All entries for December 2009

December 17, 2009

The real causes of the financial crisis

This is my comment article published in The Boar of week 10 Term 1 2009.

In week 8 at the politics society question time I was asked if there was a risk of too much regulation of the financial sector. My answer: yes. The audience laughed. I was the libertarian representative. I was not going to say “the government must regulate things”. That would have been unlibertarian. I have to admit that I was positively surprised by the laughter. It is better than being booed. I then tried to explain what were the causes of the financial crisis in one minute, I doubt many people understood the argument.


The blame for the financial crisis lies with the government. It is not a failure of the “free” market. Let us first look at the causes of the subprime lending crisis and then look at more fundamental aspects of “capitalism” (as it is currently understood, rather than what libertarians argue it should be).


In 1938 and 1970 the US Federal government charted Fannie Mae and Freddie Mac. They were privately owned but the government pledged to help them pay back their debts. The idea behind the creation of these two institutions was to help families who could not easily get a mortgage to get one. By 2000 they had 50% of mortgage they purchased had to go to borrowers below the median of their area. And 20% of the mortgages they purchased had to be “special affordable loans” aka subprime loans). This allowed the government to increase home-ownership amongst poor people (always a politically popular thing to do) without, in the short run, having to pay for it.


Since this was basically a political free lunch (increase home ownership without increasing taxes or making cuts elsewhere) they decided to do something similar with entirely private institutions. The Communities Reinvestment Act (CRA) was passed by Congress, it pushed private institutions to lend to people who would otherwise be not credit worthy enough to get a mortgage. They were not forced to comply however a high level of CRA compliance was required to do things likes establishing new branches and getting approval for mergers and acquisitions.


The result of all these policies: too many subprime loans who will eventually default and cause a crash. However this is not looking at it fundamentally enough. There is another aspect of modern finance (which is practised internationally) which is due to government intervention and which is wrong. It is called fractional-reserve banking. Under that system the bank only holds a fraction of its deposits in reserve (the rest is loaned or invested in shares or equities). Suppose a bank is only required to keep 10% of reserve deposits. If you put £100 in that bank it will be able to lend up to £900. Basically £900 is created out of nowhere. The bank then lends this money to other people and gets interest from it (effectively they are getting paid for doing nothing productive at all). Contrast that situation with full reserve banking where all of the deposits have to be kept as reserve (the bank will still be able to lend money from the money it has in fixed term accounts).


The problem with fractional reserve banking is not if a certain (not necessarily significant) proportion of its clients wants to get their money out the bank has a problem. The solution is to use the printing machine of the central bank (the central bank since it is backed by the State and its law making power does not have much a problem). This is not cost free, it creates more inflation and thus reduces the purchasing power of everyone (a sort of invisible tax on al of us). My point is: if it was not for the backing of the State banks would not engage in fractional-reserve banking.


With fractional-reserve banking the interest rates are lower (since there is more money to lend) than with full-reserve banking. This means that some of it is invested in poor investments (for example subprime mortgages). Eventually they will default and that will cause a chain reaction leading to a credit crunch. If I have not bored you to death have a look at “The case against the FED” by Murray Rothbard (it is available for free online).


There is another creation of the State which is bad and which most people commonly think of as part of “capitalism”. It is called a limited liability company. The first thing to note is that a company is not an association of persons. It is a person in itself. Why? Because Parliament has said so. It has all the rights of a natural person (even human rights) but not necessarily all the responsibilities (you can't lock up a company for murder). But that's not my main concern. My concern is a particular type of company called a limited liability company. If the company goes bankrupt the liability of the shareholders for any debt which has not been paid back from selling the company's assets is limited to the face value of their share (which is an arbitrary amount decided when the company is incorporated). To illustrate the situation better consider the following example: if I am a sole trader and I mess up I am personally liable for all the debts of the business but if incorporate a company and say it has a capital of £1000 and it goes bankrupt I only lose £1000. It is unfair and artificial. For an even more artificial example look up the case Salomon v Salomon. Basically the loss of the shareholders is limited but what they stand to gain is unlimited. This leads to an asymmetry of risk which leads the company to engage in very risky activities. I believe that it is another cause of the financial crisis.


What needs to be done is to remove all forms of government interference in the market, including fractional-reserve banking and limited liability.


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