Planned Economies as Source of Financial Crisis

[ZSorenson]

I'm an undergraduate economics student currently taking a course on global capital markets. In fact, I'm deep into a paper right now. I thought I'd take a quick break to make this comment. Sometimes econ can be so frustrating to study (utilitariansim, altruism, what ways can the government intervene, inductive errors, etc.). So, I need to kind of reorient myself from time to time.

The current global financial crisis has been explained many different ways. Some explanations, like greed, are so hopelessly naive and redundant that they can't really be bothered with. Obviously, there was some irrational decision making. One explanation for this falls under the category that economists unfortunately call 'moral hazard', thanks to the CRA, Fannie, Freddie, and so forth. This is the idea that the cause of the crisis is the result of government intervention. There are so many different ways government intervention has led to this problem: pressure on the lending market, unfree market for credit ratings (Moody's &c.), expectations of bailout, the Fed, and on and on. However, what I've studied so far seems to indicate a very massive and central cause of the crisis.

Alan Greenspan blames a 'flood' of money from China and others for the crisis. Certainly, a large amount of money available for lending would contribute to carelessness on the part of the investment banking firms, perhaps creating an irrational perception that the cost of holding the money back to do a proper risk assessment was greater than the cost of the risk itself whatever it may be. You hear that argument too.

In the end, I have a feeling from some data I've seen that what ultimately happened was a surge in production in countries with semi-planned economies (controlled economies at least), who didn't have the financial infrastructure to deal with their surpluses. As a result, they needed to unload their surpluses basically into wall street. Wall Street itself didn't have the infrastructure to deal with this level of cash to lend (junk assets getting AAA ratings for example).

What I'm wondering is if these economies, like China, had been truly free markets, whether they would have reached the levels of production they did without a more robust financial sector. And, more to the point, if this had been the case, and free market incentive had created such institutions, if this 'flood' of money would not have streamed so overwhelmingly into Wall Street, but distributed properly worldwide.

I'm saying that stupid risky debt instruments were created because Wall Street was handling more cash than was natural, and they were just trying to get the money out - and American housing and big corporation bonds seemed the best place to put them from Wall Street's perspective (ie, easier to work with English speaking lenders using modern equipment subject to US law - all institutional things).

I just don't know how to find out for sure, and I don't know of any professional banker or economist that I really trust. I've read a little of what John Allison of BB&T has said, and I believe him, but perhaps there is more to the story.

And, if this is true, how do you avoid this sort of problem except by trading only with and among properly free markets?

[C.W.]

I'm an undergraduate economics student currently taking a course on global capital markets.

The current global financial crisis has been explained many different ways. Some explanations, like greed, are so hopelessly naive and redundant that they can't really be bothered with....

Alan Greenspan blames a 'flood' of money from China and others for the crisis. Certainly, a large amount of money available for lending would contribute to carelessness on the part of the investment banking firms, perhaps creating an irrational perception that the cost of holding the money back to do a proper risk assessment was greater than the cost of the risk itself whatever it may be. You hear that argument too....

In the end, I have a feeling from some data I've seen that what ultimately happened was a surge in production in countries with semi-planned economies (controlled economies at least), who didn't have the financial infrastructure to deal with their surpluses. As a result, they needed to unload their surpluses basically into wall street. Wall Street itself didn't have the infrastructure to deal with this level of cash to lend (junk assets getting AAA ratings for example).

What I'm wondering is if these economies, like China, had been truly free markets, whether they would have reached the levels of production they did without a more robust financial sector. And, more to the point, if this had been the case, and free market incentive had created such institutions, if this 'flood' of money would not have streamed so overwhelmingly into Wall Street, but distributed properly worldwide.

Having taken a degree in undergraduate economics years ago, I do not envy your situation. Fortunately for me, I had read a lot of von Mises prior to school. I have always said that I forgot more economics in school than I learned.

One problem is that today's observers, with computers and the information on the internet, get bogged down in details, and often miss the forest.

It is interesting that in your comments your mention the Fed only in passing, but in the U.S., when you are talking about money and credit, you are talking the Fed. I don't care what money is coming into the country, the fed controls bank credit and the interest rate structure (the later indirectly).

I wonder what your course work in world capital markets has to say about the Fed?

Further, since the U.S. dollar is the world reserve currency, what it does has a big impact on the money in the rest of the world. So, keep in mind that in the last decades the circulating money in the U.S. (MZM) has gone from $1 T to $11 T and the dollars outside the country has done the same exact thing, $1 T to $11 T. You also have to add into the massive money expansion all of the "assets" lost in the tech-stock and residential real estate mortgage busts, and you have more than enough dollars floating around to smother the U.S. This "flood" of money was mostly our own coming home. If the Fed had allowed the market to raise interest rates, things might have been different. But as long as they were as low as they were, money was available to all takers.

I recently talked to a econ grad (I think he had a graduate degree) who said that he was never taught how money was created in the U.S., which is to say, how the Fed creates money. It is really important to know.

One point in your comments that I didn't understand is how the increased production of goods in other countries led to large amounts of money showing up in the U.S. capital market. Generally, to increase production savings, i.e., capital will need to be invested. Hopefully, you will generate more profits, but it would take years to build back the capital that was used.

And, if this is true, how do you avoid this sort of problem except by trading only with and among properly free markets?

This problem is the result of fiat currencies and government controls such as "pegging" their currency. There is no problem with a gold standard, since countries inflating their currency (inflation meaning expanding their money supply, not just price issues) will see their currency drop in value compared to gold and other gold backed currencies. Free markets and the gold standard protect you from this kind of fraud.

[CWEarl]

I'm an undergraduate economics student currently taking a course on global capital markets. In fact, I'm deep into a paper right now. I thought I'd take a quick break to make this comment. Sometimes econ can be so frustrating to study (utilitariansim, altruism, what ways can the government intervene, inductive errors, etc.). So, I need to kind of reorient myself from time to time.

I've just started studying Economics myself, for a Diploma of Urban Land Economics which will lead to a Bachelor Degree of Business in Real Estate (with a focus on Real Estate Development). I've noticed certain left-biases myself, but I suspect they were inserted because I'm taking the courses in Canada. The text I'm using is a Canadian, Microeconomics version of the most widely read text on economics in the world, The Principles of Economics. The text and it's American author, Gregory Mankiw, is the subject of an infuriating Adbusters Campaign. Adbusters is a publication by the Media Foundation (I see they've dropped "Vancouver" from the name) that takes a conspiratorial left view of society. I picked up the special economics issue a few months ago and wanted to throw it across the room whenever I read an article therein - but it was educational.

If you are curious about what a left view of economics really looks like, check out the campaign.

Meanwhile, I don't object to the use of the term Moral Hazard inasmuch as it refers to one of the principles of economics: people respond to incentives.

However, my studies have just begun, so I won't bore you with half-baked opinions on the matter (for now).

[Black Wolf]

I'm curious: what was the CRA's role in this financial crisis?