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Bail Outs and the Shadow Banking System So Much for the Self-Regulating Market

So Much for the Self-Regulating Market


Last week the Federal Reserve ratcheted up its ongoing efforts to halt the burgeoning financial crisis. The Fed first engineered an injection of money into failing investment bank Bear Stearns, an 86-year-old Wall Street giant, and soon after facilitated a buyout of Bear by JP Morgan Chase.

The Fed’s lending of money directly to an investment bank, an unprecedented move, follows on the heels of the US government having passed a $170 billion stimulus package last month. Once again, the state comes to the rescue of the so-called free market.

The market economy is celebrated as much for its supposed self-regulatory nature as for its theoretical associations with efficiency, innovation and freedom. But once one removes the ideological blinders of free market theory, the history of actual markets consistently demonstrates that far from being self-regulating, the crisis-prone capitalist market economy is, in all successful cases, deeply dependent on active and extensive state intervention.

One may look at the role of the state in establishing sustainable labor markets (via The Factory Acts) and securing international trade in 19th century England; in creating a stable international monetary system in the early 20th century, including the creation of the US Federal Reserve, the IMF and the World Bank; or in actively developing the highly successful export economies of the East Asian Tigers and China in the late 20th century. But the current crisis provides a case study in the fragility and utter dependence of the "free" market on the state.

The trouble for Bear, the first Wall Street bank to fail, began last summer when two of its hedge funds specializing in the subprime mortgage market collapsed. The highly-leveraged Bear, holding 30 times more debt than equity, was ultimately done in by an old-fashioned run on the bank.

To date, in addition to countless consumers who got duped into shady mortgages, the subprime mortgage debacle has taken out the titans Countrywide and Bear Stearns, the hedge fund Carlyle Capital, and other smaller mortgage companies.

The current crisis, however, is more than just dubious mortgage lending, bad bets, and a loss of market confidence. Behind the mortgage crisis is a lax regulatory environment and the development of a shadow banking system — complex financial instruments created by the investment community and traded privately outside the existing regulatory structure.

More broadly, the bubbles currently being deflated in the property and credit markets stem ultimately from speculation, fueled to a significant extent by the loose monetary policy of the Fed since the late 1990s. The current liquidity crunch began as the bubbles finally began to burst, a situation worsened by the fact that key players are overleveraged banks.

Crisis is inherent to the capitalist market economy

The foundation underlying all these macroeconomic troubles is the real economy — the production of goods and services. The troubles in the real economy, as opposed to those in the paper economy of the financial sector, are the same they have been since Marx first articulated a historically-based theory of the capitalist economy (while other economists continued to theorize the virtues of pristine free markets); namely, the contradiction of socialized production and private appropriation, and the tendencies generated by the anarchy of the market.

The anarchy of markets, populated by profit-seeking individuals and businesses in cut-throat competition, quickly generates strong pressures for regulatory agencies such as central banks (e.g., The Fed). Central banks and other regulatory agencies can only attempt to mitigate market swings and to stave off the worst effects of the tendencies of market anarchy, that is, to prevent episodes like the Great Depression that are the natural outcome of unregulated markets: speculation leading to bubbles and then to bank runs.

At an even more fundamental level are the problems resulting from the contradiction between socialized production and private appropriation. Although the productivity of American businesses is a function of the coordinated labor power of the workers, the output is privately appropriated by the owners and their organizations.

Private appropriation has generated extreme levels of income inequality; labor’s share in US productivity gains has been declining for 30 years, and remuneration is again as completely out of sync with levels of effort and skill as it was in the early 20th century.

The concentration of wealth in the hands of a small percentage of the population, which generates serious problems for the purchasing power of regular workers, was arguably a fundamental cause of the economic imbalances leading up the stock market crash of 1929.

More generally, the problem of matching supply and demand, specifically, ensuring a high level of demand to meet the capacity for supply, is an enduring one for capitalist economies. It was temporarily dealt with by Keynesian demand management policies in the decades from WWII through the early 1970s. Since then, the institutional fix to problem of matching supply and demand has been an economy run on debt spending, including the trade deficit, overleveraged banks, and consumers spending on credit financed by a combination of the property and housing bubbles.

These contradictions and problems in the real economy are intimately related to the current crisis. According to Stephen S. Roach of Morgan Stanley Asia, "Over the past six years, income-short consumers made up for the weak increases in their paychecks by extracting equity from the housing bubble through cut-rate borrowing that was subsidized by the credit bubble."

The politics behind the economics

Although crises are inherent to capitalism, the current crisis, with its roots partly in the shadow banking system, is a natural outgrowth of neoliberal policies. Classical liberalism, the political doctrine of individual freedom and limited government, was the reigning political order until the unregulated market imploded in the US in the late 1920s, setting off a sustained worldwide depression.

From these ruins emerged both the New Deal and the Keynesian consensus, leading to broad agreement that the state has a fundamental role to play in the economy: establishing a safety net and actively managing the macroeconomy.

But as corporate profit rates were squeezed and international competition intensified in the early 1970s, the conditions were ripe for the free marketeers to stage a political comeback.

Thus was born neoliberalism, the post-Keynesian political project of reasserting — as official state policy — the doctrine that free trade and deregulation are the best ways to ensure economic efficiency, economic growth, and individual freedom.

Far from being a free and self-regulating market, today’s neoliberal economy is one highly organized by the state and a variety of institutions, nearly all of which are explicitly structured in the interests of investors, against those of working families. So-called deregulation is more accurately called neoliberal regulation.

The same system generating the current financial crisis, as well as the manufacturing crisis in which 3.7 million jobs have been lost in the last seven years, is not any old free market. Rather it is neoliberal capitalism, which has, for its 30 year run, also generated rising inequality and labor market instability throughout the same period.

A saner policy environment would begin by rejecting the dogma of self-regulating markets, so that regulatory institutions may be fortified and public investment dramatically increased. The state should invest in badly-needed infrastructure and could develop an export oriented industrial policy to help rebalance the debt-driven economy.

Ultimately, to deal with the ongoing problems in the economy — crisis, underfunded infrastructure and schools, inequality, poverty, etc. — we need to reject the entire ideology of the free market. Freedom is more than a choice between dozens of kinds of TVs. Efficiency is important, but shrewd state investment and intervention can increase efficiencies, and there is an immense ground for potentially-satisfactory tradeoffs between the extremes of American-style hyper-capitalism and Soviet-style planned economy.

MATT VIDAL is a Postdoctoral Fellow at the UCLA Institute for Research on Labor and Employment. He can be reached at mvidal@irle.ucla.edu.