Capitalism In Question: Can Or Should Government Prevent Bubbles?
At a hearing recently on Capitol Hill, hedge fund billionaire and Democratic activist George Soros off-handedly dropped a one-line phrase that challenged principles that have been fixed at the core of the U.S. economy for the past 230 years or so.
"It is the job of regulators," Soros said, "to prevent bubbles from forming."
Say what? Since when?
The current financial crisis is doing more than just draining 401(k)s, throwing markets into turmoil, determining presidential elections and putting people out of jobs. It is causing Americans to question the very nature of U.S.-style capitalism.
Greed and short-sightedness have flipped our system upside down and Americans rich and poor are turning to the government for help. Each federal response, it seems, takes the economy one more step away from capitalism and toward nationalization.
In this feature -- Capitalism In Question -- we will take a hard look at these steps as a way to help us better understand what kind of economy we are becoming.
In the case of Soros, he was addressing the housing and credit bubbles, which are at the heart of the current crisis. Cheap money allowed people to buy houses they shouldn't afford, driving up housing values and allowing homeowners to draw credit out of their homes. When housing values did the unthinkable and stopped rising, the cascade of collapse began, bringing us to where we are today.
Soros was advocating broader powers for regulators as they examine the economic landscape and try to head off problems before they happen.
His comment raises at least two critical points:
A) Is it possible to accurately predict bubbles, differentiating them from real growth cycles?
B) If it is, should bubbles be slowed down or stopped, or are they part of the organic business cycle, separating the wheat from the chaff?
Think of it as a parent: If you stop your child from making a mistake before he makes it, he may never learn from it.
But consider this possibility: Suppose your child's mistake harms his entire class and indeed the entire school system. Would you then be obliged to intervene?
It turns out, these questions are being hotly debated.
We caught up with Columbia University economist Charles Calomiris, who had just returned from delivering a paper on this very topic in Brazil last week.
Calomiris told us what we're talking about is something called "macro-prudential regulation."
Translation: Identifying problems in the economy before they happen and trying to stop them.
At first blush, this sounds like a good idea. But it raises several complications. And not everyone agrees it's a good idea.
"It is currently not the job of regulators to prevent bubbles, but it certainly could be part of it," Calomiris said.
Calomiris and other economists argue that you can tell a bubble is forming if two criteria are occurring simultaneously: a) asset prices are rising rapidly and b) the amount of credit being given is rising rapidly.
Looking back to the 2002-2006 period, that describes the two characteristics of the housing bubble.
If a government empowered with macro-prudential regulation sees these two triggering mechanisms, it would require banks to instantly raise capital to create cash on their balance sheets and enable them to keep lending if the bubble bursts.
It's a two-fer, Calomiris says: Even if the bubble never bursts, it's not a bad thing for banks to have more cash on-hand.
The idea of macro-prudential regulation is not restricted to academics at faraway symposia.
Earlier this week, while giving an update on the state of the bailout and the economy, Treasury Secretary Hank Paulson lent his powerful voice to those calling for some sort of macro-prudential regulation.
"There needs to be some regulator -- we've suggested the Fed -- that has a macro-stability role," Paulson said. "It would have the ability to look across the entire financial system to look for weaknesses that would threaten the system and have the authority to do something about it."
Way back in August -- just before the current crisis really kicked in -- Fed Chairman Ben Bernanke favorably, if cautiously, raised the notion when addressing the Kansas City Fed's annual meeting in Jackson Hole, Wyo.:
"The adoption of a regulatory and supervisory approach with a heavier macro-prudential focus has a strong rationale, but we should be careful about over-promising, as we are still rather far from having the capacity to implement such an approach in a thoroughgoing way," Bernanke said. "The Federal Reserve will continue to work with the Congress, other regulators, and the private sector to explore this and other strategies to increase financial stability."
Yet, free-marketers warn that the regulatory powers required to set up such a system would be a significant intrusion of government into the markets, which they say are true proving and killing grounds of capitalism.
The government requiring banks to raise capital? Such an idea would have been unthinkable up until, oh, about September of this year.
Further, how would the banks raise capital? By selling bonds or stocks? Or by credit? If that's the case, isn't over-leveraging one of the causes of the current crisis?
And finally, it simply may not be possible to prevent bubbles.
"The assumption that we can anticipate incipient bubbles and carefully apply pin-pricks to them is dubious at best," says Temple University mathematics Prof. John Allen Paulos, author of "A Mathematician Plays the Stock Market."
"Of course," he adds, "this inability is no reason not to institute greater regulation of various markets, trades, and institutions.
December 4, 2008; 4:26 PM ET
Categories: The Ticker | Tags: capitalism, economic indicators, free markets, regulation
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