Perfect storms occur when many factors align. Sandy was one of the most damaging hurricanes in the history of the United States, but it took the confluence of a number of elements to make it so. Under normal conditions the storm would have moved northeast, away from the U.S. coast. Instead, a high-pressure cold front forced Sandy to turn northwest, where it collided with a cold front that slowed the storm as it passed over one of the nation’s most heavily populated areas. Sandy came ashore at high tide, significantly increasing the storm surge. Coincidentally, the moon was full, adding perhaps another foot to the surge.
In the United States, businesses continually come and go without causing a ripple, and even large companies have failed with no significant impact on the market. Only a large number of failures occurring simultaneously would be enough to rock an economy as big as that of the United States. But such a convergence would be highly unlikely in any big free-market economy. With countless entrepreneurs trying countless strategies at different times and locations, there is little chance of alignment.
No, a convergence of failures takes coordination, which government regulators are only too happy to provide. Regulators claim to “bring order to the chaotic marketplace,” but order is a double-edged sword. For example, requiring that companies follow the Generally Accepted Accounting Principles (developed by a number of private professional accounting organizations) establishes a lingua franca that facilitates business. On the other hand, making whole industries march together in lock step magnifies the impact of a step gone awry. One-size-fits-all rules cause companies and investors to move in herds, making booms and their subsequent busts far more likely and far bigger and more damaging when they occur. Ironically, the federal government’s efforts to reduce risk and to eliminate one-time events such as the Enron collapse are partly to blame.
Three key government interventions can lead to a perfect storm:
1. Implicit and explicit guarantees of private companies
3. Centralized control of the money supply
By assuming financial risk for banks and other lending institutions, government artificially drives interest rates down. When government assumes the risk, loan originators have less incentive to discourage potentially dicey business ventures with high-risk premiums or stringent requirements. When Fannie Mae and Freddie Mac (the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation) purchase loans, originators have less incentive to lend prudently.
Moral hazards are a natural consequence of government financial guarantees. With their losses covered, financial institutions are free to make riskier investments in the hope of higher profits. Government in turn responds by increasing regulations — the second key intervention — in an attempt to offset the moral hazard its guarantees created. But regulations increase the cost of doing business and are generally easier for large companies to bear than for their smaller competitors. That leads to business consolidation, increasing the impact on the nation’s economy should any one company fail.
Regulations can lead to uniformity within whole industries. For instance, the definition of what constitutes high- and low-risk investments for banks may be determined by government fiat. Further, the amount of reserves that banks are required to hold is determined by the degree of bureaucratically perceived investment risk. Loans to governmental entities, for example, are considered to have zero risk and by the international Basel accords, banks are not required to hold any money in reserve in case such loans go bad. As a result, banks are encouraged to make more government loans at interest rates that may not reflect actual risk, and governments are in turn encouraged to go ever deeper into debt.
Regulations also dictate responses to losses. For example, the securities that banks hold must meet or exceed minimum risk ratings determined, in this country, by credit-rating agencies, members of a cartel created by the Securities and Exchange Commission. Should the ratings of a bank’s securities fall, the bank may have to sell them in order to rebuild its reserves. But if many banks have to sell the same types of securities at the same time, prices will spiral downward, requiring still more to be sold into a declining market.
Before they were repealed, mark-to-market rules made the problem worse. The rules required banks and other institutions to value financial assets on their books at current market rates rather than at their purchase prices. Mark-to-market valuation tended to amplify the effects of both booms and busts. As asset prices soar during a boom, the value of bank holdings of such assets soars along with them. With greater nominal reserves, banks can lend more money, some of which may be invested in those same appreciating assets, further boosting their value. When the bubble bursts and values drop, banks must call in loans in order to bolster their falling reserves, tightening the money supply.
The third key intervention is control of a nation’s money supply by a central bank. Rather than simply printing more money, central banks typically increase liquidity by driving interest rates down. In this country the Federal Reserve does that in a number of ways, including adjusting the discount rate, adjusting the banking reserve rate, and buying or selling securities from or to banks and licensed dealers.
As interest rates drop, return on bank deposits falls, so people tend to save less and consume more. At the same time, despite less savings, credit expands and interest-sensitive industries such as home building and car manufacturing expand along with it. That creates a conflict as consumers vie with industry for scarce resources; one cannot both sow and eat the same bag of corn. Eventually, competition drives prices up and long-term projects that had previously appeared profitable are revealed to be bad investments.
The 2008 housing crash was not a black swan — a rare, random, and unpredictable event. Rather it was a predictable — and predicted — regulatory stampede caused largely by government interference in the marketplace. In response to the dot-com bust and again after 9/11, the Fed lowered interest rates by easing credit (or, in other words, by expanding debt). The new liquidity was herded into residential housing by tax breaks for mortgage debt and by regulations encouraging banks and mortgage companies to ease lending standards in an effort to make housing more affordable for the poor.
At the same time, Congress demanded that Freddie Mac and Fannie Mae purchase hundreds of billion dollars in subprime loans from lending institutions. That freed money up, enabling more loans to be made than would have otherwise been possible. The result was a housing boom. As home prices soared, investors snapped up triple-A mortgage-backed derivatives. Speculation became routine, as houses were bought simply to be resold, or “flipped,” as soon as prices rose again. Some houses were built strictly as investments — never to be occupied, as they were sold and sold again.
It all came crashing down when the Fed tightened credit, causing interest rates to rise and housing prices to collapse. Thousands of home buyers defaulted on their mortgages. Stock and derivative prices plunged as investors stampeded for the exits.
Had financial institutions been required to assess and manage asset risks themselves, it is unlikely that they all would have made the same mistakes at the same time. However, government acted as a guarantor of last resort, reducing incentives for investors to make prudent decisions. Government tried to limit its risks through regulation. But problems arose when one-size-fits-all rules created an environment in which failure was coordinated, simultaneous, and catastrophic. Investors were regulated into a herd and were stampeded over a fiscal cliff.
It would be far better for the government to eliminate the current system of private profits and socialized losses and allow a true profit-and-loss free-market system to exist.
This article was originally published in the May 2013 edition of Future of Freedom.