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The consequences of a bad diagnosis
Repeating past mistakes
Urbano Helguera*
The current global financial situation has brought the attention of scholars, opinion leaders, investors and politicians around the globe. According to many of these folks, the current credit crunch can be explained in one of the following two ways.
The first diagnosis holds that the crisis is an unexpected event that has befallen our species and has nothing to do with previous actions committed by ourselves. The crisis is like a raging fire or a catastrophic meteorite impact that has struck our markets due to some unlucky chain of events out the sphere of human control. The situation is so critical that a swift answer must be given immediately in order to avoid the worst of consequences. The holders of this view also believe that this answer cannot be given by market forces because the problem is beyond
them in scope and gravity. On the other hand, states -in search of the public good- have the necessary tools and coordination to face and solve this exogenous cataclysm. Thus, states (or groups of states) must act in a coordinated fashion in order to restore confidence in investors and private agents in general.
The other diagnosis holds that the crisis is the result of greedy or ignorant people that purposefully or unintentionally tried to reap fast rewards at the minimum cost, creating an artificial bubble in commodity and real estate prices.
This, in effect, caused a spurious growth in the price of stocks. These ‘bad guys’ are irresponsible people that use legal loopholes and accounting scams to show a clean balance sheet for investors to fall in their trap, with the aid of negligent credit-rating agencies. This view believes that the recent crisis shows that market forces, and individualistic and ‘savage’ market behavior must be checked and controlled by powerful entities called states (or groups of states) in order to avoid future crashes. In Iran’s president Mahmud Ahmadinejad’s words, “It is the end of capitalism”1. This is the main idea behind the view we are analyzing. But we don’t have to go to the so-called ‘Axis of Evil’ to find an opinion like the one expressed by the Iranian dictator. The current and future president of the United States thinks likewise. President George W. Bush, as well as presidential candidates Barack Obama and John McCain, have all given support to the idea that states must intervene in markets in order to restore confidence, by injecting taxpayers money to alleviate the credit stringiness. They also agree that more stringent legal controls must be enacted to stop unscrupulous or irresponsible managers and employees from creating future bubbles and crises. Summing up, this view holds that capitalism inevitably leads to this type of crunch. Thus, states must act, intervene and control private behavior. I don’t know about you, but it scares me to death to hear this from the current and future president of the United States of America, a country historically know as the “brightest beacon for freedom and opportunity in the world”2.
As we can see, though with different explanations, both views share the idea that market forces in a capitalist system cannot pull us out from the chaos we are immersed in (caused by accident or by that same capitalism). States must act to restore order by intervening markets and monitoring individual private behavior3.
Already we can see governments all around the world seizing the opportunity handed by the crisis to expand the power of their state apparatuses with the excuse that markets have failed and the must act quickly in order to
restore order. They believe that if America has the right to intervene in their market, they also have this same right. They are using western political leader’s words, diagnoses and actions to legitimate their power expansion. The West still has useful idiots.

This is what really is at stake today. It is not a financial or economic threat we are talking about but a political philosophical one (with economic and social consequences). The views exposed in the first paragraphs constitute misleading diagnoses that extend the life of a failing system and legitimize state intervention in the eyes of the people. The key idea behind this article is that what is failing is not capitalism or markets but states. Their intervention is what really brought us to this bubble which is now bursting before our faces. Paradoxically –thanks to the wrong diagnoses presented above- states are called to intervene yet again in order to solve a crisis their own intervention has caused. Ironic, isn’t it?
The government bailouts we see today create a moral hazard problem for future CEOs and financial advisors. They will not be irresponsible because they are greedy. They will be irresponsible because they will be saved with other people´s money (future taxpayers).
Since mid 2007, the Fed –virtually controlled by the executive- has been artificially lowering the interest rate on their treasury bonds because Ben Bernanke and company feared a future recession. The interest rates were going up naturally due to market forces that were trying to correct a deviation. Markets were trying to eliminate carry-trade schemes and other price fuelling mechanisms like giving credit to anybody who had a social security number. Obviously rates were very low due to the Fed’s systematic quarterly cuts. Lots of people with no credit history
whatsoever were given the opportunity to indebt themselves to buy a house or other stuff4. This artificially inflated house prices: more prospective home-buyers were brought to a market with a relatively fixed supply. The scheme worked while the Fed kept lowering interest rates: there were always new people accessing a
previously inaccessible market. This mechanism insured that while the Fed kept lowering rates, house prices would never fall. This assumption is correct. What’s not correct is that the Fed could perpetually keep lowering rates. However, the Fed did hell of a job: it lowered real rates even to negative levels.

But unfortunately, reality is implacable. It is not economically sustainable to have negative rates for long periods of time. Treasury bond holders would start to ask for their money back, rates would start to increase, and the rest of the story is known.
This example is just one of many state intervention mechanisms such as some legal obligations for banks to give loans to subprime segments. When we start basing our investment decisions on what some bald guy with
moustache says the interest rate should be we are doomed. That’s not capitalism. That’s a statist system. States and their agencies should not have that kind of power. Fortunately, in the long run, markets will catch up and bring us down to earth, all the more heavily if we didn’t pay attention earlier and corrected the state-provoked deviations on time.5
Capitalism is the best coordination system we have yet come to know. On the other hand states are the best systems for disrupting order and preventing markets form correcting deviations that would restore order in a natural and less painful way. Yet, due to the prevalent wisdom lightly proclaimed by nearly every politician in the world, we are going to continue using state intervention as a remedy, when it is exactly the opposite.

1 http://www.lanacion.com.ar/nota.asp?nota_id=1056728&pid=5174505&toi=6255
2 See President George Bush’s 9/11 speech.
3 Thus rendering the behavior public, reducing the sphere of individual actions which are left uncontrolled by states.
4 Money is a fungible good: what was saved in the house could be used to buy stocks or oil options or even start a new oil demanding venture with a low return rate (but higher than the negative interest rates gifted by the Fed and the quasi-state Fannie Mae and Freddie Mac).
5 Thanks to technological advances, this process of market catching up is going to be faster every day. Central Banks’ power is fortunately being curbed. See: “Globalization –Its effect on the effectiveness of monetary policy” (forthcoming) by Urbano Helguera.

* The author is Master in Law and Economics (2008 - Universidad Torcuato Di Tella, Buenos Aires, Argentina). He is also Bachelor of Science in Economics (2005 - Universidad de San Andrés, Buenos Aires, Argentina).