While testifying before the House Oversight Committee last week, Alan Greenspan said,
The economic crisis has revealed a flaw in the model that I perceived as the critical functioning structure that defines how the world works… Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity, myself especially, are in a state of shock and disbelief.
The recent crisis did reveal very clearly about one aspect of how the world works. There are in essence two economies: the real economy, where real goods and services are produced and consumed, and the financial economy, where assets are swapped for investment or speculative purposes. These two economies interact and affect each other, but each requires a unique regulatory framework to support. While government intervention in the real economy is almost always bad, government intervention in the financial economy is almost always necessary. For this reason, I fully agree that we need more regulation in the financial economy, as long as we are careful not to let it spill over to the real economy.
I believe this dichotomy needs some explaining.
While the invisible hand of laissez-faire does a pretty good job at keeping things in check in the real economy, it fails when applied to the financial economy. The free market relies on the mechanism of orderly discovery of equilibrium prices. In the speculative financial markets, this mechanism, although it still exists to a certain extent, fails too often and for too long.
When there are not enough shoes being produced in a real free market, for example, shoe prices go up, and the market adjusts by selling more shoes, causing shoe prices to come back down, and vice versa. Self-correcting forces keep the free market of goods from drifting too far away from the equilibrium (i.e. just enough shoemakers selling just enough shoes at just the right price). These forces of benign price discovery fail too often in the financial markets because there are other forces, self-feeding and much more powerful, that overwhelm them.
While the real economy anchors on physical goods and services, the financial economy anchors on confidence of its participants. In this confidence game, markets degenerate too easily into a self-perpetuating cycle, more so when they involve speculative assets, and especially when they are affected by the expansion/contraction of credit.
Examples of self-perpetuating cycles are everywhere in the financial world. Bubbles are caused by people buying assets that rose in price, causing the asset prices to rise even further. The richer you are, the easier it is for you to borrow money, which you can invest with and make even more money. The reverse is also true: Lower asset prices beget more selling, contracting credit begets tightening of lending standards. The abundance of these runaway processes is the crucial difference between the financial and the real markets - lower shoe prices does not get more people into the shoe-selling business!
This is not a new idea. The lack of a stable equilibrium in the financial markets has previously been described in George Soros’s The Theory of Reflexivity. Even the late economist John Maynard Keynes knew that the “animal spirit” of market participants is unpredictable, and the government will often need to step in to prevent the economy from swinging, destructively, to the either extremes of boom and bust. The animal spirit is exceptionally acute in the financial world.
But let’s not give up on capitalism yet. Recent hiccup notwithstanding, the trend towards freer and more global markets has coincided with improvements in our overall standard of living, albeit in a choppy fashion, over the long period of history. Capitalism is not dead, it just needs some tweaking. Lending standards need to be regulated, bank deposits need to be fully insured, and money supply needs to be controlled with care. But the responsible regulators and policymakers must be astute in noticing the crucial distinction between these creatures of the financial markets and those of the real goods and services.
This credit crisis has emboldened certain observers into declaring “capitalism doesn’t work”. We already hear about politicians all over the world taking advantage of this opportunity to enact regulations over many areas of the economy. There is now significant risk that governments of many nations are on the trajectory towards a more socialistic/protectionistic stance, destroying the climate of globalization and capitalistic experimentation that has served us so well throughout history.
It is not my intention to trivialize the recent credit crisis. The crash in the Dow Jones Industrial Average, for example, has effectively erased 10 years of gains. But let’s not allow this stumble to undo our centuries of progress. Yes, the pendulum swung too far to the side of deregulation, of unchecked capitalism, and we are suffering for it; but still, more important now than ever, we need to use all our power to prevent the pendulum from overshooting to the opposite side, because the consequences will be much direr.