Free markets didn't create the financial crisis. Governments did...
THIS SPEECH was delivered to the Policy Exchange on 31st March 2009 by Cobden Centre sponsor James Tyler. First published on Hedgehedge.com, it remains just as relevant today.
I WANT TO talk about two things...
- Free markets did NOT cause this crisis. Governments did.
- Inflation targeting has failed. Money has failed. What should we do?
First, free markets did not cause this problem. In theory, markets work by reacting to prices and direct capital towards where it will be most productively used. This is how wealth is created. Usually this works well, but markets are made up of humans, and can be fooled into overshooting by false signals.
Bubbles build up, expanding until people lose confidence. Bubbles then burst. It's a corrective process that, relatively benignly, irons out imbalances. The problem only comes when bubbles go on for too long, because once they get too big, the pop can be terrifying. And that's what we've got now – one hell of a big bang.
False signals have caused a spectacular mal-investment in real estate and its derivatives. But these false signals did not come from the market, but from government.
False signals came from then-Federal Reserve chairman Alan Greenspan's introduction of welfare for markets. Markets were taught that no matter how much risk they took, they would always be saved. In 1987, 1994, 1998, 2001...each bust bigger than the last...disaster was only staved off with aggressive rate cuts and increased money supply.
Clearly this was not laissez faire. Just think if events had been allowed to take their course...
- I bet if LTCM had gone bust then a badly burned Wall Street would have learned a lesson and Lehman's would still be around today;
- In 1999 Clinton mandated that Fannie Mae and Freddie Mac reduce lending standards. The poor were encouraged into debt. This intervention triggered a race to the bottom of lending standards as commercial banks were forced to compete against the limitless pockets of Uncle Sam;
- False signals also came from deposit insurance. Deposit your money in a boring mutual? Why bother when you can lend it to a lump of volcanic rock in the Atlantic at 7% and be guaranteed to get your money back;
- The Basle banking accords required banks to replace rock solid reserves with maths;
- Government protected and regulated ratings agencies produced negligent ratings, duping pension funds – who were obligated to buy high quality paper – into buying junk cleansed by untested mathematical models.
But most damaging of all was the absurdly low interest rates set between 2001 and 2004. The resultant glut of cheap money fueled an unsustainable boom encouraging more mortgages to be taken out, and pushing property prices ever higher.
The market responded by pushing scarce economic capital towards highly speculative property development. As prices rose people remortgaged, and borrowed to consume more. This unchecked process tended to be destructive, as scarce economic capital flowed out of our economy and headed to those economies efficiently producing consumer goods, such as China. Rampant asset inflation clouded our ability to see this depletion process in action. Everyone had a great time whilst the party lasted, not least Governments who were incentivised to let it run, blinded by ever larger tax revenues.
But all parties come to an end, and central banks had to prick the bubble eventually. Interest rates went too high, and sub prime collapsed, and then all property prices plummeted. Trillions of Dollars were ripped out of the financial system, and the credit crunch began.
Depite its complexity, however, there was nothing new or unpredictable about this process. All the great busts of the 20th century were preceded by a Government-sanctioned fiat currency boom. In the 1920's, the Fed pursued a 'constant Dollar' policy. This was the era of the innovation, Model T Fords, radios and rapid technological advancement. Things should have become cheaper for millions of people, but money supply was boosted to try and keep prices constant. All that extra money flowed into the stock market, pushing prices to crazy levels, and we all know how that ended.
In the modern day, targeting price changes has been an utter disaster for us too. It let the Bank of England pretend they were doing their job even when money supply was growing at a double digit rate. It let the authorities relax whilst an economy-threatening credit bubble was building up. And it gave Gordon Brown the leeway to convince people that boom and bust was over.
Things should have got cheaper, but inflation targeting made no allowance for globalization, the rise of India and China, and the benign falls in general prices that should have been triggered. Think about it; if all those cheap goods were to become available, consumer prices should fall. We would have had greater purchasing power, and become wealthier for it.
But the Bank of England was aiming at a symmetrical plus 2% target. Falling prices in some goods necessitated stimulating rises in others. They unleashed an avalanche of under priced debt and we had our own crazy asset boom. Inflation targeting was a myopic policy.
When a central bank sets interest rates, they set the price of credit. Inevitably they create distortions. Consider this; Governments cannot set food prices without causing a glut – or painful shortages. Now, food is a pretty simple commodity, yet we all understand that central planners simply cannot gather enough information to set the price accurately.
It has to be left to the spontaneous interaction of thousands of buyers and sellers to set the price. So, why do we think that enlightened bureaucrats can put an exact price on something as vital, yet complicated, as credit?
In a nutshell, if I can't tell how much my wife will spend on Bond Street this weekend, how can they?
Let's wake up from this fantasy. There is a better way. Let the invisible hand to do its time-honoured job. Leave interest rates to be set by the millions of suppliers and users of capital. Get the central planners out of the way. It's the way it used to happen. The period of fastest economic growth the world has seen was America between the civil war and the end of the 19th century. Money was free and private and the Fed did not exist.
So, how do we get back to freedom in money? Fredrich Hayek – the great Austrian economist – did the best thinking on this. What he proposed was that private firms should be allowed to produce their own currencies, which would then be free to compete against each other. People would only hold currency that maintained its value. Firms that over-issued would go bust. Producers of 'sound' money would prosper.
History gives us plenty of successful examples of private money working well, such as 18th-century Scotland with its competing banks, all with their own bank notes. People weren't confused. It worked. There are many other examples, and in the modern age, technology makes the prospect of monetary competition even more tantalizing.
Mobile phones, oyster cards, smart tags, embedded chips, wireless networks, the internet. Prices could flash up in the shopper's preferred currency. So here's an idea of how to kick the process off.
Tesco's want to get into banking. Why not currencies as well? Tesco would print one million pieces of paper. Let's call them Tesco Pounds. It would be redeemable at any time for £10 or $15. They would then be auctioned, and the price of a Tesco set.
Anyone who owns a Tesco has a hedge against either the Pound or Dollar devaluing, therefore the Tesco has an additional intrinsic value. Maybe they'll auction at £12. Tesco would then specify a shopping basket of goods that cost £60. It would promise that 5 Tesco Pounds would always buy that weekly shop. The firm would use its assets to adjust the supply of Tesco Pounds so that they kept this stable value. (They would need to otherwise their shelves would be cleaned out!)
As central banks inflated the Pound and Dollar away over time, the convertibility into these currencies would matter less. We would be left with a hard currency that meant something. There would be other competitors and a real choice about which money to hold your wealth in.
McDonalds has a better credit rating than Her Majesties Government, so maybe people would be happy to hold Big Mac tokens? I don't know – it will be a free choice. Currencies would sink or swim depending on how well they performed. What's more, firms issuing the currencies would come up with different ways of maintaining their value. Some would offer Gold. Manufacturers may use notes backed up by steel, copper and oil.
Let's see what a free market chooses. Somebody might have a brainwave and come up with an idea that nobody has thought of. That is what free markets are best at.
Now, I can guess the reactions that my proposal might inspire in some. How would the man on the street cope? Well, nobody would outlaw the Government's money, and people could carry on as before. Through the operation of the market, we would find out what worked best. Step-by step, the economy would be transformed and standards driven up. In economics, spontaneous orders are always so much more rational and stable than planned ones. Always.
In conclusion, this is not a crisis caused by free markets. A free and unregulated market in money has not existed for over a century. This is a Government crisis, a crisis over the monopoly of money. Inflation targeting seemed so persuasive...but it was a false God, and we deserve better. Stability and sound money can only come if we put the money supply back where it belongs...
Under the control of the free market.
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