US lenders should be a warningFont Size: Decrease Increase Print Page: Print Alan Wood | September 12, 2008 IS this week's bailout of the US mortgage institutions Freddie Mac and Fannie Mae a failure of capitalism or socialism? The World Socialist Web Site, published by the International Committee of the Fourth International, has no doubts about the answer.
In a well-written summary on Monday of the Freddie and Fannie debacle, it concludes that their bankruptcy points to the bankruptcy of the American capitalist system.
"The speculation, cronyism and corruption that pervaded the operations of Fannie Mae and Freddie Mac are emblematic of the parasitism and criminality of America's ruling financial elite as a whole," the article's author, Bill Van Auken, asserts. The US financial elite has certainly not come out of this episode well, but the end of capitalism?
For an opinion from the other side of the ideological divide, we need look no further than the Financial
Times blog of outspoken Dutch-born economist Willem Buiter, a former member of the monetary policy committee of the Bank of England and now a professor at the London School of Economics.
In a July commentary headlined "Time for comrade Paulson (US Treasury Secretary Henry Paulson) to pull the plug on the Fannie and Freddie charade", Buiter wrote: "There are many forms of socialism. The version practised in the US is the most deceitful one I know." He goes on to denounce the dishonest, spineless socialist policymakers in successive Democratic and Republican administrations, with Freddie and Fannie as his text. So the real problem is socialism?
Actually there is a great deal of common ground between capitalists and socialists on the essentially corrupt nature and unsustainable financial structure of Fannie and Freddie. They are the bastard children of a miscegenational union between the two belief systems, and combine undesirable traits of both.
The model should be familiar to Australians in another guise: the agrarian socialism practised for decades in Australia by the Country Party (now the Nationals). The common principle is to privatise the profits and socialise the losses, which is how Fannie and Freddie survived and prospered.
But their financial tentacles extended a malign influence well beyond the US financial system, for example into China and Russia, which have been selling down billions of dollars worth of Freddie and Fannie securities in recent months. Reassuring foreign investors in US financial assets was a prime motivation of this week's bailout.
Paulson acknowledged as much when he said that the failure of Freddie or Fannie would cause great turmoil not only in US but in global financial markets. And it was put even more starkly by Chinese economist Yu Yongding, a former senior adviser to its central bank, who warned in August: "If the US Government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it is not the end of the world, it is the end of the current international financial system."
Fannie and Freddie have not been allowed to fail, although questions have been raised about the rescue package and their ultimate fate is unclear. However, regardless of their fate, issues remain to be resolved on the future of the international financial system.
There are manifest shortcomings in theory as well as practice in financial markets, where the idea that risk management had evolved to the point where markets could manage crises without official intervention has failed spectacularly. But bad theory, bad management and bad policy shouldn't be confused with a failure of the liberal market economy.
There have been earlier episodes where margins for risk have been pushed down to very low levels and they have, like this one, ended badly, but not in the collapse of the system.
The severity of this episode reflects the fact that the financial sector has grown relative to the size of the overall economy as part of the process of economic development.
The inevitable consequence of this is that movements in financial asset prices have a much greater impact on the economy.
However, while the specifics of each episode differ, they have common elements, which the Reserve Bank of Australia's Philip Lowe identified in a speech last month.
All have common roots in the build-up of risk in the good times, with booming economic conditions leading to rising asset prices, a greater willingness to take on risk, a readiness to lend by financial institutions, a cycle of optimism, leverage and financial innovations.
While central bankers in the rich economies sounded warnings about excessively low pricing of risk, rising debt and speculation, and dangers in the rapid growth of new and opaque financial products, they did not stand in its way in any effective sense. Indeed, led by the US Federal Reserve, they provided liquidity too generously, too cheaply and for toolong.
As usual an economic shock comes along and the cycle goes painfully into reverse. However, the growth of the size of the financial sector and its institutions, the global interconnectedness of financial asset markets and widespread holdings of mispriced financial securities presents central bankers with a new problem: institutions too big to fail.
No central banker or government is prepared to take the risk of letting a large financial institution go under, lest it lead to a systemic collapse.
This is the world we are now in, and central bankers, financial regulators and others are looking for the answer to two crucial questions: How do they deal with the build-up stage of the financial cycle to prevent the emergence of excessive risk taking and speculation? And how do they change the system to solve the too-big-to-fail problem?
Increasing the size of capital buffers financial institutions have to hold in the good times is getting a lot of attention internationally. So is the search for market structures that will limit the ability of individual financial institutions to spread risk through the financial system.
But one clear lesson for Australia has already emerged: don't have anything to do with suggestions that we set up an Aussie Mac here.
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