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Free Market Economics.

Much of the discussion, analysis, and debate regarding the Financial Crisis of 2008-09 has revolved around the role and functioning of "the free market". Unfortunately, most of the discussion of "the free market" is more political ideology and social idealism than objective economic analysis.

While is is clear that the Classical economists, most famously Adam Smith, constructed a theory of the free market, it is equally clear that such a market is an idealistic abstraction that has never existed and can never exist. All modern economies are mixed economies. They rely both upon markets and government regulation to efficiently meet society's needs.

Furthermore, the very theory that is so often used to argue that the free market will self-adjust more efficiently than any government intervention also states the conditions required for the free market to effectively exercise this ability commonly do not exist in actual economies. In other words, we know from economic theory, analysis of economic models, and actual history (the current crisis is an example) that unregulated, free markets often fail to acheive efficient self-adjustment and desirable results. Furthemore, we know the conditions under which they are likely to fail. Guess what? Many of these conditions existed in the housing and financial markets leading to the crash, conditions like the following:

Market Power - firms being so large that they can control or manipulate market conditions, such as prices or relevant market information. In the currrent crisis, firms are so large that even an anti-intevetnionist administration (Bush, Paulsen, Bernanke) finds it cannot allow them to fail, so it intervenes to keep them afloat even though they have clearly failed as competitve firms. Such firms are so large that they move capitalism away from free, competitive markets toward oligopolistic markets, which justify regulation.

Collusion - firms choose to cooperate to enhance profits by avoiding competitive prices. In the current crisis, security rating firms (e.g. Moody's, and Standard and Poor) did not properly rate risky securities because they, and the rest of the financial industry, profitted from inflated securities prices. They had no incentive to do costly analysis which cut their customers' credit ratings, reducing both their customers' sales as well as their own.

Imperfect information - firms did not fully disclose the range and nature of their investments in risky securities. This included the poor risk evaluation of the rating firms. In many cases, the banks and executives themselves did not understand nor have the necessary information to make efficient decisions. Under such conditions firms, their executives, their investors, and shareholders cannot make efficient decisions if they do not even understand their own investments.

The Role of the Government and Government Regulation.

No modern economy exists independent of a government. In order for capitalism to exist, for example, there must be a complex system of contract law, property rights, and a civil justice system. Additionally, there must be police and national security institutions. Civil libertarians, because of their political beliefs (not economic analysis), would like to limit government to these narrow areas of responsibility. However, these are not the minimum governmental needs of an advanced capitalist market economy.

Precisely because the market commonly fails to produce the most efficient or optimal result the economy requires the government to address a range of economic problems that "the free market" will not or cannot address. These areas correspond precisely to the areas of "market failure" that Neoclassical free market theory identifies: market power, public goods, externalities, imperfect informaiton, and concentration of wealth.

Additionally, as proven by John Maynard Keynes, free market capitalism can fail to appropriately self adjust under specific conditions short of social collapse. (More on this below under Keynesian Theory and Stabilization Policy).

Finally, all major infrastructural networks and systems require development by or under the authority of the government both because they are required prior to the emergence of private firms capable of financing national infrastructure and because infrastructure is usually a public good. If a firm produces it then it has to operate as a monopoly (anti-competitive market power) or it cannot profit from the investment. The government has been integral in the development of the national highway system, railroad system, airports and air traffic control system, modern seaports, electrical grid, hydro-power, nuclear power, flood control, water delivery, sewage treatment, et cetera.

John Maynard Keynes.

The current financial crisis is generating a revival of Keynesian economic theory, and for good reason. Keynesian economic theory provides the primary analytical structure for virtually all of contemporary macroeconomics. Additionally, it was constructed specifically to address the issue of proper governmental policy during a depression. Thus, his theory is particularly appropriate, and is the beginning point of any macroeconomic analysis of the crisis.

This is what "The History of Economic Thought" website writes about Keynes:

John Maynard Keynes is doubtlessly one the most important figures in the entire history of economics. He revolutionized economics with his classic book, The General Theory of Employment, Interest and Money (1936). This is generally regarded as probably the most influential social science treatise of the 20th Century, in that it quickly and permanently changed the way the world looked at the economy and the role of government in society. No other single book, before or since, has had quite such an impact...Indeed, with this book, he almost single-handedly constructed the fundamental relationships and ideas behind what became known as "macroeconomics".

The long answer: he is not as controversial as his critics claim. The truth is that he was so successful in proving the errors of a purely non-governmental approach and in outlining sound reasoning and evidence in support of a range of potentially effective government stabilization policies, that the vast majority of economists today, whether they are employed in the private sector, the government sector, or are researchers and theorists, rely on his theories to do their analysis and even to criticize his theory. The best evidence of this is the fact that strong free market proponents (Bush, Paulson, Bernanke, Greenspan) returned to his analysis and recommendations after their view of the economic world collapsed with the collapse of Lehman Brothers, in September 2008. The $750 billion banking rescue package (TARP), the $17.4 billion loans to the auto industry (both proposed and implemeneted by the Bush administration), and the proposed $825 billion Stimulus Package proposed by President Obama are all based upon Keynesian economic theory.

Keynes and Macroeconomics.

Keynes introduced the analysis that a modern capitalist economy is driven by the level of demand in the economy, the amount of money that consumers are willing and able to spend. In the Keynesian view there are four major sources of demand spending: consumers, private investors, foreign consumers, and the government. Keynes argued that during some economic crisis there is not enough spending to keep the economy operating at its capacity. Due to increasing unemployment, declining wages, insecurity about future income, and poor job opportunities consumers may not have enough income or confidence to maintain their spending. At the same time investors may be unwilling to invest, lend, or borrow because of poor profit expectations or massive losses in the market. If the crisis has spread internationally then foreign consumers will also be unable or unwilling to buy imports. The government remains the only sector of the economy that has the ability to restore spending to a level that employs the population and maintains production near its capacity. If the government does not increase spending, then Keynes concludes, that the economy is likely to enter long term depression that can keep employment, wages, production, investment, and profit suppressed for years at a time.

Because this policy prescription potentially expands the both the size of the government and the role of the government beyond the traditional Classical laissez faire ideal Keynes' theory alarmed both Classical theorists and small government advocates. Consequently, he and his theory have been inaccurately criticized as being Socialist. This is major misunderstanding, both of the theory and of Keynes. Keynes was an ardent supporter of Capitalism and was anti-socialist. However, he was a reformer. He viewed Capitalism as imperfect and prone to periodic major crises. His theory and policy recommendations were designed to protect Capitalism from its own excesses, not to undermine it. In his view a modern Capitalist economy is far more complex than the economy that Adam Smith observed in 18th century Britain. In his view an advanced Capitailst economy requires a large and active government engaged in ensuring the stability of the market.

From Keynes' perspective the goal of government economic policy is to keep the market stable, avoiding major depressions and major inflations. In his view the market is inherently unstable, prone to unpredictable volatility and ocassional crises. General goals of Keynesian stabilization policy are to keep production and employment near the economy's full capacity, keep inflation low, and keep the economy growing at a stable level consistent with full employment and low inflation. The U.S. Congress formally endorsed Keynesian policy with the passage of the Full Employment and Balanced Growth Act of 1978 (the Humphrey-Hawkins Act) which set national targets of a 4% unemployment rate and a 3% inflation rate.

There are only two policy areas that the government might be able to manage in order to stabilize the economy. I say "might" only because there is some controversy as to how effective these measures are. Keynes had little doubt about there effectiveness. The policy areas are Monetary Policy and Fiscal Policy.

Monetary policy focuses on trying to manage major interest rates in order to influence the level of investment, borrowing, and inflation. The primary interest rates in the U.S. economy are managed by the Federal Reserve Bank ("the Fed"), which is a private bank that is given governemntal authority to manage the U.S. money supply. The Fed sets the interest rates that banks pay to borrow money from the Fed nad from each other. The U.S. Treasury manages the interest rates that it pays to borrow money. The Treasury borrows money by selling U.S. Treasury Bonds.

By lowering interest rates the Fed attempts to encourage borrowing, investing, and spending, thereby stimulating the economy to avoid or pullout of a recession. This ype of monetary policy (expansionary) will always expand creidt in the economy and, thereby, encourage debt. Conversely, to avoid or lower inflation, the Fed can raise interest rates to discourage borrowing, investing, and spending and to encourage saving. This type of monetary policy (contractionary) will always constrain the availability of credit and, thereby, encourage savings and debt reduction.

Fiscal policy focuses on managing the level of taxation and government spending in order to influence the total level of income in the economy. Fiscal policy intended to stimulate the economy out of a recession includes any combination of increasing government spending and cutting taxes. This type of fiscal policy (expansionary) will always generate government deficit spending and reduce a surplus or expand the national debt. Fiscal policy intended to avoid or reduce inflation uses the opposite combination of mechanisms: cutting government spending and increasing taxes. This type of fiscal policy (contractionary) will always run a government surplus and pay down the national debt.

The goal of managing fiscal policy long term is to balance the government's budget over the business cycle (through repeated periods of growth and recession) NOT annually. In order for fiscal policy to be effective overtime and not be overally disruptive the government must borrow money and spend it, that is it must run deficits, during recessions, and run surpluses to pay down the debt during expansions.

M A Y 1 9 3 2, The Atlantic Monthly
The World's Economic Outlook
by John Maynard Keynes

…This is the point at which, on the precedent of previous slumps, we might hope for the beginning of recovery. I am not confident, however, that on this occasion the cheap-money phase will be sufficient by itself to bring about an adequate recovery of new investment. It may still be the case that the lender, with his confidence shattered by his experiences, will continue to ask for new enterprise rates of interest, which the borrower cannot expect to earn. Indeed, this was already the case in the moderately-cheap-money phase which preceded the financial crisis of last autumn.

If this proves to be so, there will be no means of escape from prolonged perhaps interminable depression except by direct state intervention to promote and subsidize new investment.

Formerly there was no expenditure out of proceeds of borrowing that it was thought proper for the State to incur except for war. In the past, therefore, we have not infrequently had to wait for a war to terminate a major depression. I hope that in the future we shall not adhere to this purist financial attitude, and that we shall be ready to spend on the enterprises of peace what the financial maxims of the past would only allow us to spend on the devastations of war.

At any rate, I predict with an assured confidence that the only way out is for us to discover some object which is admitted even by the deadheads to be a legitimate excuse for largely increasing the expenditure of someone on something! …

The debate about whether the federal government should nationalize the failed and struggling banks (e.g. Citibank, Bank of America, et al) is obscured by the debate about the name. Some conservative critics claim nationalization is the equivalent of creating socialism. Other commentators, including conservatives, claim it is the appropriate government response to a collapsing banking system. To get down to the fundamental economic issues of nationalization we have to first clarify the meaning of words and concepts.

Capitalism is an economic system in which the productive assets ("means of production") are privately owned. Individuals and groups of private individuals own the raw materials, machinery, technology, factories, productive facilities, and companies in the economy.

Nationalization is any process in which the government takes over privately owned productive assets. Historically, there are two basic motivations for nationalization: to implement socialism or to protect capitalism from economic crises by providing government funds and management to revive failed private enterprises. What is essential to understand is that these are two opposite motivations - to create socialism or to revive capitalism.

Many countries have nationalized companies or industries in order to try to create Socialist economies, for example the Soviet Union, China, Cuba, and even Mexico to name a few. These countries did so with the intent of permanently keeping the companies or industries under the ownership of the government.

Other countries have have nationalized industries temporarily in order to infuse the companies or industries with government funds, change their management, and implement new organizational structures. They have then returned the nationalized companies or industries back to private ownership by selling them to private investors or companies. These nationalizations are implemented with the intent of reviving the market and saving Capitalism from prolonged crisis.

Thus, commentators that warn that nationalization of U.S. financial institutions during the current crisis is the implementation of Socialism either do not understand nationalization, or worse, are intentionally misinforming the public for political or personal benefit (Jim Cramer on CNBC and Rush Limbaugh are the two most outrageous commentators on this topic). All proposals for nationalization of financial institutions in the U.S. during the current crisis are explicitly oriented toward reviving the private market and returning the institutions to private ownership as soon as the crisis has ended. There are no proposals being made by any administration representative for the permanent nationalization of any financial institution. Nationalization under these circumstances is entirely intended to benefit the capitalist system.

A Rose By Any Other Name ...

The calls for nationalization in the current crisis are really nothing more than calls to develop and implement a bankruptcy process for institutions that do not have such a process in place. Nationalization would include four fundamental actions:

A federal government agency (most likely the U.S. Treasury) would take controlling ownership of the company. This could be done a number of ways from purchasing shares of stock to declaring the company financially worthless and commiting the U.S. government to manage its debts.

The current management would be replaced by the government appointment of an adminstrator, conservator, receiver, or new board of directors. These managers are typically paid at a standard government adminstrator rate. Some are paid nothing.

The company would be re-structured to pay off debt. This would probably require selling assets at a loss incurred by current investors and shareholders, with partial to full compensation to creditors.

When the company returned to stable profitability and when the staock value of the company rose enough to compensate taxpayers to some minimum degree the government agency would sell its stock back to private investors, fully restoring the company to private ownership.

Several government agencies already have the authority take all of these actions over particular inustries whenever they deem it necessary. The FDIC (Federal Depositors Insurance Corporation) has such authority over member retail banks. The Comptroller of the Currency has similar authority over commercial banks. The Office of Thrift Supervision has similar authority over Savings and Loan institutions. In 2009 the FDIC has already taken over more than a twenty retail banks, selling off their assets to healthy banks, and restructuring their debt, while protecting depositors and taxpayers.

Listen to:

Anatomy of a Bank Takeover, All things Consider, NPR, March 26, 2009 Radio podcast 13 minutes

The main difference between the process implemented by these agencies and nationalization is that these agencies are empowered to take over control of the private financial institutions without having to buy ownership of them and without any commitment to inject money into them. The process is called conservatorship or receivership, depending upon the legal authority granted.

The reason that nationalization is an issue in this crisis is that the financial institutions currently in trouble are both unregulated and so large that other alternatives for taking control of them do not exist. Bear Stearns, Lehman Brothers, Citibank, and Bank of America were operating as investment banks (not retail or commercial banks). AIG (American International Group) the world's largest insurance company, was operating as derivatives trader. As such, none of these institutions were operating under a regulatory agency that had the authority to take conservatorship or receivership of them. Additionally, they were so large that simply liquidating them (selling off al their assets to pay off as much creditor debt as possible) would have forced tens, perhaps hundreds of other financial institutions, thousands of companies, millions of investors to go bankrupt, and tens of millions of people to lose their jobs worldwide . Thus, the government has an incentive to take control by buying shares to both legally establish its authority to take control and to infuse money into the financial system via these failing institutions.

Who supports nationalization?

Nationalization is controversial because it is perhaps the most powerful intervention the governmant can make into the private market. (Impementing wage and price controls as the U.S. did during WWII and under Nixon in 1971 are another strong intervention.) However, it is not nearly as controversial as critics and commentators claim. There is a surprising range of political and economic perspectives that support nationalization of some of the failed financial institutions.

Conservatives who support nationalization include:

Alan Greenspan, former Chair of the Federal Reserve,
John Makin, economist at the American Enterprise Institute,
Douglas Holtz-Eakin economist and economic advisor to Sen. John McCain during 2008 Presidential campaign,
James Baker, Secretary of Treasury under Pres. Reagan and former Secretary of State under Pres. Geo. H.W. Bush,
Sen. Lindsey Graham of South Carolina.

Liberals who support nationalization include:

Nobel economist Paul Krugman, Prof. of Economics and International Affairs, Princeton University; Centenary Professor, London School of Economics
Nobel economist Joseph Stiglitz, Prof. of Economics , Dept. of Economics and Columbia School of Business, Columbia University
Simon Johnson, Professor of Entrepreneurship, Sloan School of Management, MIT; Fellow at Peterson Institute of International Economics; and former Economic Counselor and Director of Research of the IMF
Nouriel Roubini, Prof. of Economics and International Business, Stern School of Business, NYU; Research Associate at the National Bureau of Economic Research; former staff economist/advisor positions in U.S. Treasury and Council of Economic Advisors
Matthew Richardson, Charles Simon Professor of Applied Economic Financial Economics, Stern School School of Business, NYU; Director of Salomon Center of financial research, NYU; Research Associate National Bureau of Economic Research

Conservatives that support nationalization often do so for two basic reasons: pragmatism and principle. Many conservatives accept nationalization as the only practical option in financial crisis as large and threatening as this one. In normal, run-of-the-mill recessions or financial declines these conservatives would never consider nationalization as a solution. However, they understand that when we face a crisis potentially on the scale of the Great Depression then nationalization is the only option available. Alan Greenspan was clear on this when he stated to the Financial Times on February 18, 2009:

”It may be necessary to temporarily nationalise some banks in order to facilitate a swift and orderly restructuring,” he said. “I understand that once in a hundred years this is what you do.”

Some conservatives also support nationalization out of a sense of principle - although the government is intervening and taking over private companies it is doing so to both implement some degree of market discipline (forcing executives and shareholders to bear some of the losses from their decisions) while limiting losses to creditors and taxpayers, and while reviving the market economy.

Liberals tend to support nationalization primarily from a Keynesian perspective: the market is not perfect, requires consistent government regulation, and ocassional government intervention to keep it from its worst crises.

To Nationalize or Not to Nationalize, That is the Question

The truth about nationalization is that the U.S. government has in fact already nationalized several of the major financial institutions at least partially (as of March 24, 2009):

On Sept. 7, 2008 under the authority of the U.S. Treasury Fannie Mae and Freddie Mac the largest holders of housing mortgages in the U.S. were placed in conservatorship by the Federal Housing Finance Agency. The executive management was replaced and the U.S. Treasury committed $200 billion to purchase shares in both institutions.

This is the major issue of speculation for the last several months. At the time of publication, March 24, 2009, the Administration just announced yesterday that it would seek to remove toxic assets from the banking system by encouraging a joint Public-Private Investment Plan by subsidizing the purchase of the toxic assets with up to $100 billion of the previously approved TARP funds. Thus, for now it appears that nationalization is not in the cards.

News reports continue to report differences of opinion within the administration between the economists with Wall Street experience (Larry Summers and Treasury Sec. Tim Geithner) who disapprove of nationalization for fear that it will frighten investors out of the market for too long of a period, and the academic economists (Ben Bernanke, the Fed chair and Christina Romer, Chair of the Council of Economic Advisors) and other policy advisors (David Axelrod, Senior Advisor to Obama) supporting nationalization as both unavoidable and the best policy to quickly end the banking crisis.

As for Obama himself, he appears, as always, to keeping his ship pointed toward the center with all options open. It appears that the administration is opting for a stratgy of devising all possible options to avoid nationalization, while keeping it in reserve as the absolute last resort. Thus, we get this Public-Private Investment Plan, which will take a couple of months to implement and evaluate, while we await the "stress testing" of the trouble banks to evaluate their long term viability. Nationalization has not been rejected, it is just not being addressed at this point by the administration.