David Strom

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Free Markets Failed? Hardly

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Monday, 08 June 2009 11:22 Last Updated on Monday, 08 June 2009 11:23 Written by David Strom

 

It has become commonplace for left-leaning economists and politicians to blame the current financial crisis on unbridled capitalism.

This story—this fantasy—is nothing but a fable they have cooked up to justify new government interventions into the economy on a grand scale.

I’m not talking about the bailouts, as bad as they are. Those could have been (wrongly) justified as necessary interventions to prevent the imminent collapse of our economy. No, what I am speaking about is the massive restructuring of our economy planned by the Obama Administration.

Their plans include completely reworking the energy, health care, educational and industrial sectors of our economy. They have begun implementing industrial policy on a grand scale, justified by the claim that the current economic mess we are in was caused by excessive reliance on free markets.

That justification, of course, is based upon pure bunk.

While America has certainly had markets which have been in general freer and more flexible than Europe’s and indeed most of the world, it is not the case that we followed laissez faire policies. Not by a long shot.

For the indictment of free markets to hold water, you would have to believe that the financial industry and corporate America were unregulated by the government. This, obviously, was far from true. In fact the financial industry is one of the most tightly regulated industries in our economy.

It was also one of the most poorly regulated industries, and that is saying a lot. Government regulations not only did not prevent the crisis, but in some cases exacerbated the tendencies which helped cause the crisis. Highly regulated does not mean well-regulated. And the solution to poor regulation is not necessarily more regulation.

The belief in more regulations as the solution to our problems is based upon faulty assumptions: that regulators are omniscient and omnipotent, and that the regulated aren’t wily enough to game the new system to their advantage.

Relying on regulations to tame the market system into submission is pretty much a fool’s errand. More often than not you fail, and when you don’t fail the consequences of that tamed system is often economic sclerosis. Socialism provides a tamed market, but not one that works.

Which gets us back to the whole question of those bailouts I alluded to above. More than any regulatory failure over the past several years, the growing belief that government will cushion the blow of failures in the marketplace has made our financial and economic system more, not less risky.

Government’s willingness to backstop private businesses when their losses become truly staggering has encouraged behavior that results in truly staggering losses.

The cost of the current bailouts and government guarantees has been estimated to be as high as $15 trillion. If you had a $15 trillion insurance policy on your bad behavior, wouldn’t you be just a tad more likely to take big risks in pursuit of huge rewards? Economists call this the problem of moral hazard.

We’ve created a pseudo-capitalist system that privatizes profits and socializes losses. Is it any surprise that the results of that system are economic actors willing to do almost anything, no matter how risky, in pursuit of profits because they know that others will bear the cost of their losses?

Blow up a bank? Collect the bonuses and walk away. Destroy an auto company? Keep your gold-plated pay and benefits. Write billions in risky mortgages that blow up a housing bubble? Take the profits and begin investing in property once the bubble has burst.

Government is trying too hard to tame the market, rather than not hard enough. Only with the rough justice of failure and its consequences will market actors begin to manage risk in a reasonable way.

It wasn’t inadequate regulation that created this mess. It was the “too big to fail” policy of lemon socialism that has brought us to the brink of disaster.

And as far as I can see, things are only getting worse. The advent of industrial policy on a grand scale will mean a gradual takeover of much of the economy by the government, and the politicization of economic decision-making on a scale never before seen here in the US. If that happens the US truly will become a second-rate power with an economy to match.  

Lemon Socialism vs. lemonade stand capitalism

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Monday, 08 June 2009 10:33 Last Updated on Monday, 08 June 2009 10:35 Written by David Strom

No matter how often it fails, the allure of lemon socialism never seems to diminish.

Lemon socialism is an economic system where profits are kept private but losses—at least large losses—are borne by the society as a whole. Lemon socialism is so attractive because it often succeeds, for a while, in maintaining the illusion of a free market system and all its efficiencies while providing a level of security for workers and investors by foisting the cost of failure onto the society as a whole.

The reality, of course, is that lemon socialism is everywhere and always an unmitigated disaster for both the companies involved and the society as a whole. The sorry history of Britain’s auto industry is an object lesson in the dangers of lemon socialism. British Leyland—the nationalized auto industry that Britain dismantled in the 80’s because it failed so badly—is now a byword for failed industrial policy.

Here in America we have rapidly become the new home of lemon socialism.

Take the current bailout of General Motors. In just the past few months the government has poured about $20 billion into the company as bridge loans in order to prop it up during the financial crisis. That money—never appropriated by or debated within Congress—is now slated to be written off in GM’s bankruptcy. It will be gone. Kaput. Burned to ashes. Shoved down a rathole. Choose your metaphor.

As part of GM’s bankruptcy the government will agree to put in another $30 billion. To put that into perspective GM’s current long-term debt owed to bondholders is currently $29 billion and its market capitalization was less than $1 billion. So GM’s debt and equity were $30 billion, and in less than 8 months the government will have poured $50 billion into the company to keep it going.

See any problems with that? Apparently our overlords in Washington don’t.

Even a cursory glance at the AIG bailout shows that the GM disaster pales in comparison. After $180 billion in government bailouts AIG is still bleeding cash and customers. Would you want AIG as your insurer? Then why on earth would you want to own the company?

The huge financial firms that have been bailed out by the government are said to be “profitable” again, and we have even seen their share prices skyrocket since the government unveiled the “stress test” results. Of course what is left unspoken is the fact that almost nobody would want to own these companies but for the fact that we all can rest assured that should they run into continuing trouble the US Treasury will be there to bail them out. With the government promising to do whatever it takes to keep the banks alive and even profitable why not invest in them?

The government has half-nationalized these companies: taxpayers take the losses, private investors take the profits.

Lemon socialism can’t work for a simple reason: with no prospect of real failure companies cannot and will not do what it takes to be competitive. This damages the firms that are rescued—by reducing the risk of failure and the need to be competitive—and those that refuse government largesse—by advantaging their competitors with subsidies to keep them alive. GM and Chrysler will take market share that Ford would have seized had they been allowed to fail or forced to downsize to their competitive size.

Lemon socialism hurts everybody: the companies that take the government money, those that don’t, and of course and especially the taxpayers who are being forced to pick up the tab for all this mucking about in the market.

Businesses can only succeed if they follow the very same capitalist principles that a lemonade stand must: buy the inputs at a low price, add value in the most productive manner possible, and have an attractive product that customers want at a price they are willing to pay. And do so better than the kid next door. These are principles that we try to teach our kids when they open a lemonade stand, and these very same principles that should animate America’s largest companies.

Unfortunately our descent into being a bailout nation has subverted these very principles. Kids learn a very bad lesson if their parents are willing to subsidize their losses if they fail to run their lemonade stands properly—mom and dad will always be there to bail them out. American companies are learning the same bad lessons in today’s bailout friendly environment. If things turn south, expect others to pay.

It's Risky Out There

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Tuesday, 19 May 2009 18:50 Written by David Strom

Has the economy turned a corner? Are the “green shoots” just “yellow weeds?” Did the stock market bottom in March or will it reach new lows? Are we facing inflation or deflation? When will housing prices bottom out? Is the commercial real estate market about to implode, and if so what will that mean for our fragile financial system?

If you watch CNBC or Bloomberg you will be bombarded by opinion after opinion on these and other issues, and be given reams of investing advice based upon the particular answers each guest is wedded to.

Surely someone is right, but how to tell? Perhaps more importantly, how much are you willing to bet that your guess about what is to come will turn out to be correct?

And that is the point. Right now too many variables are in flux for anybody to truly know what direction the economy will take in the near and medium term. For a long time we all claimed to know that investing was risky, but few of us truly believed it. And despite the lessons of the past year, it seems that most of us are longing for a return to a normality that we thought existed before the present crisis—a normal where a “risky” investment usually just meant one that provided abnormal returns.

The fact of the matter is that investing is always risky, but the next few years will be particularly so. It is not only the financial system that is fragile, but many parts of the world economy are as well. The current financial crisis has exposed enormous imbalances that existed before the crisis and still persist in the US and world economies, and the readjustments will take a long time to accomplish and be especially painful. In the process the relative stability that we have enjoyed in global politics will be threatened, in turn threatening the economy even more.

Consider just a few facts: entire industries such as the automobiles, newspapers, and retailers are being pummeled and fundamentally reshaped during this recession. Consumer spending patterns will be fundamentally altered, but nobody knows exactly in what way. Government has engaged in unprecedented interventions in the market, the limits of which we still haven’t seen. Don’t even get me started on the unsustainable levels of debt that the government is relying upon for its “stimulus” and “reform” packages. Unemployment will continue to rise into double-digits, and it is unlikely to come down quickly, adding pressure on both consumer spending and the housing market. International trade has plummeted, decimating export-oriented economies such as Japan and Germany. And of course international tensions have been on the rise both independent of the economic crisis and because of it.

For these reasons and many more it seems insane to me to blithely assume that things are getting back to “normal”—meaning the conditions that existed prior to the bursting of the housing bubble. The housing bubble itself was not “normal” and under no circumstances can we turn back the clock to 2007. And even if were somehow possible to do so, it seems extremely unlikely that our policymakers could accomplish this task given all the political constraints that exist.

In short we face several years or more of elevated risk in the economy and the investment environment—years in which it makes no sense to make plans that are based upon an assumption of relative stability and predictability.

If you think things are bad in the US...

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Friday, 15 May 2009 13:21 Last Updated on Friday, 15 May 2009 15:24 Written by David Strom

Every era has its dominant myth that shapes how we view it. The “roaring 20’s” are looked back upon as a time of frivolity and excess, despite the fact that they were actually times of enormous innovation and real economic growth. The 30’s are the time of the Great Depression and Roosevelt saving the United States through his successful New Deal—a view that has largely been discredited in academic research and recently through Amity Shlaes’ book The Forgotten Man. Everybody knows the myth that defines the 60’s for us: baby boomers bravely speaking truth to power and stopping the unjust Vietnam war—never mind the millions of Vietnamese and Cambodians who died for their moral conceit (and in some cases physical cowardice).

The story is developing about the current era—the new era that began with the onset of the financial crisis and that will play out over the coming decade or so—is that we are living in the time when Anglo-American style capitalism has obviously and completely failed. The moral of the story is that we need to replace our individualist economy with the European social democratic style of capitalism.

This, too, is a complete myth, and like the others it has developed because it fits neatly with the world view that dominates the intellectual, media, and political elites who try to run this country.

Consider a few inconvenient facts: the US economy has contracted drastically due to the financial crisis at an annualized rate of about 6% for the past two quarters. Those are terrible numbers. Yet when you turn to Europe you quickly see that their economies are performing even worse, despite the fact that many Euro Zone countries did not have asset bubbles like the housing and stock bubbles in the US.

Numbers just released by the European Union show that the Euro Zone economy shrank at a stunning 10% annualized rate—dwarfing the US’ 6% decline. Germany’s export-driven economy contracted at a 15% annualized rate, putting it into serious depression territory. Canada, our largest trading partner, has seen its GDP drop at a 7% annualized rate, Japan’s has dropped by over 12%.France was an outlier, contracting at a 3.2% annualized rate, but that is balanced by the fact that their baseline unemployment rate before the crisis hit was almost 8%.

It has become crystal clear during this crisis that despite all the talk of “decoupling” of the world’s economy from the US’, it is still the case that if the US sneezes the rest of the world gets the flu. Our trading partners have been harder hit by the crisis than the US itself because their economies are utterly dependent upon a vibrant and expanding US economy.

The US remains the engine that pulls the train of the world economy—and will remain so if we don’t destroy the engines by throwing too much sand into the diesel tanks. Unfortunately that is precisely what the Obama Administration is doing. Overturning longstanding bankruptcy laws on the fly, bailing out every business it can find (if they are big enough political contributors), threatening to take over 14% of the US economy through nationalizing health care, raising energy prices through cap and trade, financing 50% of current spending through running up huge deficits—there is no end to the bad ideas they are pushing.

We may indeed be seeing an end to the Anglo-American style of capitalism. But if so it won’t be because it failed us, but because we failed to protect it and the enormous benefits it has provided us over the years.

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