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."