Everywhere today politicians are blaring that they must save America’s financial institutions, alleging catastrophic risk to the economy were any to fail. Paulson and the entire Bush administration, in a discernible panic, are now pouring $700 billion into the big banks, having already bailed out AIG, Fannie Mae, Freddie Mac, and Bear Stearns to the tune of $300 billion.
Capitalism doesn’t work, they declare, but fortunately the government is here to rescue us.
Sadly, they have it all backwards. The credit crisis is just more evidence that whenever the government supplants the free market and attempts to “manage,” i.e., control, the economy–disaster ensues.
Overlooked here is that in a free market business failures are not just normal, they’re crucial for the best products and ideas to emerge. Most restaurants fail in their first three years because customers have other preferences. Many mom-and-pop grocers go out of business because Walmart offers better selection and lower prices. Even whole industries–think typewriters, 8-tracks and horses and buggies–vanish because new inventions and competitors arise.
None of these failures are a problem, nor do they threaten the system. On the contrary, they are an inherent part of the progress which only capitalism makes possible.
So why would failures in the financial industry be any different?
Typically, the answer given is also the one used to rationalize the creation of the Federal Reserve, the FDIC, the FSLIC and any number of other government agencies and regulations intended to “manage” the banking system: financial firms carry systemic risks for the nation’s economy and therefore can’t be allowed to fail. As evidence, bank failures from 1870 to 1913 (pre-Fed) are cited, followed by the assertion that their number was simply “unacceptable.”
But every business forms part of the economic system and thus has “systemic” impact. If Microsoft were to fail, thousands of suppliers, customers, and workers would be affected, as would their customers, suppliers, workers, etc. Yet this would be no reason to bail them out. We know that new businesses would arise to fill the void, better for having learned from Microsoft’s mistakes.
And as a historical fact, the U.S. economy during the period 1870 to 1913 grew significantly faster than it did after the Fed was established. True, there were many bank failures in this period, but there were also many business failures in general: banks were actually less likely to fail than were other businesses. The number of bank failures speaks to the dynamism of the period, not to anything fragile in the financial system. Precisely because market mechanisms were permitted to work, depositors, creditors and counterparties all kept a close eye on banks, monitoring leverage and withdrawing funds at the first sign of problems.
When the free market functions–and failure is allowed–people become viscerally aware of risk, with the result that they voluntarily assume less of it.
Conversely, when the government tries to “manage” the economy–when the consequences of risky behavior are shifted from self-interested actors to taxpayers, as was done by the creation of the Fed and its various insurance programs, or when weak financial firms are propped up rather than being allowed to fail–people take on risks they would not otherwise. Banks are less careful, depositors no longer evaluate their institutions, and risks are concealed and amplified until they become catastrophic.
So pre-Fed we had runs on banks, some undoubtedly severe–but with the Fed we’ve had the Great Depression, the S&L meltdown and now perhaps the greatest worldwide credit crisis ever.
An analogy may be helpful here. Historically certain types of forests naturally experienced frequent, but small, wildfires. Because their frequency kept deadwood at a minimum, the fires never grew into large conflagrations. However, when government forestry services instituted fire suppression policies, they eliminated most small fires, but caused deadwood and other fuel to accumulate. When at last a fire came that could not be suppressed, it grew into a devastating inferno.
Learning from their errors, forestry services have abandoned fire suppression policies.
It’s time for our government to do likewise. First, by immediately abandoning its bailout binge, and then by phasing out all of the economic controls by which it attempts to “manage” the financial system–from the FDIC to the Federal Reserve itself. Nothing less can reestablish the freedom essential for a sound and vibrant economy.