March 14, 2010

Intelligent Libertarians, Regulation and Financial Crisis: An Essay

Posted in America, Economics, History, Intellectual History, Nerd Posts, Political Philosophy, Politics, Society at 10:31 pm by Paul Sagar

Below is an essay – I think it’s fair to call it that – arguing that intelligent libertarians should favour regulation of the financial industry.

I’m looking for responses from sensible libertarians, liberals, and leftists of all stripes. I’m sick of abuse-hurling and tribal partisan sloganeering. Ideas are best refined when they are forced to clash.

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In this weekend’s Financial Times there was a fascinating series of articles on the collapse of Lehman Brothers following the release of the 2,200 page Valukas report into the investment bank’s failure. It transpires that Lehman was employing extremely dubious financial instruments for months before its eventual bankruptcy, in order to disguise the appalling state of its balance sheets. Using practices similar to those “pioneered” by Enron, Lehman was able to disguise its ill health from investors and creditors. Now that the truth is out, Lehman’s auditors Ernst & Young have come under intense scrutiny for waving-through Lehman’s practices, invoking the spectre of Andersen Accounting and its post-Enron demise.

The case of Lehman appears to show that if “light touch” regulation is applied to financial institutions, at least some of the lightly touched will self-destruct. It’s important to stress that Lehman wasn’t brought down by greed (though there’s little doubt that Lehman bankers, like most investment bankers, were greedy). It was brought down by the firm’s over-exposure and over-dependence on complex financial instruments that ultimately couldn’t be sustained.

There are many reactions to the story of Lehman. But I want to explore and develop just two, although I’m going to have to start by simplifying. The first is the standard response from most on the left: that Lehman should have been subjected to greater regulation. Call this the Sensible Statist position. This group claims that had Lehman been better regulated, it would not have been able to over-expose itself and become over-reliant upon financial instruments that generated short-term profit but in the long term led to implosion. By being reigned reined-in during the short term, the bank would have survived into the long term.

The other response I want to examine is what I will call the “Intelligent Libertarian” view. Again I am simplifying. The Intelligent Libertarian argues that if Lehman over-exposed itself, then tough luck for Lehman. It was not only right that it was eventually allowed to fail – it was right that it was allowed to get itself into a position where it could fail. Intelligent Libertarians believe that capitalism is a game you play at your own risk. Accordingly, financial markets should be totally de-regulated. Those firms that, like Lehman, over-expose themselves will fail. That’s the harsh reality of capitalism. But it’s not all bad: those firms that survive will be those that don’t over-expose themselves, the ones that make the right moves and the right gambles. The best will survive – and the rest, wanting to compete with the best, will emulate the activities and practices that have proven successful.

Yet straight away we must complicate the picture. Lehman’s failure was not an isolated case of one investment bank over-exposing itself and failing, indicating that it was a worse-run business than its competitors and thus deserved to die by the sword of capitalist competition. Those sorts of bank failures happen all the time – but Lehman was different. Lehman’s collapse was part of a systemic failure in the banking system. All the world’s financial institutions were circling the plug hole. Lehman was allowed to go, but when the US Fed (and the UK Treasury, and the ECB) realised that all the rest of the world’s investment banks, insurance providers, hedge funds, building societies and brokers were going to go too, action was taken. Following the lead of Hank Paulson and George W. Bush, trillion dollar bailouts were announced. The world’s banks became socialised, and capitalism was turned on its head.

What do our Sensible Statists and Intelligent Libertarians have to say about this? There are two areas we need to consider: whether the bailouts were justified, and whether the crisis would have been averted if the world of finance had been subjected to more thorough-going regulation. The argument I am going to make, however, is that the two issues are intimately connected, and as a consequence Intelligent Libertarians should end up backing greater and better regulation of the financial industry. I’ll start off by examining only the arguments about whether the 2008 bailouts were themselves justified.

Sensible Statists have always offered a resounding “yes” to this question. The argument they put forward is clear and compelling: that a collapse in the global banking system would have caused unimaginable, unprecedented chaos. If the banks had failed, then all bets would have been off. Not only would cash have ceased to come out of ATMs, the very wheels of capitalism would have stopped turning. Panic would have swept the developed world, riots would have begun, governments would have collapsed, and an entirely new era of human civilization – or lack of it – would have ensued. This, Sensible Statists say, was not a price worth paying. Trillion-dollar bailouts with taxpayer money, plunging Western governments into unimaginable debts, were the cost that had (and have) to be endured.

Intelligent Libertarians disagree. They argued – and have argued consistently – that the price of the bailout was too high; not just in terms of taxpayer dollars, but in terms of the perversion of the very essence of the capitalism which has made the west rich and free. Intelligent Libertarians do not deny that a banking collapse would have been painful – indeed, horribly so. But they argue that growing out of this pain a new order of capitalism would have emerged. Drawing upon the ideas of seminal 20^th Century philosopher and economist Joseph Schumpeter in particular, Intelligent Libertarians might argue that if the banks had failed, this would have led to the much-needed process of “creative destruction”. The old order would have fallen – but a new and better one would have risen in its place, one that learned the mistakes of the past and built on them to improve. Instead – the Intelligent Libertarian points out – what happened was that western states merged with the banks. A nightmare vision thus arose. The already out-of-control behemoth corporate institutions that strangle competition and free enterprise (what genuine free market capitalism depends upon in order to be a force for good) were married with the power of modern states. Diabolical hybrids were born: financial institutions that are not only too big too fail and can thus commit economic sins with impunity, but which are propped-up by the tax-dollars of ordinary people, and maintained by the coercive power of the state. For the Intelligent Libertarians, the 2008 bailouts heralded a nightmare vision of capitalism twisted beyond recognition into something hideous.

There is much to be said for the Intelligent Libertarians’ concern at the mutant offspring of states and megacorps that has emerged from the world financial crisis. Witness the spectre of RBS. Operating like a private investment bank, RBS pays its executives billions in bonuses, funds the extracting of Canadian tar sands oil (which climate scientists describe as one of the biggest single factors likely to facilitate run-away climate change) and refuses to lend to struggling businesses. All the while it has a taxpayer guarantee that it cannot fail should it make poor market decisions, and its debts are backed by the coercive power of the British State. Intelligent Libertarians are right to sound the alarm bells at the rise of such entities.

Yet what has happened as a result of the bailouts is a different issue from whether the bailouts should have happened. As outlined above, Intelligent Libertarians do not think that the immense pain of a global capitalist collapse should have been suffered for the fun of it. Rather, they see it as the necessary though unpleasant price to pay for an improved world order. But are they right?

The Intelligent Libertarian world-view looks, quite simply, untenable. We already have examples of what happens when capitalism fails – and they’re not pretty. The obvious case study is, of course, Weimar Germany. When hyperinflation, extended depression and mass unemployment took hold, ordinary Germans did not call for more capitalism. They looked for solutions in Hitler’s National Socialists, who promised authoritarian routes out of crisis that bred not only the horrors of global war and the Holocaust, but precisely the sought of state-corporate gangster capitalism that Intelligent Libertarians abhor. (It may be worth reminding Intelligent Libertarians that their bete noir John Maynard Keynes developed his theories in order to save capitalism from the twin threats of fascism and communism at a time when liberal capitalist democracy looked like it was about to kick the bucket).

But we need not rely solely on such dramatic and emotive examples. Think of Britain in the 1970s and 80s. In the midst of dire economic straits, many Britons did not call for more free market liberalisation. Thatcher’s reforms were unpopular and pushed through only because Labour dove so far into the hard left that it could mount no meaningful opposition, whilst the power of the state was employed to crush organised labour. During the 1970s and 80s, the National Front thrived – by offering extremist solutions to an extreme situation (making Nick Griffin’s present BNP look positively wet). Indeed, look at Britain today: when the economy struggles and jobs are scarce, ordinary people do not call for more free market capitalism. They call for protectionist policies to defend home industry (think Cadbury) and for draconian impositions on migrant labour (think Daily Mail).

Intelligent Libertarians may want to argue that such responses in ordinary people are wrongheaded and ultimately self-destructive. Perhaps they are right. But this reply misses the point. In times of large-scale capitalist crisis, political movements develop that are deeply antithetical to the free market capitalism that Intelligent Libertarians espouse. Even if Intelligent Libertarians are right that if left to itself the market would recover from a global capitalist crash to produce a better form of capitalism, the problem is that the market will never be left to itself in such circumstances. Following a global crash of the sort envisaged had the 2008 bailouts been denied, extremist groups seizing control of nation-states on the promise of never allowing capitalism to rise again would have been far more likely than a short spell of pain followed by rational economic actors diligently picking up the pieces. The alternative universe in which the bailouts were denied has tanks on the streets, with people and nations falling back into state communism and fascism. If the bail-outs had not happened, state-minimalist capitalism would have been the last thing to emerge.

Thus the Intelligent Libertarian claim that the bailouts should have been denied, and the pain endured, looks misguided. I now, however, want to take a brief detour and examine some of the intellectual history around questions of state intervention in times of extreme emergency.

Many Intelligent Libertarians will look to Adam Smith as an important intellectual forbearer. And in many cases, they are justified in doing so. In particular, Smith’s Wealth of Nations addressed – amongst many other things – a central question in the history of the development of property rights: whether the law concerning property rights ceases to apply to desperate individuals in times of extreme necessity. Previous thinkers like Hobbes hard argued that the law does so cease: if a person is starving and the only way they can survive is to steal a loaf of bread, then they are automatically excused from breaking the law. In such a case – Hobbes thought – the law could have no purchase; it ceased to have meaning and excuse was automatically conferred on the law-breaker. Law’s function, in Hobbes’ schema, was to protect all of our rights to survive; if the law stood between an individual and the loaf of bread they needed to carry on living, then the law ceased to have meaningful content. Violation of the property rights of the bread-holder were thus automatically justified, and the violator was automatically excused (though the law against bread-stealing would itself stay in place due to its general tendency to promote the wellbeing of all, considered collectively and systemically).

Smith disagreed. For him, property rights had to be enforced as foundational to the jurisprudential structure of society, and they had to apply in all cases. If a starving man stole a loaf of bread to survive, then he broke the law. Now, if apprehended and taken to court for such law-breaking, a judge might consider the circumstances and offer clemency to the bread thief whilst still finding him guilty. The point, however, is that the law continued to apply – but in this case, punishment might be forestalled on the grounds of extenuating circumstance (the bread thief, after all, was starving). Whereas for Hobbes the law against stealing bread ceased to have meaningful content because the bread-thief was starving, for Smith the law continued to apply (a violation of the bread-owners legal property rights had certainly occurred) but punishment for this violation might be mitigated by a sympathetic judge. Though equally it might not. (However, given what Smith says in his Theory of Moral Sentiments, it seems that he would personally have hoped that judges be sympathetic in such cases).

As a result, Smith made property rights foundational. They became, indeed, the central supporting pillar of his vision of (broadly) free-market commercial society. And it’s Smith’s vision that we have embraced. Steal a loaf of bread today and – even if you are starving – the authorities will still charge you with theft. If you are lucky, the magistrate will let you off with a slap on the wrist when you go to court – but then, she may not. Thus, the centrality of continuing absolute property rights – as envisaged by Smith and his natural law forbearers like Grotius, Pufendorf and Locke – goes to the heart of modern capitalist society. And insofar as Intelligent Libertarians uphold the inviolability of property rights, they are indeed following Adam Smith.

Yet perhaps many Intelligent Libertarians would be interested to know that Smith did not consider the same rules to apply from the perspective of the state. Whilst individuals were always bound by the rules of property, as enshrined in law, the state was sui generis. Here Smith followed his friend and intellectual interlocutor, the great philosopher and economist David Hume. Hume had argued that, in times of extreme national emergency, the government must do whatever was required to save the nation. Under ordinary circumstances it would of course be wrong for the government to burn the suburbs of the capital city – but if that was the only way to prevent the enemy’s approach then it must be done.

As Istvan Hont, the world’s most pre-eminent authority on the foundations of modern political economy has remarked:

“Hume had taken it for granted that magistrates had the right to open private granaries and distribute grain to the poor at set prices, not merely in a situation of actual starvation, but ‘even in less urgent necessities’. He had used this example to argue that ‘the rules of equity or justice depend entirely on the particular state and condition in which men are placed’. In situations of ‘extreme necessity’ it was ‘perfectly useless’ to insist on maintaining an unlimited right of private property. Smith followed this line, but seems to have closed off the case of ‘less urgent’ necessities. Only actual impending starvation appears to qualify as the ‘case of most urgent necessity’ which would justify the suspension of property rights in grain.”

Istvan Hont, “Needs and Justice in Adam Smith’s Wealth of Nations”, in Jealousy of Trade, (Harvard, 2005).

(Grain was a favoured 18^th Century example, because fluctuations in the grain price and in extreme cases the lack of grain itself could cause riots amongst the common people that had the potential to topple governments).

The point is that for Smith, from the perspective of the state, extreme necessity justifies suspension of the law regarding property rights. If the only way to hold a nation together was for the state to violate the property rights of individual grain holders then so be it. Salus populi suprema lex est – the safety of the people is the supreme law.

It is interesting therefore to note that when George W. Bush announced the 2008 bailout, he invoked the safety of the American Republic as his justification. The threat to national security was deemed so extreme that the normal rules of capitalism were suspended: salus populi suprema lex. Bush was, therefore, acting within the Smithian tradition. So it is worth Intelligent Libertarians reflecting upon their own intellectual heritage. Whilst the 2008 bailouts might jar with their ordinary preferences for state minimalism, it is not inconsistent – or necessarily unprincipled – for them to agree that desperate times call for desperate measures. Smith would, I think, have supported the 2008 bailouts, albeit grudgingly.

So Intelligent Libertarians need not – by virtue of their ideological principles – be committed to opposing concerted state intervention in times of extreme emergency. And given the likely consequences of not undertaking such a bailout in 2008 – namely, the collapse of global capitalism and the rise of something much nastier in its place – Intelligent Libertarians should think hard about that, in terms of their own long-term ideals and goals.

It is now time to return to the issue I earlier put aside: the question of general regulation of the financial system. I promised that this would connect up to the question of the 2008 bail-out, so let me now draw that connection.

Whilst some Intelligent Libertarians – such as Jeffrey Friedman – have argued that the crisis which broke in 2008 was a crisis caused by the wrong sort of government regulation (even if it was extremely minimal) and would have been averted had there been even less regulation, what the 2008 crash ultimately seems to have shown is that systems fail. And they can fail spectacularly. In her book Fools’ Gold, FT editor Gillian Tett demonstrates that the crisis was certainly not caused by greedy bankers deliberately bringing down the global financial system whilst stroking white cats and chortling evilly. Rather, the crisis arose because many interdependent actors all pursued actions which were individually rational, but when summed-together added up to catastrophe. Yet a key problem that Tett identifies is that not only were the new financial instruments developed by the world’s biggest banks unregulated – they were barely understood by the people using them. Furthermore, the bosses and senior managers of the people inventing and manipulating new financial instruments were largely ignorant about what their subordinates were doing (and in most cases frankly uninterested in, so long as the cash kept rolling in). Accordingly, the world financial system kept on accelerating towards lightspeed – until one day it fell off a cliff.

Now, even if someone like Friedman is right that the 2008 crash was caused (in part) by the wrong sort of regulation, one thing that doesn’t seem to follow is that crashes would be averted if there was no government regulation. What Tett ably brings out is the fact that systems can fail – and the more complicated and fast-moving those systems are, the more spectacular and devastating those failures can be. There are some libertarians – let’s call them the Unreflective Libertarians – who will claim that a financial system devoid of any government regulation will never fail, and that only government attempts at regulation cause crisis.

Yet this sort of Unreflective Libertarianism is untenable. This is because it’s a piece of sheer dogma. The idea that the market can never fail because it is the market, and that financial crashes are only caused by government meddling, is crass ideological rhetoric motivated not be consideration of the facts or of history, but by blanket hatred of government. It’s simply ludicrous to claim – as the Unreflective Libertarian must – that the law of unintended consequences can be avoided by simply removing one actor (i.e. the state). As Tett demonstrates, the 2008 financial crisis arose because of interconnected actions which, whilst individually harmless, were collectively disastrous. To say that free markets are not vulnerable to such phenomena simply because they are free markets, is to employ the most mentally-crippling of ideological frameworks.

However, coming at things from the other angle, there does seem to be a case for some government regulation of financial markets – and certainly more than was in operation prior to 2008. It is surely not insignificant that the Wall Street Crash occurred during a period of relatively low financial regulation. Nor that following the Reagan-Thatcher era of financial deregulation we have witnessed major financial crises in South East Asia, Russia, and Latin America, the bursting of the dot-com bubble, and the great crash of 2008. Indeed, concerning the latter Tett is again instructive: if senior managers and regulators had even possessed the barest clue about what derivatives traders were actually up to – and had imposed measures to slow down the pace of financial innovation – then it’s possible that investment banks and insurance companies like AIG would not have been able to build up the “super senior” debt that went toxic over 2007-8 when credit lines ran dry, eventually bringing the global system to its knees.

Which is not to say that government regulation universally prevents financial crises. That would be wrong, and also to commit the sin for which I criticise the Unreflective Libertarians. Yet it does seem to be the case that whilst government regulation cannot eliminate financial crises, it can certainly mitigate their frequency and devastation if done sensibly. In turn, that makes the need for 2008-style mass bailouts less likely.

Which brings us full circle. Although I hope to have shown that there are good grounds for why Intelligent Libertarians ought to be able to endorse drastic state intervention in times of extreme necessity, no Intelligent Libertarian would want to make a habit of it. Indeed, neither would any Sensible Statist. We’ll be picking up the pieces from the 2008 bailout for decades to come, even if we only start to feel it after the next government begins the deficit-slashing.

A 2008-style bailout has to be – for Intelligent Libertarians – something which can be resorted to only in times of extreme desperation. Accordingly, it is surely better if we collectively undertake measures to prevent the need arising for such extreme measures. How do we do that? We regulate financial markets.

Thus it appears that if Intelligent Libertarians are to avoid having to resort to the sorts of mass government intervention that they despise – or likewise avoid advocating the collapse of global capitalism on the fantasy-land justification that a new Capitalist Utopia will inevitably arise in its place – they would do well to endorse regulation of the financial industry. Of course, Intelligent Libertarians won’t like this. But then, in politics and life we all often have to do things we don’t like. And in case Sensible Statists are feeling smug, they should recall that deregulated financial capitalism brought an unprecedented 15 years of sustained economic growth to Britain, vastly improving the lives of millions. Increased regulation would mean less super-growth capitalism, and that would have negative impacts upon all our lives too (though we might think that’s the price to pay for avoiding extended economic depressions caused by financial crashes).

So it seems that there are good grounds for thinking that Intelligent Libertarians ought to support some regulation of the financial industry (exactly how much is a question for extended debate – yet given the above I suspect the answer is “more than what Reagan and Thatcher left us with”). And if hyper-capitalist Libertarians must accept this, then it seems that anybody thinking sensibly about the issues at play will have to agree (you can’t really get more pro-free market than a Libertarian, after all). So when Giles Wilkes – chief economist of the liberal think tank Centre:Forum – criticised Intelligent Libertarian Johan Norberg’s book Financial Fiasco and urged him “to recognise that government, very occasionally, offers the best way to protect the economic liberty so precious to the author”, I would go further than Wilkes. It is not just “very occasional” government intervention that Intelligent Libertarians should reconcile themselves to, but – and on their own ideological grounds – sustained and well-considered routine regulation of financial markets.

There is, however, the lingering problem touched upon earlier: the mutant offspring sired by state-power and gigantic corporate failure. The 2008 bailouts happened, and those entities now exist. This is a problem. Whilst it might seem straightforward – at least, post 2008 – to criticise hardline free marketers for their views, Intelligent Libertarians are nonetheless absolutely correct to ring alarm bells about the new monsters of socialised corporatism that the bailouts have awakened. These new entities take us into virgin territory in the development of economics and political economy. The deep suspicion and hostility espoused by Intelligent Libertarians towards these behemoths of socialised corporatism are feelings that we ought all to share – whatever else we might disagree about.

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