Over the anguished cries and resigned sighs of its victims, the financial storm that broke out in August 2007 also echoes with a different kind of noise, ringing with shouts of triumph and head-shaking: I told you so. Here we have the utter failure of Anglo-American laissez faire! This is the shameful result of immoral greed on the part of capitalists lacking any sense of social responsibility! Neo-liberalism (but why neo?) has shown its noxious impotencethe strong hand of the state is needed to save the system! After thirty years of mindless deregulation, we must now urgently erect a new, comprehensive, and tight framework of regulation!

Nearly everyone seems persuaded that the financial system that has been behaving so perversely in the recent past and has not yet finished doing so is one of purebred deregulated free market capitalism. This is not the case (just as the late lamented Soviet Union was not a purebred socialist system). It is true that since World War II, the economies of Western Europe and North America have been gradually freed of a certain amount of regulatory ballast. Trade was liberalized, controls on capital movements relaxed or abolished, and the institution of contract has regained some of its 19th century liberty. Nevertheless, the system remained a hybrid, with a great deal of active or latent state intervention, an oppressive fiscal regime, an anti-capitalist and anti-profit public ethos in Continental Europe, and important financial regulations that were capable of producing self-defeating results and did produce some in the present turbulence. In fact, they were among the chief causes that set off the turbulence.

How and Why The Storm Broke Out

One of the initial impulses was the smooth, steady and seemingly inexorable rise in American home prices over the last 15 years or so. Economic growth was brisk and fairly regular. Brisk growth should lead to higher interest rates, but the interest rate environment stayed comfortably low (and consequently, mortgages were relatively cheap) because the progress of globalization put a downward pressure on traded goods prices and inflation remained moderate. Buying a home with mortgage loans, or more often than not selling the old home and buying a more expensive one, seemed a sure-fire method of making a handsome capital gain. Strengthening this tendency was the American income tax law that made mortgage interest on loans up to $1 million tax-deductible. This favor to homebuyers was estimated to amount to an annual subsidy (tax savings) of $80 billion. Thus, after-tax borrowing costs were cheap. Lending to homebuyers as much as 100 percent of the homes price seemed practically riskless. Moreover, regulations encouraged mortgage lending to less creditworthy borrowers. For instance, the Community Reinvestment Acts of 1977 and 1995 required banks to discriminate in favor of poorer borrowers. The Comptroller of the Currency treated more leniently the banks that lent socially. The result of these practices was that as long as home prices did not start falling, perhaps only a few hundred billion out of the 13 trillion dollars of mortgages in existence was dubious. But declining home prices in the first half of 2007 caused the volume of subprime mortgages to multiply quickly.

Much blame has since been heaped on two recent financial techniques, securitization and the extensive use of various derivatives (especially credit default swaps, a method of insurance whose volume now exceeds $60 trillion, more than four times the United States GNP). These techniques have been of enormous benefit to the world economy because they distributed risk to those most willing to bear it. A very rough estimate, though little more than a guess, put their total contribution to world wealth at 30 trillion. However, the fact that securitization transformed mortgages into marketable securities had dire consequences.

The Perverse Effect of Regulations

As home prices declined, the market value of securities backed by subprime mortgages started to fall. Partly because the quality of the collateral was unclear, there were few willing buyers and mortgage-backed security prices fell steeply (one such portfolio was sold by Merrill Lynch at 22 per cent of face value). Fair value accounting under FASB and IASB rules requires that marketable securities be carried in bank balance sheets at market value. Marking down their mortgage portfolios to the price of an almost nonexistent market made huge holes in the banks own capital. This, in turn, made them violate the regulations (the Basel II rules) prescribing the capital backing they must have against risky assets. Being in violation forced them to sell the assets at almost any price, and the resulting pressure on mortgage-backed security prices caused them, and other banks, to be in ever greater violation of the regulations.

Thus, the combined effect of two seemingly reasonable regulations has produced an avalanche. Some old and prestigious names simply collapsed under it, and almost every bank and insurance company fell under (usually quite groundless) suspicion of insufficient liquidity and solvency. Interbank lending, an absolutely basic element of any modern financial system, dried up because lenders suspected that any borrower might be hiding some secret weakness or regulatory vice.

The two accounting standard boards that prescribe what auditors will or will not accept or certify remain inflexible about marketable assets having to be marked to market, even if the holder is under no pressure at all to sell and even if market conditions are temporarily chaotic and prices absurd. There is something to be said for such severity, but giving some discretion to banks for valuing their securities portfolios by reason rather than rigid regulation might have avoided much unnecessary havoc. Much the same could be said of Basel II. The interaction of the two rules generated a vicious circle that reinforced itself with every turn. The whole scenario illustrates the potential of hybrid systems, such as the actual set of liberal elements mixed with dirigiste ones, for making a moderately bad initial disequilibrium into something very much worse.

Doing Their Best To Create Panic

As we all know, the function of a banking system is to solicit resources from depositors by offering them a high degree of liquidity and to offer these resources to other economic agents on a longer-term basis. The obvious condition for the transformation of short liabilities into longer assets is confidence. The corollary tells us that if confidence is shaken and panic starts, no amount of even the most severe regulation can save the system from at least partial breakdown. There are then only two possible outcomes. One is to let the breakdown happen and work itself out. This involves sharp losses for some and equivalent gains for others in a zero-sum game. The other is to force the taxpayer to lend the resources that are needed for the immediate repair of the breakdown. This game is also zero-sum, though more complex. The taxpayer may end up among the gainers, as happened with the United States Resolution Trust Corporation that was called upon to repair the savings and loan bankruptcy after 1989 and as is quite likely to happen with the quasi-nationalization of the AIG insurance giant or the Fortis group in 2008.

One of the saddest and most depressing aspects of the 2007-2008 financial breakdowns is that panic was generated without sufficient objective grounds for it and without the intention to do so. The American mortgage default problem caused a loss to the lenders, mostly banks, estimated at just under 1 trillion dollars. This was in major part also zero-sum, for there was no destruction of real wealth and no loss of current production of goods and services; the mortgaged homes were still standing and were lived in by the original borrowers or could be rented out if foreclosed. The trillion-dollar loss was really a redistribution of existing wealth, painful but not catastrophic, nor really large in relation to a 14 trillion dollar American economy.

The news media have nevertheless opened up a round-the-clock barrage of panicky comment, sufficiently shrill and intense to put fear into all but the coolest heads. We might say that the media must be forgiven, for their business is to interest and excite an audience, not to serve the common good. What cannot be forgiven is the panic-mongering declarations of some of the most august authorities whose business is not to excite the public and get their names in the headlines, but to use their authority to preserve calm and a sense of proportion. They, unlike the media, are paid to serve the common good, not their own personal notoriety from the prestigious pulpit where they have been placed. Least of all are they paid to play Cassandra.

Dominique Strauss-Kahn, the probable Socialist candidate in the 2012 French presidential elections, was nominated last year to head the International Monetary Fund by the center-right French government, reputedly in order to remove him from the leadership of his party. This objective, if true, has failed. Mr. Strauss-Kahn is using his Washington post both to manage the fund in a high profile, strident manner quite unlike the discreet style of his predecessors and to gain authority in France as an economic expert of world renown. Since the outbreak of the financial turmoil in August 2007 soon after his appointment to the IMF, he has on several occasions declared that the situation was due to get worse and catastrophe was threatening the system. Saying so has certainly helped to make it so. In fairness to Mr. Strauss-Kahn, he was not alone in earning publicity by frightening bankers, depositors, and businessmen alike and rendering the situation more and more difficult to manage. Alistair Darling, Britains Chancellor of the Exchequer (finance minister), a mediocre man with a precarious hold on a position too big for him, has also done his best, as have several less highly placed public figures. Given that financial stability depends essentially on confidence, their alarmist prophecies had a good chance of becoming self-fulfilling.

Transforming the Hybrid System

The current financial upset looks particularly frightening because both the North American and the European economies are expected to move into recession or are already there. Many observers even believe that the recession has actually been caused by the financial systems near-collapse. It is amusing to reflect how this state of mind lacks a sense of proportion. French GDP in the second quarter of 2008 has declined by 0.3 percent and is expected to fall by 0.1 percent in both the third and fourth quarters. There is general alarm and despondency that the worst has in fact happenedthe recession is in place. Suppose, however, that the official statistics, instead of stating the percentage decline, simply stated that GDP in the second quarter was 99.7 and for the following two quarters was forecast at 99.9, compared to 100 a year earlier. It would surely be grotesque to call this a catastrophe.

There is now near-unanimity that the actual hybrid system of banking regulation was far too liberal, permissive, and tolerant of irresponsibility and greedperhaps even the cause of irresponsibility and greed. Prominent voices are calling for moralizing it and for purging it of the speculation that is understood to be a synonym for financial immorality.

This populist wave will probably peter out when the storm calms down and will merely leave a belief in the popular mind that liberalism does not work; it was tried and see the result. One lasting effect is likely to be a series of regulatory obstacles to make speculation more difficult to carry out. Such measures, reflecting economic illiteracy and a childish incapacity to understand the place of speculation in a market economy, will do damage too dear to the Everymans heart to be avoided. The marking to market accounting rule will probably be relaxeddoing so would in fact be a liberal and benign move. For the rest, however, the present liberal-and-dirigiste mixed system is likely to be remodeled in a very much more dirigiste mold.

Such a change would make banking and finance neither safer nor more moral. In fact, it would favor the least scrupulous and most agile type of bankers and financiers who are best able to get round or slip through the regulatory net.

In a pure liberal system, durable success and profit maximization depend on gaining and retaining the confidence of depositors and other creditors. In a pure dirigiste system, it is not the customers that must be satisfied, but the regulators. In any hybrid system between the two, it may not be possible to satisfy either the customers or the regulators.