The Real Answer to Our Economic Problems: Abandoning Free Market Capitalism

Note: Before you, my beloved reader, continue I just want to preface this short essay with some background information. Many readers will notice the above title is eerily similar to Mr. Jefferson's recent post. This was of course intended. Readers should know that Mr. Jefferson and I have a long history of verbal sparing on economic issues and it is only in that spirit and with a smile on my face that I wrote what you are about to read. So please, do not think any ill-will is meant by this post. It is just another chapter in the battle Mr. Jefferson and I have been gleefully waging against each other since 2006.

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This IS a failure of unregulated markets.

I couldn't have said it better myself. In fact, the very notion that our once powerful economy is "failing" is nothing new to the more liberal sort of this country as we've been saying it for as long as The Left as been alive and (barely) kicking. However this is not a time to point fingers and say "I told you so." People are loosing their retirement funds, houses, jobs, and untold amounts of wealth, something needs to be done. But what's to blame? I'll tell you: Credit Default Swaps (CDS) and a partial free market system.

CDS:

Credit Default Swap is a bastard child of JPMorgan, used in the mid-90s to solve a growing problem they were facing which could threaten to hold back their profits.

The problem: JPMorgan had loaned billions of dollars to governments and corporations, but due to federal law had to keep enough capital reserved in case the loan went bad. This meant that there were large sums of money which JPMorgan couldn't give out for loans because the government was "unfairly" forcing them to protect their investments.

The answer: JPMorgan started using the credit default swap. A CDS is when a bank or lending institution finds a third party to take responsibility for a bad debt (paying it if it goes bad) in exchange for small regular payments, just like insurance premiums. By doing this the extra money on their books reserved for covering bad investments can now be used to issue more loans.

Yet, how did this effect the economy?

By 2008 the value of CDS grew to $62 trillion with Lehman Brothers having $700 billion in CDS and AIG possessing $14 billion worth of CDS that they had loaned to banks, insurance companies, and God knows what else. When investments like these went bad the third parties (just like a credit card company) came calling for their money, and when groups like AIG couldn't pay (due to a lack of extra funds in reserve) they defaulted. Causing what happened next, which has been in the paper for the last two-months.

The problem with CDS was that they WERE NOT regulated by the government and no mechanism was in place to help determine their value.

CDS were used to promote investments in dangerous foreign markets, protect against company failure (like Enron), and most importantly to back mortgages. Lenders, like sharks, would let families take out mortgages they knew the family couldn't pay and would then offload the debt onto a third party via CDS. However once people started defaulting on their mortgages, the lenders started to default on their payment to the third party, which like a domino effect cause a crash as it was quickly discovered that no one (not even the third party) could pay or absorb the loss. When no one absorbed the loss AIG crashed and when AIG started to crash investors began to pull money out of every major lender and investment bank, causing the same effect as a snowball rolling down a hill.

Free Market Problem:

Free market capitalism caused this problem. While my colleague is correct in pointing out that the Feds got involved by lowering interests rates, he is wrong by placing blame on the government for labeling Fannie and Freddie as a GSE. The real problem was the unregulated CDS market, which grew and grew until lenders were caught in their own greed and the bubble truly did burst. While this example alone should show many why we don't need full-blown free market capitalism, I will offer another more powerful one to solidify the argument: the Rational Actor (RA).

Free market capitalism such as the version proposed by Mises, and the game theory which studies all brands of free market jargon, relies on the Rational Actor to ensure the system works properly. Let me explain:

"As this malinvestment is discovered markets; left unhampered by government interference; will naturally correct and be able to separate good investments from malinvestments." -- Ludwig von Mises

That sounds all well and good but Mises and his allies are relying on the players within the market to be Rational Actors. To be an RA means to be well informed about the state/aspects of the market and to act accordingly in the best interests of yourself and everyone else. As such the ideal RA would think: "This seems to be a bad investment. I'm going to ignore it so that I may invest in this safer endeavor."

Great, but free market believers make two mistakes:

1.) They assume the actor is well-informed and/or not withholding information.

A common mistake is to assume the actor knows everything about market economics so they can make sound decisions. This is impossible, especially as the market has gotten more bloated with technical jargon and complex schema. In addition, they also assume that other actors within the market (like a bank, stockbroker, or investment firm) are not withholding information from others to gain an upper hand. This means (for a simple example) that even though a stockbroker knows investing in a certain company would be bad for their client, they might recommend it anyways just so they can get a commission, be dammed if it puts their client at risk.

2.) They assume the rational actor is in fact rational.

Imagine two cars driving towards each other playing a game of chicken. One actor knows that he is either going to swerve and save his life or stay the course, make the other guy swerve, and be the hero. Rationality would dictate these thoughts in both actors. But what if one actor rips off his steering-wheel and chucks it over the side giggling to himself? Even though he is being irrational the other actor thinks he is still being rational and undoubtedly the chances of the cars colliding increases. This is what happened with mortgages. Families went in to banks looking for loans to buy a house, but instead of being an RA in seeing that a family couldn't afford certain mortgagees, the banks threw their steering-wheels out the window, irrationality loaning the family large amounts of money they could never pay back.

Now apply this to the whole market. If we had a free market system we would be relying on rational behavior by the actors within the system, something which I have just shown is not always the case. Actors within the economy or not well-informed, they withhold information to gain the advantage, and will irrationally act in order to increase their own gains. These three faults of the RA alone prove that a free market system is not the answer. A regulated one is.

If the market was more regulated the CDS market would never have swelled to the size it did or even took place to being with, actors would be fined for withholding information, and institutions would be more closely watched to ensure they do what's best for both parties, not just themselves.

Regulate It:

My fellow citizens, if you want more of the same economic worries push for a fully free market system that relies on "rational actors," we already saw were a partial system got us. However if you want to level the playing field, support a regulated market. It won't stifle competition or invention (a common claim by Republicans), all it will do is ensure that everyone is forced to play by the rules which in turn will ensure that everyone makes money and those companies that should fail will fail, something I'm sure free market believers will love.