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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.

-- Frank Ahrens
The Ticker is Twittering!

By Frank Ahrens  |  December 4, 2008; 4:26 PM ET
Categories:  The Ticker  | Tags: capitalism, economic indicators, free markets, regulation  
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It is asinine to consider heavier regulation of markets without first examining the Fed's primary power of credit multiplication.

People do not seem to understand this enormous component of our economy and credit system. There is a huge difference between a 2:1 and a 20:1 reserve ratio, but nobody is talking about this. They only want to know what happens to the money after it has been created as credit. Until people, including the politicians, understand the Fed's role in every bubble that has come to pass, we will never have control over the boom/bust cycle. And, of course, this is fine by the Fed's shareholders - they collect a 6% dividend no matter how badly inflated our money becomes.

Posted by: patrick4 | December 4, 2008 4:55 PM | Report abuse

Government can prevent bubbles by not inflating them in the first place by manipulating a fiat currency and interest rates. Just ask Congressman Ron Paul, or go to

Posted by: awendel1 | December 4, 2008 5:00 PM | Report abuse

Soros is not thinking. Bubbles come from enthusiasm of investors. Some pay off and some collapse. It is the nature of a "gold rush."

The cure would be worse than the problem.

Posted by: gary4books | December 4, 2008 5:35 PM | Report abuse

The government probably cannot prevent stock market bubbles because no entity, including the Federal Reserve Board, would want to interrupt the "party." Greed is too entrenched in this and most cultures, so expect bubbles in the stock market in the future.

However, the recent housing bubble could have bee be prevented or at least minimized, as well as any possible bubbles in housing could be prevented, by a few common sense regulations. Most importantly no person should be eligible for a mortgage unless they provide a minimum 20% down payment. Perhaps a 30% down payment should be required for persons seeking a mortgage on more than one home. Only fixed rate mortgages should be allowed.

However, given how greedy many financial institutions and people are, I would be surprised if these basic rules were enacted , as well as enforced.

Posted by: Aprogressiveindependent | December 4, 2008 6:00 PM | Report abuse

Of course the monetary authorities, including the central bank, should try to avoid destabilising bubbles. If the financial system is behaving irresponsibly, by extending credit to borrowers who have no prospect of being able to repay their loans and thus driving up prices (sound familiar) then the central bank can and should require financial institutions to be more prudent, incidentally existing powers allow them to do this for, by example, requiring higher margin requirements in the case of the Fed. It is worth noting that there was no housing bubble in France or Germany because the banks did not join the bandwagon. However, their financial systems are under stress because of their exposure to the consequences of the bubbles in the UK and US.

Posted by: iansmccarthy | December 4, 2008 7:07 PM | Report abuse

What really bothers me is that none of this is new. My parents' era of youth had the Roaring 1920s, which led to the Great Depression because of uncontrolled speculation. My era had the Go-Go 1980s, with it's "Greed, for want of a better word, is good" Gordon Gekko philosophy. Even I failed to see that this was a bubble that seemed "un-burstable," for want of a better word. Then, first the technology bubble imploded -- also known as the dot-com collapse -- and I and many others lost almost everything. That was followed by the bursting of the real estate bubble; then the credit bubble; then the financial bubble, and so on. Yes, government should prevent bubbles. They also should pay attention. The real sin behind all of this is that our economic chaos could and should have been averted.

Posted by: TESimonton | December 4, 2008 8:19 PM | Report abuse

Why was the Kansas City Fed meeting in Jackson Hole? Why weren't they meeting in Kansas City? This sounds like the kind of extravagant behavior that Congress has been taking the heads of the Big 3 automakers to task for.

Posted by: swmdalswmdal | December 4, 2008 8:23 PM | Report abuse

The role of the Fed has traditionally been to "take the punchbowl away when the party gets out of hand." In the case of the tech bubble in the 1990's, instead of complaining about "irrational exuberance" the Fed should have raised margin requirements, which they have the power to do. The banking regulators could also have maintained proper capital requirements on the banks.

The housing bubble was substantially based on fraud by the lenders. I've seen enough stories about people being sold into agreeing to mortgages that they didn't understand.

As best I can tell, the lenders were qualifying people based on teaser rates that weren't even the actual rates being charged. The difference was being added to the principal. Instead of the mortgages being paid off, the principal was growing and the rates were just plain being raised, but not in accordance with an index. If "Truth in Lending" could have been strictly enforced, that part of the scheme would have collapsed.

It was straight predatory lending and was done to get fees from the mortgage bond bubble, that was again fraudulent. The rating agencies were telling investors the bonds were good when they weren't, because of fees from the bond issuers. Another fraud was perpetrated by credit default swaps, that could be purchased by people who didn't own the bonds they were "insuring." Then speculators could bet on the insolvency of the issuers and do things like naked shorting to destroy investor confidence in the issuers and help the issuers become insolvent.

Newsweek had an article about some banks that deal with the same demographic as the toxic lenders did. Except they work with their borrowers, make loans at fixed rates, and operate honestly and prudently. Their default rates are much lower than the overall average for loans and mortgages.

This reads like something from Charles Mackay's book, "Extraordinary Popular Delusions and the Madness of Crowds," except his book was written in the mid-1800's. The markets he describes have no "unseen hand." They are either crazy, fraudulent, or both.

Regarding the mathematics, it has been studied, but not for markets. If you have a non-LCD, traditional TV, a circuit that operates like a bubble market helps paint the picture on the screen. The mathematics of that kind of circuit was included in books on non-linear analysis years ago, and has some relationship to the analyses of chaos theory.

Posted by: StanKlein | December 4, 2008 9:05 PM | Report abuse

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