is highly doubtful to attribute the financial and banking crisis to unregulated activity. It rather seems a consequence of such regulation that exists.
Research in different times of expansion and slump – 1837, 1873, 1893 and 1929 – suggests that the prime factor behind crises has been government action. Ludwig von Mises and Friedrich von Hayek, among others, attribute these to the manipulation of the ratio between the interest rate and monetary supply. The interest rate, they argue, is a signal which predetermines the economic agents’ appraisals and choices. When the interest rate is low, people feel it possible to take loans to make chosen investments. When the rate begins to rise, their willingness to borrow diminishes. These are commonplace and natural market processes.
The economy also gives rise to circumstances where the interest rate is intrinsically high, whereupon the government opts to keep it deliberately low. In these conditions the interest rate loses its predetermining quality. Investors, for whom it is virtually impossible to know political motives and decisions behind the supply of money, deem it profitable to take loans and invest the money in capital goods.
As a consequence of the interest rate manipulated by political power, entrepreneurs make their investments and believe they are doing the sensible thing. Believing in the interest rate to be a rational signal indicative of the direction of the economy, many of their investments prove in time sadly erroneous. They cannot however be accused of selfishness or greed. Nor can they be blamed for lack of professional skill, for they could not know better.
Neo-liberal thinking acknowledges the fact that a period of expansion, borne out of manipulated interest rates, will be eventually and inevitably followed by a slump to remediate faulty investments. Firms expunge their products of properties and features, for which consumers were unwilling to pay. Firms, for whose products and services there was no demand, go out of business. Market economy redresses itself in this manner, and does it considerably more effectively than political decision-making.
Political will can at best save a firm teetering on the brink of bankruptcy. It cannot, however, redress the situation, because the rescue operation is likely to lead to the bankruptcy of some other, possibly healthy, firm. This way a sensibly led enterprise will bow out of business, and one that has made faulty choices remains.
Centralization of political power
Political power is relatively centralized in every country, and this fact has its validity in explaining the financial and banking crisis. When political power becomes concentrated, it attracts an amount economic power, and features of corporate governance enter political decision-making.
As political and economic power becomes centralized, the same happens to individuals’ mental landscape. They no longer believe they can fix their affairs by themselves. They require public government to help them with their diverse endeavours.
The centralization of political, economic and mental power reduces the possibilities open to people, turns markets one-dimensional, and renders society very vulnerable. In time it will lead to a situation in which people must compete with each other all the more vehemently for ever smaller surpluses. As a result of this struggle, they will lose first their confidence in market economy and then in politics.
Kevin Hassett (American Enterprise Institute for Public Policy Research, December 1, 2008) analyzes a claim, according to which the faulty ideology of neo-liberalism fed an unfounded sense of freedom. If this were true, the financial and banking crisis would afflict most severely those countries that are relatively the most liberal, that is, least centralized. Based on the Economic Freedom of World Index by the Fraser Institute, he disproves the claim. The more centralized the country, the more severe the crisis.
It is correct to argue that for government decentralization and centralization are means to tackle different kind of problems and challenges. Thus, the real question is whether the world needs decentralization or centralization in order to fix the problems and set the wheels in motion. It may turn out that centralization is less needed in areas where it will be now offered by politics, and more needed in spheres in which it is not targeted. If this proves true, public policies will weaken the moral foundation of the market economy as well as local and regional self-government, both of which are fundamental building blocks of European integration. Further, they will burden political decision-makers with such massive responsibilities they never can live up to them.
In the end
It is amazing to read and hear opinions according to which liberalism is to blame for everything bad and unsatisfactory. It is amazing, because it is the classical liberal thinkers who have made room for freedom, democracy, constitutionalism, and civil freedoms. In our world there are many governments which methodically deny these institutional arrangements from their people. But, nations which honour and promote them are more prosperous, peaceful, and humane than others. Thus, in fixing the world’s problems governments must not sacrifice the free market economy, or the traditions of local and regional self-governance.
Risto Harisalo
risto.harisalo@uta.fi 0500-675 477
Professor, Department of Administrative Studies, University of Tampere
Member of The Academic Counsil of The Centre For European Studies
