Banks, Not the Free Market, Are to Blame

One nice thing about the Internet age is that libertarians and other supporters of the free market have a platform to offer our own narratives on financial crisis and recession. This democratization of publishing means we can offer counter-narratives to the those of the elites, and do so contemporaneously and permanently in a way that we were unable to during and after the Great Depression. As a result, there is plenty of good free-market analysis out there and no excuse for anyone to think there’s only one (statist) side of the story.

However, I do think many of us who have written such analyses — and I very much include myself here — have not been consistent about making an important distinction, and this has left us unnecessarily open to a reasonable criticism. For example, I have used the analogy of traffic lights to explain why it’s wrong to blame the crisis on irrational behavior. Suppose someone turned all the traffic lights green. The obvious result would be a whole bunch of accidents. Would we blame those accidents on the drivers? Would we say they were acting irrationally? No, in fact we’d probably say they were behaving quite rationally given the signals they faced. A green light doesn’t just mean “go”; it also implies the light the other way is red and that going is safe.

Changing the Incentives

One way to view the housing boom is as the outcome of government’s turning all the lights green, changing the incentives facing market actors and causing their rational responses to distorted signals to produce irrational outcomes. The Austrian story of boom and bust is really a story of the unsustainable boom. Central bank-generated inflation (in this case combined with policies to subsidize housing) led to artificially low interest rates and excessive investment in long-term projects that cannot be sustained by the amount of real saving taking place.

So what’s the problem? Some have interpreted this argument as letting the bankers off the hook too easily. This and similar arguments seem to suggest the bankers were innocent in that they just responded rationally to signals generated by the central bank or Congress. The problem is that, as several critics of mine have rightly pointed out, many of the housing policies were not imposed on the bankers but rather were aggressively lobbied for. In many cases (such as Countrywide), it was the bankers themselves who asked Congress for policies making it easier to lend to marginal customers and for Fannie and Freddie to have access to the Treasury. They also favored the implicit bailout promise, which sustained the mortgage-backed securities market. And many bankers cheered on the Fed’s low interest rates during the middle of last decade.

In addition to any ethically shady dealings banks might have had (and I do believe there are examples of this), we should not hesitate to blame them for the crisis for the reasons outlined: They were at least partially responsible for the passage of many of the government policies that created the boom and therefore the bust. To that extent, then, we can agree with our friends on the left that the bankers were part of the problem, which also suggests that protesting Wall Street is not wrong. None of this undermines the importance of my traffic lights analogy to make the point that rational responses to bad signals is a better way to understand the problem than irrational or “greedy” behavior. But that point needs to be supplemented by reminding people that it was often the bankers in cahoots with politicians who turned all the lights green in the first place!

Face the Facts

The upshot is that we have to acknowledge these issues. For too many people, the claim that “the bankers are responsible” is the same as “the free market is responsible.” We have to disentangle these two claims not by appearing to deny both of them, but by agreeing that the bankers are responsible — and showing that their responsibility consists in preventing the free market from working.

We — and I again include myself here — have to be careful to say that the lesson is not that bankers bear no responsibility, but that the free market bears no responsibility. We should make it clear to those we talk to that bankers are not exempt from Horwitz’s First Law of Political Economy: “No one hates capitalism more than capitalists.”

Regards,

Steven Horwitz