When Free Markets Go Bad

I don't know much about economics. I do love reading the old narrative economists like Adam Smith or Karl Marx. But I don't know anything about modern finance.

Which troubled me because, wanting to be an informed US citizen, I felt out of the loop about the mechanics of the 2007 banking collapse and the subsequent government bailout. What happened? And how could we prevent this from happening again?

So I've been reading a lot of books about the banking crisis, trying to get a clue. To be honest, still the most helpful thing I've found about the mechanics of the crisis is this video I posted a few years ago:

The Crisis of Credit Visualized from Jonathan Jarvis on Vimeo.

Based upon all this reading here's my simplified summary about what led to the banking crisis.

A great deal of modern economic theory is based upon equilibrium models. The notion is, if you allow free exchange the markets will tend toward stable optima. This is known as the "efficient markets hypothesis." Otherwise known as "markets know best."

The great scourge of equilibrium models are feedback loops, where the system doesn't settle down into stability but, rather, becomes a runaway train. Think of the feedback loop when a microphone and a speaker get synchronized, where the sound from the microphone is amplified by the speaker which is picked up by the microphone and is fed, now louder, back into the speaker creating a loop of increasing amplification until we get that crazy loud scream of noise.

Feedback loops also plague financial markets. A common positive feedback loop is a bubble, where buyers cause a price to soar because, well, people are buying it. This is the famous "irrational exuberance" of markets. Another common feedback loop is a bank run. People start taking their money out of a bank which causes other people to worry about the bank's stability causing them to take their money out of the bank further destabilizing the bank. A feedback loop similar to a bank run is dumping stock causing the price to drop which triggers other people to sell as well causing the price to drop even further.

The trouble with all this is that free market theory (and the Reagan-era policies informed by the theory) is based almost solely upon equilibrium models. The notion is, if you just leave markets alone they will stabilize and remain steady. But financial markets are full of instabilities and they often don't settle down into an equilibrium. This is just an empirical fact. Just look at what happened in 2007.

In short, capitalism, as a physical system, is full of instability. Markets cannot stabilize themselves because of these feedback loops. Worse, the economic models, which are based on equilibria, now dominant in finance and on Capital Hill share little resemblance with real world markets (with their nasty feedback loops).

To deal with one of these feedback loops--banking runs--the Federal Reserve was created after the Great Depression to protect banks from collapsing during financial panics. The result has been relative stability in the banking system.

However, during the '70s and '80s free market theory led to a massive deregulation of the banking and lending markets. According to free market theory, this deregulation makes sense. Markets know best. Thus, less regulation would allow greater competition and this competition, per Adam Smith, would allow markets to find those stable equilibria.

But that's not what happened. When banks become deregulated they start to compete against each other. And what do banks do to compete? They invest and lend. And to get an edge on their competition those investing and lending practices become more and more speculative and risky. This feedback loop produced the Savings and Loan crisis in the 1980s and the 2007 banking crisis. In short, when banks compete all you get is increasing risk and a very, very unstable financial system. This positive feedback look (a credit bubble) then triggers a catastrophic feedback loop. In 2007, once the risk inherent in the bubble became apparent, bank runs happened leading to widespread damage and failure.

One take home point, for me at least, is that capitalism, despite all its wonders, isn't inherently stable. Markets don't always know best. Because free market ideology doesn't recognize feedback loops it ignores the fact that deregulation can cause instability, as it did in the '80s and in 2007. This conclusion was admitted by Alan Greenspan, that Champion of Free Markets and Apostle of Ayn Rand, when he was before Congress trying to make sense of the 2007 crisis. Rep. Henry Waxman pointedly asked about Greenspan's free market ideology: "Were you wrong?" Greenspan, not willing to concede too much ground, answered that he was "partially wrong" for cheerleading deregulation. But Greenspan did admit that he "found a flaw" in his free market economic philosophy and that this flaw has "distressed" him. I bet it did. So what was the flaw? It was the foundation of modern fiance--the efficient markets hypothesis--the notion that "markets know best" and that unfettered self-interest tends toward economic stability:
"I made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms."

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27 thoughts on “When Free Markets Go Bad”

  1. The problem is that we do not have a free market and we never had in this country.

    Consider the Federal Reserve. The Federal Reserve has the authority to print currency and loan it at 0% interest. You have $10. They print $10. Suddenly, your purchasing power is cut in half even though you earned your money and they brought theirs forth ex nihilo

    Consider the US dollar. You are not allowed to set up a competing currency. The Liberty Dollar movement was met with armed government goons who pointed guns in the faces and confiscated the gold. So even though you KNOW you're getting robbed by the USAFed (see above,) you're not allowed to compete with them.

    Consider the bailouts. Amtrak. The airlines. The banks. All the megacorps are "too big to fail" but there ain't anybody "too small to fail." The government hands out bread and circuses to the poorest of the poor because it's the only thing keeping their heads on their shoulders. What would the million people of Detroit do if the Welfare was cut off? Revolt, or starve.

    Look, it's all about "moral hazard." If you reward people for theft, you'll get more theft. If you reward incompetence, you'll get more incompetence. This is exactly what our government does in order to keep the good old boys network at the top, and the blacks and Appalacians at the absolute bottom.

    It's not an accident. It's DESIGNED that way, it's centrally planned that way from the get-go. The purpose of a system is what it does. The means ARE the ends.

    You should check out LewRockwell.com
    They bill themselves as anti-war, anti-state, and pro-market. They even have a lot of articles on what we discussed the other day; economics within the context of the New Testament.

  2. When malinvestment, moral hazard, and cheap money are explicit values of a market gamed by the regulator for the regulated, you're going to get bad outcomes.

    If we're counting on an ennobled class of regulators to be smarter than the collective action of millions of people in a free, transparent, open environment (NONE of which can be used to describe today's markets), one not gamed for the major institutions, then we are setting ourselves up to fail.

  3. Dammerung is right,

    We don't have a free market.

    I can't speak for the 80's I wasn't paying attention then but I was a broker for 10 years leading up the the mortgage crisis. Fannie and Freddie removed all the risks of Mortgages. Which encouraged created the bubble.

    Bond traders saw this coming for years and the bush administration tried to stop it but Barney Frank, et al put a stop to it.

  4. Gary:

    But where'd the money come from in the first place?

    The Federal Reserve is the ROOT. It's Emperor Palpatine, it's the Colour Out of Space, it's Mother Brain. It's the mysterious sickness at the bottom of the village well that poisons EVERYTHING. Every dollar bill is one of its tentacles, every issuance of credit is received only after they get their cut. It's the power behind the American Wehrmacht and it's the funding to throw non-violent drug users in jail for decades.

  5. I agree 100% with what Dammerung and Schnack said. I also wanted to bring up a point of interest rates.

    In the video, it talked about how the interest rate was set as low as 1% in 2001 by Alan Greedspan (its .5% now!). The fixing of interest rates, NOT set by the Free Market, is what causes these incorrect feedback loops you discuss. When interest rates are low, that encourages businesses, banks and people to invest in projects/building/etc rather than save cash. The lower interest rates make investing look to be more profitable, because less of their money would go towards interest. This leads to the bubble, when more and more people are using credit to expand their investments. This is called the 'Austrian Theory of the Business Cycle'. This is a good place to start: http://en.wikipedia.org/wiki/Austrian_Business_Cycle_Theory

    Its funny you quote Greenspan. He was a MAJOR CAUSE of the crash. The day he stepped into Fed, he clearly abandoned any Free Market theories that he talked about years before, ie Gold Standard. He is only pointing the finger away from himself to protect his "legacy". Also, google 'Greenspan Put' and learn about how Greenspan opened the floodgates of moral hazard.

    Finally, it is good to hear that you're trying to learn more about the market collapse. You're way past 99% of all Americans. I urge you to read 'Meltdown' by Thomas Woods. He lays out the 7 major causes for the crash in language even I, a non Doctor, can understand.

  6. Money is not the problem it's a symptom.

    The problem is a lack of character and a lack of the fear of God in our leaders.

    The other problem is the lack of education in the electorate. We know how to put a condom on a banana but are completely ignorant about basic civics and economics.

    Most students don't know the 3 branches of govt but believe we are all gonna die from global warming.

  7. Stability and steady-state are not synonymous. All of us who deal with dynamical systems, including but not limited to markets, are constantly confronted with this unassailable fact. So to interpret the broad corpus of free-market economic thought as if it affirmed a STEADY STATE hypothesis is just flat inaccurate. (There may be isolated theorists who work with models of idealized systems and set forth the steady-state hypothesis, but they're not dealing with reality, and they know it.)

    All of these systems exhibit behavior known in general as "overshoot." Following an overshoot, you get either a "correction" or a "collapse," depending both on the magnitude of the event and the tolerance of the observer. What we're trying to build is not a steady state economy, which is impossible, but rather a stable and robust economy, which is able to weather the external shocks (e. g., 9/11 - anyone want to debate the economy's resilience?) and the corrections that result from internal structure.

    Anyone who has played MIT's famous "beer distribution game" - Google it - knows that even the simplest market systems are prone to overshoot and correction/collapse because of structural interactions - delays, primarily, that affect the interpretation of information used in inventory management and consequent decisionmaking. That's not news! And what's more, even cranking down on the game's parameters - by issuing constant orders at the retail level, for example - does not eliminate the short-term instabilities.

    What IS news is that the current administration is quietly trying to get us acclimated to a new quasi-steady-state, a new "attractor," if you will, in the unemployment rate: 10% is the new 5%. And that is a fabulous illustration of what has often been said about socialist policies: they spread the misery more equitably.

    Why the h*ll do the most credible investment advisors advocate diversification of a portfolio? Precisely to spread out the risk of catastrophic collapses such as Enron, Fannie Mae, etc. They know, as everyone ought to know, that there's no such thing as a sure-fire investment, and that stability does not mean steady state. It means robustness. Corrections are PART AND PARCEL of robustness. Raiding our grandchildren's bank accounts to ensure that noone is responsible for making the kinds of wise decisions that elicit sober economic behavior is a recipe for disaster. Welcome to Barack Hussein Obama's new world, a world of increasing codependency, higher unemployment, and lower aggregate prosperity...and still no guarantee of stability, much less the promised Utopian steady state.



  8. qb :

    It's unfair to blame this whole mess on our first half-white president. Dubya = bailouts and off-budget wars. Clinton = tax and spend neo-liberalism and global interventions. GHWB and Ronnie Raygun were all about useless military spending and borrow and spend economic policies despite their rhetroic. This problem wasn't made in November 2008, it goes back DECADES and we are just now starting to reap what we have sown.

    It's just; despite being dealt a bad hand, Obama's policies are making it worse, not better.

  9. By the way, "negative feedback" is a term usually reserved for damping effects that bring long-term stability, not the reinforcing you spoke of in your post. Think of the parameter k in the time-varying equation y=EXP(kt); when k is positive, y runs off to infinity (instability), but when k is negative, y gets damped out and approaches a very stable value, zero. System dynamicists call k>0 loops "reinforcing loops" and k<0 loops "balancing loops." A system in which k goes from negative to positive is an idealized picture of a "tipping point."


  10. Dammerung,

    I mostly agree, however when I'm driving down the highway and I start to drift across the center line the answer is not to jerk the wheel to the left. Which is exactly what we did.

    Obama took a bad situation and multiplied it, and continues to.

    Reaganomics worked. Income into the treasury went way up. The problem was a spend happy congress. Military spending alone did not cause the deficits. It was a lack of discipline by a spend happy congress.

  11. I am under no illusions about Dubya's economic policies, Dammerung. He ended up being far too much of an accommodationist to neoliberalism (e. g., the Rx drug benefit) anyway. But you're quite right: Obama is making a bad situation worse. FAR worse. And the narcotized masses who voted for him will just adjust and say, "ho-hum, at least everybody wealthier than me is getting his comeuppance. Stick it to 'em!" Meanwhile, the nation as a whole drifts lazily into a European funk, and we'll eventually forget what it was like to have 95% of the workforce employed.


  12. Gary: I see Reaganomics as a socialist catastrophe, but I'm a hardcore Austrian school.

    As to budget surpluses, look, every dime the government has in its possession came from US. It brings me no great joy that the government stole more from US one year than even it believed it needed (a miracle in itself.) Economic growth comes from private investment and spending. The more money we don't pay to the government, the more money we have to buy new clothes and school supplies and new cars and video games. It's not a zero-sum game. Private earning and spending grows the economy. Government spending stagnates it.

  13. Dammerung,

    completely agree except for the
    "socialist catastrophe" part :-)

    Reaganomics gave private investment room to work, created over a decade of economic growth, and generated record tax revenue. The best of all worlds.

    People want to blame deregulation and free markets for the mortgage crises. It's wrong the people and markets are much smarter than the over educated morons running the world right now.

  14. Dammerung,

    I didn't say deficits don't matter they definitely do.

    I said Reganomics didn't cause them.

    Presidents don't spend money or pass laws. Regan never had a majority in either the house or the senate the 8 years he was president. He was the only bipartisan president in my adult life. What he did worked the problem was a congress that spent more than the record income.

  15. Good Lord. The political conservatives and libertarians are arguing on my blog. What's happening to the world? This used to be a nice, liberal place...

    But seriously, thanks for all the comments gentlemen.

  16. Reagan gets blamed for deficits but it was the democrats that caused them.

    Clinton gets credit for reducing abortion but it was a republican congress that caused them.

    Presidents only have the power of influence. Congress controls the purse strings.

  17. What about Reagan and the "War on Drugs?" Or Iran-Contra? Or the invasions in Central America? Economic policy, social policy, and foreign policy are intricately linked. Reagan set the stage for throwing pot smokers away for a decade while filling the ghetto with crack and Funding Latin American death squads.

    He wasted absurd amounts of money on hopeless weapons programs and made tens of thousands of new homeless while giving banks preferential treatment.

    Kill the myth.

  18. Richard, I was just about to say the same thing. You have started to attract a lot of wingnuts.

    I won't even get into the silliness of the Reagan comments, but the guy who blamed Fannie and Freddie for the subprime crisis is just flat-out racist. Some would like to think that the gov't guaranteeing loans for a tiny number of minorities almost caused the world economy to collapse.

    That's idiotic. The facts are that Fannie and Freddie loans have defaulted at a far lesser pace than loans written by specialty lenders (Countrywide was particularly bad) and large banks. The GSEs own a tiny percentage of subprime loans.

    Let me just say that for someone who isn't well-versed in economics, your summary was pretty well spot on. Free markets are -- have always been -- unstable. People don't dream up regulation for fun -- they come about to address real problems that exist.

    The banking crisis was caused by greediness of people at every level -- homeowners who borrowed more than they could repay, banks who wrote the loans knowing they would sell them and didn't care about the quality, brokers who were paid by volume, bankers whose bonuses were dependent on short-term profits, rating agencies who pretended that loans were not likely to default, etc.

    At every level, the incentives worked to create problems. That's why we need a government regulator to actually oversee the markets. In fact, Greenspan's biggest failing was his refusal to ensure that the banks played by the existing rules with regard to leverage and levels of risk. No new regulations (although I don't quarrel with most of the ones being proposed) would even be needed if the old rules were enforced.

    But nothing will ever stop bubbles. Look at the whole AIG situation. If AIG was just a normal insurance company, it would not be possible to lose the amount of money they did. In fact AIG's insurance business was always profitable.

    But the problem came from its hedging (insuring) of derivative contracts, an industry that is fairly new. AIG guaranteed trillions of dollars of derivatives that were not backed by any tangible asset. It was a group of traders betting with each other about the direction of the market, and AIG insured the bets.

    The way the insurance business is regulated, companies have to have capital to back up their policies. But there were no such rules for derivatives. So when the market turned, AIG was on the hook to pay hundreds of billions of dollars with no means to repay.

    Regulate the derivatives market so that bets have to be made using real cash-flowing assets or by forcing counterparties to set aside capital for losses and even if the subprime problem existed, it would have been a small issue in the scheme of things.

    I have worked in the financial services industry since the mid-1990s, mostly writing about commercial mortgage backed securities. I know the guys who wrote a lot of the biggest CRE loans that led to the downfall of Lehman, Bear, Wachovia and others.

    That doesn't make me right, but I'm not talking out of my ... like so many others.

  19. Anonymous,

    You were writing about it, I was living it, not talking out of my ...

    The government took the risk out of it. Deregulation was not the problem and calling me a racist only reveals your warped world view and doesn't clarify the issue at all.

  20. Richard Beck said...

    Oops. Sorry, being at work myself I didn't have the courage to check it either and didn't know it contained anything NSFW. I can't edit it so please delete it.

    What were the SEC doing instead of their job of regulating?

    Masturbating to kiddie porn

    The SEC investigated Bernie Madoff for fraud three times and found no evidence of wrongdoing.

  21. Gary:

    Living it how? I clicked on your link, you have no connection to the MBS industry, nor do you seem to have any connection to anything to do with finance. You say you work for a non-profit in the middle of nowhere. (Guessing by your location, you must be connected to the Focus on the Family world.)

    Listen, if you want to challenge me on something for which I am paid a Wall St. salary to have expertise, offer me some hard statistics, not right-wing talking points.

    Bush-administration officials have testified under oath that Fannie and Freddie were not responsible for the crisis. As I said, the FACT is that the GSEs generally have much higher lending standards than the private market and their product defaults at a much lower rate than the private industry.

    Subprime loans by definition involve a lack of documentation or low credit scores or something else that would not meet the GSEs' lending standards.

    But you're a genius, prove me wrong. Cite something real. Show me you have some clue. What do you think about a central clearinghouse for derivatives trading? How long will it take before we see another CDO squared? Is CMBS cheap or expensive to corporate bonds in your opinion?

    C'mon, make my day. I like talking to smart people.


  22. Anonymous,

    drawing a big salary doesn't make you an expert.

    I was a broker for 10 years, my boss was a bond trader for Merrill Lynch before he came to manage our firm where he stayed a trader for a large regional midwest bank.

    Don't cherry pick quotes from politicians. Look at the facts.

    Fannie and Freddie were the market. GRE's took the risk out of the mortgage market and allowed greed to run amok.

    You can yell and throw around jargon all you want but it doesn't make you right and the more you talk the more you reveal your world view. Which is just wrong.

  23. Your boss was a trader? So? My brother is a misisonary, does that make me a Christian?

    You were a broker? Of what? Residential loans? There are a million "brokers" in the country. It is no different than being a shoe salesman.

    "Fannie and Freddie were the market" is not a fact. Do you mean 100%? Of what market? The whole MBS market? Seriously? What about subprime standards?

    So you think GSEs took the risk out of private mortgages originated by Countrywide? How exactly did that work? If that was true, why did Countrywide and Indymac go bankrupt? After all, the GSEs took the risk out of the market.

    And you think the street rewards people who know nothing? But ... then capitalism must not be efficient, and I'm living proof.

    Please, man, give me something, anything. I know that just because I work in financial services doesn't make me right, because people I know in the industry have a wide range of views (although nobody would say what you do about Fannie and Freddie because it is asinine).

    But you're just bluffing. The more you talk, the more you sound like a moron. Challenge me when you learn a little bit.


  24. I strongly agree with Dammerung on the following (I agree with Dammerung more than
    he does on many things actually):

    Dammerung said:
    "It's not an accident. It's DESIGNED that way, it's centrally planned that way from the get-go. The purpose of a system is what it does. The means ARE the ends."

    Do a search for "Executive Order 11110", (initiated by JFK in June of 1963).

    I'll accept being labeled as a bit over the top and maybe a bit of a conspiracy theorist, but I'll try to behave myself HERE amongst too
    many astute and articulate minds:

    1. What if the U.S. succeeded in restoring 100%
    backing of the gold/silver standard?

    2. Who might be most threatened by such ...
    the Federal Reserve ... maybe?

    I don't enjoy dwelling on it, but I agree
    with those here who have stated in so many
    words that we do not and have not lived in
    a free market.

    Gary Y.

  25. Anonymous,

    Your too funny, I was a series 7 and 65 studying for the 24 when I decided to go to Bible college. I started a ministry a year ago. guess I need to update my google profile.

    I worked mostly with managed money but also retirees life savings. After they sold farms it's all they had.

    Your right I'm not as smart as you I'm just a simpleton. My job was to protect, grow and or provide income for people who were not adding to their accounts and when I do something I'm all in.

    Traders, my boss, saw this coming a mile away. I know there are "smart" people on both sides of this. We saw it coming and watched it develop. I left before it hit critical mass but I stay in touch with people I worked with as well as some of my old clients.

    You and I both made assumptions, you assumed I was a sound bite spouting racist moron, I assumed we were talking about the sub prime mortgage crisis. Sorry if I missed the bigger picture.

    And no one but Barrons and Bloomberg would make such an asinine statement as "Fannie and Freddie became the market".

  26. I've said it before, but owing to the recent burst of political discussion here I'll say it again: nobody here is actually arguing with each other. Instead, people seem to prefer to construct these horrible straw-men caricatures of their ideological opponents, and then spend all their efforts tearing down these false images instead of actually engaging with anything that anybody else has to say. This is why you guys find these arguments so frustrating. It's because nobody is actually listening to each other.

    I mean, we're entering an election campaign here in Australia and so I'm experiencing more than my fair share of terrible sound-bite arguments and ideological slander from both sides, but, dare I say it, sheer wilful stubbornness of this kind seems to be a peculiarly American phenomenon.

    P.S: Richard, I've only been following your blog for a short time, but I too find the conservative/libertarian argument here to be amusingly out of place as compared to the normal string of comments :)

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