A Failure of Capitalism?

Posted By Elgin Hushbeck

There is still a lot of confusion over how the current financial crisis started and thus why we are in the mess that we are in.   Some argue that it is the failure of Capitalism.  Others argue that it was cause by government not doing enough, an absence of regulation.  There does seems to be a general agreement that it had something to do with the housing bubble, and many assume that it was Bush’s fault because he was in office at the time. 

While the former is correct, the latter is only partially correct, and both miss a very key aspect of the problem.  The subprime mortgage crisis following the collapses of the housing bubble was the initial cause of our current problems. Yet rather than the banks being too greedy, the housing bubble was caused by laws such as the Community Redevelopment Act, which literally forced banks to make loans that they had before considered too risky.  Unsound policies at government sponsored Fannie Mae, and Freddie Mac also played a major role in this.   Bush actually warned about these growing risks, and sought reforms that might have avoided, or at least lessened, the problem in 2003 and again in 2005. Both times Democrats were successfully able to block any reform.  Still, while the collapse of the housing market started the current problems, by itself, the recession that followed would probably have been a mild one.

The real missing piece to the puzzle is that on Nov 15, 2007 the US Financial Accounting Standards Board issue rule 157 which imposed Mark to Market (MTM) on companies as they started their fiscal year after that date.  MTM says that assets had to be valued at what they would be worth on the open market if you tried to sell them.  This is fine for assets that can be easily sold at any time such as gold, and it is normally not a problem for long term assets in a growing economy.  But in a downturn it can be a real problem.  There was a reason that FDR repealed MTM during the depression and its re-imposition beginning in late 2007 was a huge and very costly mistake.

Given the collapse of the housing bubble, as MTM was phased in nobody wanted to buy mortgage backed securities so they had to be valued at basically zero, even though they were long term assets and most people were still paying their mortgages. The bottom line was that companies that otherwise were doing ok had to post huge losses because of an accounting rule change. Even worse, companies which were required to keep certain levels of assets, because of MTM, suddenly found themselves short and scrabbling for loans to make up the difference. Yet given all the uncertainty, nobody wanted to make any loans.  The negative effects of MTM rippled through the economy all through 2008 as more and more companies began their fiscal years.  By Sept, 10 months into MTM, a real crisis was developing.

This is when the government did step in with Toxic Asset Relief Program (TARP), but TARP was at best a bandage for the symptom and did not actually address the real problem.  Therefore, not only did it not work, it only made things worse. The economy plunged deeper and deeper.   It did not cease its slide until March 2009, virtually to the day that it was announced that MTM was being repealed yet again.  The short experiment with MTM lasted 17 months, but did trillions of dollars in damage to the economy.

Once it was repealed, many of the institutions that needed bailouts, suddenly recovered and were able to pay back their loans. While the core problem was fixed at that point, and markets did bounce back a bit, by then the economy had been so damaged and burdened down by all the “Fixes” that the government had tired,  TARP, the bailouts, the Stimulus, etc, that it continued to struggle.  It is rippling effects of the now repealed MTM,  government’s ‘fixes’ and the ‘fixes’ to the ‘fixes’ along with the uncertainly caused by the Obama administration’s policies, such as Obama care and increased regulations,  which are what are harming us now.

So, bottom line, this was from start to finish a crisis of government’s making. It was not a failure of capitalism, or a lack of government regulation. If fact it was the opposite.  Government regulations distorted the housing market causing the housing bubble in the first place.  MTM then threatened to turn a problem in to disaster.  Finally when Government tried to fix things, they did not address the root problem and in fact only made things worse.   So it was not a failure of capitalism, but a smothering of capitalism that has caused the current problem. This solution is a return to capitalism.

(A more complete discussion of this can be found in Preserving Democracy pg 245-263, particularly 255-263.) 

Dec 12th, 2010

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