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George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)rwEconomics.com

 

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It’s what you know for sure that just ain't so.
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The Rise of Utopian Capitalism
And The Crash of 2008

George H. Blackford © 2011

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Now that there has been a host of Congressional hearings investigating last fall’s financial crisis a consensus is beginning to emerge as to how the financial crisis of 2008 came about:  Namely, that this crisis is the direct result of deregulation in the financial markets that has occurred over the last thirty years, the failure to enforce existing regulations over the last fifteen years, and outright fraud on the part of mortgage originators, securitizers, and bond rating agencies over the last eight years.  The history of this period is yet to be written, but to date virtually all of the economists, regulators, lawyers, bankers, bond raters, and other individuals that either participated in, or in some other way gained firsthand knowledge of this debacle that testified before Congress agreed that the scenario laid out above is essentially what brought us to where we are today.[1]  (Hearings HLS)

 

There is, however, another scenario put forth by Republican politicians and their friends during the last election while these congressional hearings were being held that is still being argued today.  In this scenario the problem was that community action groups in league with Democratic politicians forced banks to make unsound loans to poor people and somehow this led to the collapse of the system.  This alternative view permeates the web, and I suspect will do so forever.  It is the product of the Right-wing Propaganda Machine in our country, and even though Fox News, Rush Limbaugh, and Republican politicians all allude to this scenario whenever the opportunity arises, there doesn’t seem to be a coherent presentation of this scenario to be found anywhere except in an article by “M. Jay Wells” entitled Why the Mortgage Crisis Happened.  This article was first published on a right-wing website (The American Thinker) and subsequently republished in Investor’s Business Daily.  It is still available on the Investor’s Business Daily’s website. 

 

This article is clearly a piece of propaganda that appeals to emotion rather than reason.  In addition, there doesn’t seem to be any biographical information as to who M. Jay Wells actually is.  (Google)  Until it is possible to verify his identity there is no reason to believe M. Jay Wells even exist or that anything in this article is true.  Nevertheless, since this is the clearest statement of the alternative scenario I can find it is worth examining here.  In addition, since this kind of propaganda has played a major role in bringing about today’s crisis it is worth examining in its own right.[2]

Republican View of the Financial Crisis

According to the scenario put forth in this article the Clinton Administration aided by congressional Democrats and the Community Reinvestment Act (CRA) of 1977 changed the rules at Fannie Mae and Freddie Mac to allow these Government Sponsored Enterprises (GSEs) to make unsound loans to poor black people, and that when Republicans tried to stop this practice the Association of Community Organizations for Reform Now (ACORN) was able to use the changed rules and their political clout to force these unsound loans on banks. 

 

The first problem with this scenario is that virtually all of the economists, all of the regulators, all of the lawyers, all of the bankers, all of the bond raters, and all of the other individuals that either participated in, or in some other way gained firsthand knowledge of the current financial crisis that testified at the Congressional hearings agree that this scenario is false.  (Hearings HLS

 

The next problem with Wells’ scenario is that when you look at the core of his argument it just doesn’t make sense.  Putting aside the fact that he blames Democrats for everything and paints the Republicans as doing their best to save the system against overwhelming odds, his use of emotive terms such as anti-capitalism, socialist, radicals, and redistributionist, and his blatant appeal to racial prejudice, the crux of his argument is the notion that ACORN in league with the Democratic Party from the 1990s onward were somehow able to bring Wall Street banks to their knees and force them to make unsound loans to poor black people in spite of the valiant efforts of Republicans to save the day. 

 

ACORN is a nonprofit corporation that does community organizing, and the Democratic Party lost control of the Congress in 1994.  Wall Street banks are a collection of trillion dollar institutions with hundreds of billions of dollars to hire lawyers to fend off attackers and to lobby the government to protect their interests.  What’s more the Republican Party not only took control of the Congress in 1994, they won the presidency in 2000, and the Republican Party has always been a strong defender of the interests of Wall Street.  The notion that Wall Street cowered at threats from ACORN and the Democratic Party from the 1990s onward is just incomprehensible.  To believe this is to ignore virtually everything known about wealth and power and money and politics and human nature and people and the entire concept of there being order in the universe.  It is easier to believe in the Tooth Fairy than to believe that Wall Street banks have been afraid of ACORN and the Democratic Party since the 1990s.

 

Putting aside Wells’ notion that the poor are to be denied the kingdom of heaven but instead have inherited the Earth, virtually every other claim made in this article is out of touch with reality.  Consider the following claims made by Wells:

  1. The claim that enforcement of CRA was the root of the problem is contradicted by the testimony of every banker that testified before the Congressional hearings that were held to investigate the financial crisis.  The bankers all supported this act because it was profitable for them.  Even though the default rate was higher for the loans they made under this act, according to testimony at the hearings, the higher interest rates and down payments they were able to require for these loans more than offset the higher rate of default.  All of the experts agreed that there were no problems with subprime mortgages originated under CRA before 2002 even though this act had been in existence since 1977.  

    What's more, there is no empirical evidence to support the claim that CRA was the root of the problem.  The empirical research undertaken and reviewed by the Federal Reserve shows that mortgages created by way of the CRA program preformed better than mortgages created outside this program. (
    Duke Laderman FRB)

  2. The claim that forcing banks to make unsound loans was the root of the problem is contradicted by the testimony of every expert before these hearing.  None claimed that banks were forced to make unsound loans. What's more, almost all of the bad mortgages were not covered by the CRA. This testimony is reinforced by the Federal Reserve.  (FRB)

  3. The claim that Fannie Mae and Freddie Mac were the root of the problem is contradicted by the fact that all of the witnesses at these hearings testified that these GSEs were slower to get into the subprime and alt-A securitization business than were the non-GSE securitizers—that even though the GSEs were a major player in this drama, they followed the trend set by the private mortgage securitizers.  They did not set this trend

    In 2005 Fannie Mae changed its policy with regard to this market and jumped into it with both feet.  Their support of, and participation in this market from 2005 through 2007 opened the flood gates for the deluge of toxic mortgages that followed, but there is no reason to believe that they did this to help the poor.  They went into this market because that’s where the money was, and they were losing market share to private mortgage companies.  In the heady atmosphere of cowboy finance from 2000 to 2005 they thought they were getting a free ride on a gravy train.  They ended up in the back of a garbage truck, but it was the lust for profit not compassion for the poor or the CRA that got them there.  They ended up in that truck because they were competing with non-GSE securitizers for dominance in an unregulated market that, given the lack of regulation, was destine to destroy itself. 

  4. The claim that ACORN’s use of affirmative action to force banks to give blacks unsound loans was the root of the problem is contradicted by the testimony of experts that while blacks were over represented among recipients of subprime and alt-A loans the vast majority of these loans went to whites not blacks.  What’s more, more than 60% of the subprime mortgages were issued to people who were actually qualified for prime mortgages, and a large majority of these mortgages were issued to middle and upper-income borrowers.   In addition, something like 40 percent of these loans refinanced existing mortgages, and in many, if not most of these refi’s a prime mortgage was converted into a subprime or alt-A mortgage without the borrowers being aware of it. 

  5. As for the claim that Congressional Democrats kept the Congressional Republicans from regulating the capital requirements of the GSEs because the Democrats wanted to continue to force banks to lend to the poor, this is a red herring.  As was noted above, the errant behavior of Fannie Mae and Freddie Mac was not the source of the problem.  Leverage (inadequate capitalization) was a problem for all of the financial institutions involved in this drama, and the GSEs were a very important part of this problem, but there was no attempt by Republicans to regulate the rest of the financial system

Hedge funds were left unregulated.  The Credit Default Swap (CDS) market was left unregulated.  The mortgage origination market was left unregulated.  Investment banks and conglomerate banks were allowed to leverage themselves to the hilt.  It was lack or regulation of hedge funds and the CDS market that created the explosive leverage in the financial system that caused the problem.  There is virtually unanimous agreement among the participants in the Congressional hearings that stricter regulation of the GSEs would have helped, but no one argued that stricter regulation of the GSEs would have solved the problem. 

 

Virtually all of the bankers, lawyers, economists, regulators, investigators, experts, and individuals with firsthand knowledge of the events that transpired in bringing on the current financial crisis who testified before Congressional hearings since September of last year agree with the facts as I have laid them out above.  (Hearings)  Virtually no one who actually knows what has gone on in the financial markets for the last twenty or thirty years disputes these facts.  The only people that dispute these facts are Republican politicians and free-market ideologues, that is, those individuals that have an abiding belief that the government is the source of all economic problems and that a system of unregulated free markets is the savior of mankind.   

The Free-Market Movement

It is impossible to understand the cause of the current financial crisis without an understanding of how the Free-Market Movement in our country has generated the kind of propaganda that Wells’s article exemplifies.  Anyone that doesn’t understand this movement and doesn’t know how it works—whether Republican or Democrat or independent—is virtually overwhelmed by its distorted view of reality, and even those that do understand this movement and do know how it works are susceptible to its effects.  (Westen Altemeyer Lakoff Kuttner)   The influence of this movement is so pervasive and so effective that the average person can read something like the Wells’ article and think that somehow it makes sense even though it is ridiculous on its face and the essence of the whole thing is a lie. 

 

At the heart of this movement is a network of well funded right-wing think tanks that are dedicated to advancing the ideological views of Ayn Rand, Friedrich von Hayek, Ludwig von Mises, and the Chicago School of Economics that provide the intellectual foundations for what has come to be known as Neo-conservatism in the United States and Neo-liberalism in the rest of the world (Harvey) or what Krugman refers to as Movement Conservatism.  The most well known of these think tanks are the Ayn Rand Institute, Heritage Foundation, Cato Institute, Ludwig von Mises Institute, Scaife Foundation, Hoover Institution, and American Enterprise Institute, but there are literally hundreds more listed on the Heritage Foundation website.  (HF)  They hire thousands of individuals to do research and to write papers and books to propagate their views.  They flood television interview shows, talk shows, and news programs with their representatives to put forth their arguments.  (Dolny)  They dominate talk radio and literally control Fox News.  (Bai)  They flood the internet with slanderous emails and bogus websites designed to further their agenda.  They pay for marketing research to sell their ideas and use focus groups to find the best way to present their ideas and when necessary to find the best ways to conceal their views when their views are rejected by the public.  They come up with and distribute talking points to coordinate their presentations and arguments.  They run educational seminars to train political candidates on what to say and how to say it so as to focus the debate on divisive issues such as gay marriage or gun control or racial prejudice or abortion or whether Obama is a Muslim or controlled by William Ayres in order to avoid issues of substance.  They function as a huge Right-wing Propaganda Machine to implant their ideas and their utopian view of reality into the mind of the body politic in an effort to attain their ends.  (Westen Lakoff Hartman Frank Kuttner

 

The onslaught from the operatives of this movement is so massive that it has virtually dominated the political and economic debate in this country and throughout much of the world for over forty years, and the ideologues that fuel the ideas of this movement are extremely powerful and they are dangerous.  (Frank N Klein Mayer Altemeyer Miller)  They have been so successful in implanting their distorted view of reality into the mind of the body politic that their influence on economic policy has driven the economic system of the entire world to the brink of destruction, and they are now in the process of trying to push it over the edge. 

 

The reason these ideologues are so powerful and so dangerous and have been so successful in imbedding their distorted view of reality in the mind of the body politic is that they were able to take over the Republican Party back in the 1970s.  (Frank)  They are the source of the Republican mantra that government is the source of all problems; that free-market capitalism is the source of all that is good in our society; that government regulations inhibit the ability of entrepreneurs to create innovations that are essential to economic growth and the increase of economic wellbeing; that taxes are a burden and should be cut because it’s your money and you know how to spend it better than the government; that the only legitimate functions of government are to enforce contracts and to provide for personal and national security; and that all government interventions in the market beyond these two functions are inherently wasteful and should be privatized or divested from the government so that free markets can provide these functions more efficiently. 

 

The Republican Party has been so effective in selling these ideological ideas to the electorate that in the 1980s virtually any Democrat that took a stand in favor of raising taxes, or against cutting taxes in order to eliminate the deficit was defeated at the polls.  Even Bill Clinton, after losing the Congress to the Republicans in 1994, declared that the age of big government is over and cooperated with the Republican congress to deregulate the financial system.  With the election of Bush in 2000 the takeover of the government by the free-market ideologues was complete.  As a result of this onslaught the entire political system in this country has shifted dangerously to the right.  There are no Republicans and very few Democrats in Washington today that are willing to take a stand against the ideas promulgated by this movement.  

 

All you have to do to see how effective this movement has been at selling its distorted view of reality is to note that a substantial majority of the American electorate believe (at least they did up until 2006) that the source of all of our problems is a bunch of liberal politicians in Washington in spite of the fact that there hasn’t been a liberal president in this country since Lyndon Johnson, and virtually all of the liberals in Congress were purged in the 1980s and early 1990s to the point that Liberals have represented an insignificant minority since then.  During the last forty years a right-wing, free-market ideological bias has been instilled in the mind of the American body politic to such an extent that right-wing conservative political leaders have brought into being a series of free-market economic policies that have led to utter chaos and an unmitigated disaster, not only for our own society, but for the entire world.  And in spite of this, a very large proportion of the American electorate believes that somehow all of this has been brought on by the policies of liberals! 

 

Some of these ideologues, such as Milton Friedman or James Buchanan, whose ideas feed the Right-wing Propaganda Machine that is the core of this movement are brilliant and are called to their task by the sheer elegance of their ideological beliefs.  Others are not only impressed with the elegance of this ideology, but are even more impressed by the amount of wealth that promoting these beliefs allows them to accumulate.  Others still see this ideology as the path to political or economic power.  But most are just intellectual and political hacks that are told what to believe and what to think and how to repeat what they are told to believe and to think.  Nevertheless, whether brilliant or not, whether motivated by greed and power or not, whether a hack or not, all of these ideologues have one thing in common—an unshakable belief in unregulated free-market capitalism.  A large portion, perhaps even most, are totally out of touch with reality, and are incapable of perceiving anything that is inconsistent with their ideological beliefs.  They see the elegance of their theories to be so beautiful, and the rigor of their logic to be so mathematically precise and irrefutable that they cannot even conceive of the possibility that their beliefs are not in tune with the Mind of God.  And as I have said, they are dangerous.  (Frank N Klein Mayer Altemeyer Miller)

 

In the real world, regulation is essential to the efficient and safe functioning of markets.  There are reasons why markets are regulated.  (Musgrave Kuttner)  We regulate the markets for food and drugs and consumer goods because without regulation it is inevitable that dangerous foods and drugs and consumer goods that have the potential to cause great harm to innocent people will be fraudulently or negligently foisted on an unsuspecting public.  (Nader)  We regulate markets to control pollution because without regulation it is inevitable that our air and water, rivers and streams, fish and fowl, and even the very Earth on which we live will become contaminated and poisonous to human beings.  (Carson)  We regulate the labor market because without regulation it is inevitable that the forces of competition and the drive for profit will lead to increasingly dangerous and harmful work environments with sixteen to eighteen hour days and eight and ten year old children working in coal mines.  (Cody)  We have a comprehensive progressive tax structure and antitrust legislation because without them it is inevitable that the drive for accumulation and collusion will lead to the concentration of income, wealth, and economic and political power in the hands of fewer and fewer people and abject poverty for the vast majority of the population.  (Josephson Harrington Veblen)  And we regulate financial markets because without regulation it is inevitable that greed and the lust for profit will lead to fraudulent and reckless behavior that will not only cause a great deal of harm to individual victims, but also has the potential to bring down the entire economic system as a whole. 

 

This is reality.  This is the truth.  This is what happens in the real world when markets are left unregulated, but the free-market ideologues that have taken over the Republican Party are completely oblivious to this reality.  What’s more disturbing is that they don’t even care about finding the truth or telling the truth because they know the truth!  The only thing they care about is proving that they are right, because in their minds their truth is so self evident, so eternal, so elegant, and so beautiful that proving they are right justifies whatever means they can find to prove it even if they have to present a false view of reality to do so.   

 

The Free-Market World of Phil Gramm

For an example of the reasoning processes the free-market ideologue we need go no further than Phil Gramm’s analysis of the financial crisis in his presentation Is Deregulation the Cause of the Financial Crisis at the American Enterprise Institute.  Along with Alan Greenspan, Phil Gramm is one of the most important actors in the current financial drama.  He is the Senator who sponsored the Financial Services Modernization Act (FSMA) in 1999 and the Commodity Futures Modernization Act (CFMA) in 2000.  (Lipton)  These two pieces of legislation played a central role in the financial meltdown that subsequently took place.[3]  How does he view this crisis? 

 

Setting aside his self serving interpretation of history in this presentation he acknowledges that poor people (he does not explicitly blame poor blacks but leaves it to your imagination) were only an “excuse” for writing subprime mortgages.[4]  He then presents a very confused explanation as to why regulated quotas and political pressure on Freddie and Fannie to hold the loans of poor people are the source of the problem (in spite of the fact that neither he nor anyone else has provided any evidence of any kind for this assertion (FRB Hearings)) and in the process he quotes statistics that sound alarming but are not relevant to the problem at all. 

 

He makes no suggestions for regulating of the CDS market, but rather provides a list of sound lending practices that should be applied to mortgages while completely ignoring the fact that the practices he lists were standard, strictly enforced practices even in the subprime market before his free-market crowd took over the government.  Instead, he throws up his hands and says, in effect, that since the Fed has assumed the role of regulating the entire financial system de facto in the current crisis this power should be made de jure

 

In response to questions he lets it be known that he is not at all responsible for anything that has happened since others had asked him to put forth the bills he sponsored, and then presents the oxymoronic argument that there was no deregulation in either of the bills he sponsored since all FSMA did was let financial institutions do things they were not allowed to do before and all CFMA did was prohibited CFTC from regulating the CDS market.  Nothing in these bills kept existing regulators from regulating markets as they see fit. 

 

He then claims the CDS market has actually worked “remarkably well” since this market is still liquid and there have been very few actual defaults in the CDS market in spite of the fact that this market is unregulated.  He apparently was unaware that back in September AIG was bailed out to the tune of $85 billion by the government to keep if from defaulting on its outstanding CDSs, (Merced) and as of March 2, 2009 the cost of the AIG bailout to keep this market ‘liquid’ has reached $160 billion.   (NYT)

 

Aside from this oversight, Gramm is either completely oblivious to, or is unwilling to acknowledge the fact that his keeping the CDS market from becoming regulated led to the creation of something like sixty trillion dollars worth of CDSs that are insuring something like ten trillion dollars worth of Mortgage Backed Securities (MBSs).  Because of this failure to regulate the CDS market and to provide for a comprehensive regulatory structure to regulate the conglomerate banks that FSMA brought into being, the leverage in the financial system exploded to levels that were hitherto unimaginable.  As a result of all this we ended up in a situation in which no one knows which of these CDSs are sound and which are not and, thus, which of the MBSs or other Asset Backed Securities (ABSs) that these CDSs are supposed to insure are, in fact, not insured because the sellers of the CDSs are so highly leveraged that they will not be able to meet their financial obligations.  The introduction of this uncertainty and leverage into our financial system is in the process of bringing down, not just our financial system but the financial system of the entire world as well, and as the effects of the collapse of the international financial system work themselves out, the entire world is threatened by an economic catastrophe the likes of which we haven’t seen since the Great Depression.  The very existence of millions of people is at stake as well as is the economic wellbeing of billions more, and all Gramm can come up with is that there have been relatively few defaults in the unregulated CDSs market—a market that has been bailed out by the government to the tune of $160 billion!  There comes a point where you just have to ask yourself, where is this man’s head?  His distortion of the truth in his discussion doesn’t matter to him.  All he cares about is proving he is right, and his distortion of the truth helps him to prove he is right.

 

Now this may seem unfair.  After all, Phil Gramm is a Ph.D. economist, a fairly bright and personable guy, and is at least indifferent honest—certainly no more dishonest that the average person.  If all of these things are true why would he deal with them in the way he has?  This may sound like a mystery, but after watching these guys for over forty years within the discipline of economics it is no mystery to me. 

 

In Gramm’s mind he is telling the truth.  Not the truth I have laid out above, but a higher truth that is universal, inevitable, and unalterable: namely, that government interference in free markets causes more harm than good, and whenever there is an economic catastrophe, especially one of the magnitude we are experiencing today, it is the fault of government intervention. 

 

Gramm does not approach the problem of explaining the current economic crisis with the mindset of an objective social scientist that examines the evidence with an eye to finding the truth.  He already knows the truth.  He approaches this problem with the mindset of an attorney that examines the evidence with an eye to proving a case.  Whatever misrepresentations or distortions of the facts that may occur in the process are fully justified in his mind by his unequivocal belief in his client’s innocence, where Gramm’s client is free-market capitalism.  In his mind if he can convince people of the innocence of his client by way of these distortions of the truth what’s the harm?  He has served a higher good. 

 

The Free-Market World of Peter J. Wallison

Even more startling than Gramm’s rationalizations are the comments on Gramm’s talk by Peter J. Wallison at the end of the seminar.  Wallison’s comments are the most striking example of ideological blindness and convoluted ideological logic I have ever seen.  He boldly states that “actually during Republican administrations we have had the toughest regulation of the institutions that have to be regulated” because the Federal Deposit Insurance Corporation's Improvement Act (FDICIA) was passed in 1991 during the first Bush Administration.  According to Wallison this is “the most powerful piece of regulatory legislation ever imposed on the banks, and in spite of this legislation after this law is passed we end up in the worst banking crisis of all time.”  Regulation doesn’t work.  Case closed.  I’m right! 

 

To anyone who knows anything at all about the current financial crisis, the structure of the financial system, FDICIA, and the history and implementation of regulatory policy it is frightening to think that anyone would take this man seriously let alone hire him as White House counsel to the President.  This is the man that Reagan appointed as “general counsel of the United States Treasury Department, where he had a significant role in the development of the Reagan administration’s proposals for deregulation in the financial services industry” from 1981 through 1984.  He stood at the very center of the financial debacle of the 1980s (FDIC) and obviously learned nothing from the experience. 

 

To begin with, the jurisdiction of FDICIA is limited solely to depository institutions.  Depository institutions played a secondary role in the current financial crisis other than being crushed by the consequences of this crisis just as everyone else is being crushed.  The institutions that played the primary role were the nonbank mortgage originators, investment banks, conglomerate bank holding companies, GSEs, bond rating agencies, and unregulated hedge funds and CDS dealers.  FDICIA had no relevance of any kind to the regulation of any of these institutions. 

 

Second, government regulation begins with the law, but it ends with the regulators.  The heads of all of the federal regulatory agencies are appointed by the President and confirmed by the Senate.  The President sets the policies of each agency, and the President’s policies are implemented, within the law, by the politically appointed head of each agency.  The idea that a Republican administration dominated by free-market ideologues would nominate tough regulators to head regulatory agencies, a Republican Senate dominated by free-market ideologues would confirm these tough regulators, and the result would turn out to be “the toughest regulation of the institutions that have to be regulated” we have ever had is too absurd for words. 

 

According to the testimony of virtually everyone at last year’s Congressional hearings, that’s just not what happened when the party whose mantra is free markets are responsible for all that is good in the world and interfering with free markets is responsible for all that is bad came to power and took charge.  What happened was free-market ideologues were nominated and appointed to head the regulatory agencies, and we ended up with the weakest regulation of “the institutions that needed to be regulated” since 1929.  What’s more, given the Bush Administration’s lack of respect for the law, it is highly unlikely that the Bush Administration policies toward regulation even bothered to follow the law.  (Mayer Frank)  In any event, there is certainly no reason to believe financial regulation in the Bush Administration was stronger than the disastrous record of the Reagan Administration that brought us the savings and loan crisis of 1988.  (FDIC)  After all, unlike Bush, Reagan’s ineptitude did not bring about an international financial crisis of such magnitude that it threatened the entire world.

 

Third, if we look at the history of financial crises and regulation in the United States we find no support for Wallison’s notion that financial regulation is not necessary.  Throughout the nineteenth century there were booms and busts every five to fifteen years associated with financial crises.  The end of this era came with the disastrous crisis of 1907.  In response the Federal Reserve System was created in an attempt to bring stability to the financial system.  We then went twenty two years without a crisis until the Great Crash of 1929.  (Friedman)  In the 1930s a comprehensive financial regulatory system was established, and we went almost sixty years without a financial crisis.  This period ended with the savings and loan crisis of 1988 which, as Wallison pointed out, led to FDICIA.  Then we had a period of twenty years before we arrive at the current crisis of 2008. 

 

Now let’s look at the history of financial deregulation during this period.  It started in earnest with the passage of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) in 1980 and the election of Ronald Reagan—our first free-market ideologue president.  This act eliminated Regulation Q that allowed the Federal Reserve to set maximum interest rates on bank deposits, and it also allowed thrift institutions to issue checking deposits and expanded the types of loans they could make.  The Garn-St. Germain Depository Institutions Act  (GGDIA) was then passed in 1982.  This act lowered the capital requirements of depository institutions.  Both of these acts rescinded central elements of the regulatory scheme put in place in the 1930s in response to the Crash of 1929. 

 

Within eight years of electing Reagan and passing DIDMCA and GGDIA we experienced the first catastrophic financial crisis since 1929. 

 

Then came FSMA in 1999 and CFMA in 2000 along with the election of George W. Bush—our second free-market ideologue president.  FSMA repealed portions of the Glass-Steagall Act of 1933 by allowing commercial bank holding companies to become conglomerates that are able to provide both commercial and investment banking services along with insurance and brokerage services.  CFMA prevented the Commodity Futures Trading Commission (CFTC) and state gambling regulators from regulating the over-the-counter derivatives markets, including the market for CDSs

 

Within eight years of electing Bush and passing FSMA and CFMA we experienced what Wallison calls “the worst financial crisis in history.” 

 

An ordinary person would look at the history of financial regulation, deregulation, and crises outlined above and conclude that the lesson to be learned is 1) don’t deregulate the financial system, and 2) don’t elect a free-market ideologue to the presidency.  What is it about Wallison, Gramm, and their fellow travelers that keep them from coming to this seemingly obvious conclusion? 

 

What Free-Market Ideologues Know

Free-market ideologues know that free markets work to protect our individual freedoms and that government interference in free markets leads to totalitarian socialism.  They know that whenever the government interferes with a market it does more harm than good.  They know that if markets are left free they will self regulate to eliminate whatever problem the government thinks it is trying to solve without threatening our freedom.  They know that the only way to provide economic growth and prosperity and to protect our freedom is to get the government out of the way and let the free-market system function to solve all of our problems.  (Hayek Mises Friedman

 

They know all of this is true, and knowing all of this is true they also know that whenever there is a problem in a market it must be the government’s fault and in the name of freedom it is their duty to find out where the government went wrong and to explain it to the public to protect our freedom.  As a result, in their minds today’s financial crisis is a wonderful example of the harm that is done by government regulation, and it is their job to figure out how the government caused this problem and explain this to the world so that others can know what they know and the world can be made free.   And virtually nothing can shake this belief in what they know. 

 

If you try to debate these fundamental beliefs with them the argument never ends because they have a logical answer for any possibility you might bring up.  Why?  Because they live in a delusional world in which the government is the source of all evil and markets are the source of all redemption, and in that world anything that goes wrong must either be the government's fault because it interfered with free markets or the individual's fault because she didn't abide by the rules of free markets.  Since they start with this assumption they can always prove their point by going back to this assumption in the same way that if you start by assuming a circle has three sides you can prove that a circle has all of the properties of a triangle by continually going back to the assumption that a circle has three sides.  When you point out that real world economic circle does not have three sides they respond, with righteous indignation, either that the real world is enough like a triangle that the fact it is not a triangle is unimportant or that the way to fix the problem is to make the real world economic circle more like their delusional world's economic triangle! 

 

It is of no consequence to them that the economic theories from which the arguments of their economic triangle flow are static and assume perfect markets where no actor has economic or political power, everyone is perfectly informed as to the nature and consequences of the choices available to them, and the economy is always in perfect equilibrium with no unemployment, whereas, the real world economic circle is dynamic, markets are not perfect, actors do have economic and political power, only a select few have the information necessary to be adequately informed as to the nature and consequences of their choices, the economy is not always at full employment, and it is impossible to transform this real world circular economy into their delusional world triangular economy.  These are all trivial details that obscure, but do not refute the truth of their beliefs.  (Kuttner Amy Phillips)

 

There is simply no way to defeat this kind of logic.  If you point out that today's crisis actually occurred as a result of deregulation and a failure of the government to adequate enforce existing regulations, they respond that this misses the point.  If the regulations weren’t there in the first place market discipline would have created a world in which bad actors would have been eliminated from the market before this crisis occurred and, hence, either the crisis would not have occurred in the first place or it would not have been so devastating.  How do they know this?  Because that's the way their delusional world's economic triangle works.

 

If you point out that the crisis was brought about as a result of the actions of free-market ideologues that attempted to apply their free-market principles to government regulation with disastrous results, they respond that this just proves their point.  If the regulations weren’t there in the first place they wouldn’t have been able to bring this disaster about.  It just happened to be free-market ideologues in charge of the government this time.  It is inevitable that this sort of catastrophe will happen no matter who is in charge if the government attempts to regulate free markets.  How do they know this?  Because that's the way their delusional world's economic triangle works.

 

If you point out that in the financial markets the incentives for fraud and reckless leverage is so powerful that it is inevitable that these markets will be unstable in the absence of government regulation, they respond that fraud can be dealt with by building more prisons and filling them with the criminals who commit fraud, and market discipline will deal with reckless leverage by eliminating those who are reckless.  How do they know this?  Because that's the way their delusional world's economic triangle works.

 

If you point out that market discipline eliminates those who are reckless only after the consequences of their actions have created a financial crisis, that if those who are reckless are able to get out of the market before the crisis occurs they will not be eliminated, and that millions of innocent people who are not reckless, most of which have no direct connection to the financial markets at all and are in no way responsible for the actions of reckless investors, suffer irreparable harm as the process of a financial collapse works itself out, they respond that people must be responsible for their own self interest to guard against the consequences of speculative bubbles.  If they do not do this it is their own fault, and they must be held accountable for not doing this in order to maintain market discipline.   How do they know this?  Because that's the way their delusional world's economic triangle works.

 

If you point out that it is virtually impossible for most people to guard themselves against speculative bubbles, especially those that are not directly involved in the financial markets, that it is unreasonable to expect people to be able to do this and not regulating financial institutions to keep them from behaving recklessly undermines the economic security of the society as a whole, they respond that the reduction in economic security is more than offset by the increase in freedom and economic wellbeing that is the result of free markets, that regulating markets is the first step down the road to poverty and totalitarian socialism, and that some degree of economic insecurity is the price that must be paid to preserve our prosperity and freedom!  How do they know this?  Because that's the way their delusional world's economic triangle works and these unfortunate consequences of free-market capitalism are unimportant.

 

If you point out that when societies are faced with financial crises and the economic system fails people are devastated and this devastation leads to social unrest, an increase in violence, and a breakdown of the social order, they respond that a breakdown of social order is a threat to freedom and violence must be dealt with forcefully by building more prisons and filling them with the criminals who threaten freedom and the breakdown of social order.  Why do they say this?  Because that's the way their delusional world's political triangle works.

 

If you point out that we are talking about the freedom to starve here and that in a democracy the people have the right to use the power of the government to tax in order to keep people from starving, they respond that providing for the needs of starving people is not a proper function of government but, rather, is the function of private charities and should be undertaken by private charities.  Taxing one group of people for the benefit of another is a violation of the individual freedom of the people being taxed, and freedom is an inalienable right, not a democratic issue to be decided by popular vote.  How do they know this?  Because that's the way their delusional world's economic and political triangles work and, in any event, these unfortunate consequences of free-market capitalism are unimportant.

 

As I said, the argument never ends because they have a logical answer for any possibility you might bring up, and no amount of empirical evidence that contradicts their triangular view of the world can shake their faith in it or defeat the tautological reasoning with which they defend this world. 

 

Assuming the government is the source of all evil and markets are the source of all redemption tells us nothing about the real world, just as assuming a circle has three sides tells us nothing about a circle, and it is patently absurd to believe that it does.  But if these arguments are so patently absurd why aren't they drowned out in the free marketplace of ideas?  The answer is quite simple: The free marketplace of ideas isn't free!  The network of right-wing think tanks by way of their funding by corporations and wealthy individuals are able to spend literally tens if not hundreds of billions of dollars to hire thousands of individuals to do research and to write papers and books to propagate their beliefs.  As was noted above, they flood television interview shows, talk shows, and news programs with their representatives to put forth these absurd arguments.  (Dolny)  They dominate talk radio and literally control Fox News.  (Bai)  They flood the internet with slanderous emails and bogus websites designed to further their agenda.  They pay for marketing research to sell their ideas and use focus groups to find the best way to present their ideas and when necessary to find the best ways to conceal their views when their views are rejected by the public.  They come up with and distribute talking points to coordinate their presentations and arguments.  They run educational seminars to train political candidates on what to say and how to say it so as to focus the debate on divisive issues such as gay marriage or gun control or racial prejudice or abortion or whether Obama is a Muslim or controlled by William Ayres in order to avoid issues of substance.  They function as a huge Right-wing Propaganda Machine to implant their ideas and their utopian view of reality into the mind of the body politic in an effort to attain their ends, and, in the process, they literally drown out those who attempt to present reasoned, rational arguments on the other side.  (Westen Lakoff Hartman Frank Kuttner Amy Phillips

 

Democracy in Free-Market Capitalism

To someone that has not followed this ideological debate within the discipline of economics the notion that taxing one group of people for the benefit of another is a violation of an inalienable right may seem to be a small, almost trivial matter, but it is not.  It is huge because it acknowledges the fact that the concepts of ‘freedom’ and ‘democracy’ that drive the free-market ideologues are at odds with the concepts of freedom and democracy that are embodied in the Constitution of the United States.  (Lakoff Buchanan Kuttner Amy)

 

The Constitution of the United States defines America.  It is our founding document.  It provides the basis for all law and social order in our society.  It lies at the very core of our concept of democracy.  It is the one thing that we all have in common.  It is the one thing that the vast majority of the people in our country believe in.  As a result, free-market ideologues are stymied by the fact that the Constitution gives the government the ‘right’ to take their money without their permission for the benefit of other people.  Thus, the state can tax them to pay for the education of other peoples’ children, or to build bridges and roads that they will never use, or to provide for parks that they will never see, or to pay for countless other things that “promote the general Welfare” they don’t wish to pay for.  And the Constitution of the United States gives the people the right to regulate markets to promote the general welfare just as it gives the people the right to tax people for this purpose. 

 

Free-market ideologues don’t like this.  They don’t think it is right.  They see it as a violation of their freedom of contract.  But they have to accept the fact that promoting the general welfare is part of the concept of democracy embodied in the Constitution, and the Constitution allows the government to take their money and regulate markets without their permission by a majority vote, not by a consensus vote (Buchanan) or by a “great bulk of us” vote.  (Friedman

 

This is the way the ideological debate within the discipline of economics has been progressing for over a hundred years (Kuttner Amy Polanyi Lakoff Schumpeter Buchanan Phillips), and the main point at which the free-market ideologues have faltered is with the concept of majority rule within our democracy as defined by the Constitution.  Democracy is a problem for them because it confronts one sacred cow with another.  The concept of democracy is so interwoven with the concept of freedom in the mind of the American body politic it can’t just be brushed aside in the name of freedom the way other issues can.  As a result free-market ideologues have been forced to concede that even though it is, in their view, a violation of an inalienable right of man, under the Constitution of the United States—as it stands today and until it can be changed to eliminate this loophole, (Friedman) either through amendment or by favorable decisions of the Supreme Court (Kuttner)—the government does have the power, if not the ‘right,’ to tax people and to regulate markets to "promote the general Welfare" in spite of the fact that it violates—in their minds—the ‘freedom’ of the people being taxed and regulated. 

 

Once they have been forced to make this concession and are literally pushed to the wall they are also forced to concede that there are other situations where it is permissible for the government to intervene in the economic system in the absence of a consensus, such as when there are externalities, public goods, and in other situations where markets obviously fail, but getting these concessions from them is like pulling teeth because the concept freedom embodied in their ideology is fundamentally different from the concept of freedom embodied in the Constitution of the United States.  (Kuttner Lakoff Amy

 

None of this leads to a problem in the context of academic debate where the wheat can be separated from the chaff and brilliance distinguished from nonsense.  The difficulty arises when the arguments from these debates are fed through the Right-wing Propaganda Machine where the obvious flaws and concessions necessary to make sense of these arguments are swept away.  When processed through this machine reasoned arguments are condensed to a set of inane slogans that severely distort reality:  Government doesn’t solve problems; government is the problem.  It’s your money and you know how to spend it better than the government does.  Taxes are a burden that must be cut to eliminate government waste.  The only way to control wasteful government spending is to cut taxes.  Government regulation stifles innovation, economic growth, and progress and must be eliminated.  We have to get the government off our backs.  The problem is the intellectual liberal elites that think they know better than you do.  These big spending tax increasing liberals promote feminism, abortion, and homosexuality.  They have taken God out of our schools and are destroying the family.  These left-wing, socialist, tax and spend, intellectual, liberal elites are bringing our country to ruin!  In the name of God, mother, country, all of humanity, and your family pet these feminist homosexuals must be stopped!  And the only way we can stop these Godless, baby killing abortionists is to cut taxes and government spending; privatize Social Security, Medicare, and our education system; eliminate Medicaid; spread freedom throughout the world; and get rid of government regulation! 

 

This is literally the level at which the Right-wing Propaganda Machine wages the debate, and it is not at all surprising that the success of these appeals has led to a distorted view of reality in the minds of those they influence.  (Westen Lakoff Kuttner Amy)  When we return to the world of ‘rational’ debate, however, and confront the free-market ideologues with the fact that their concepts of freedom and rights are inconsistent with the Constitution the tenor of the debate chances.  Rather than take on the Constitution which they have learned from bitter experience is sacred to the American people, they concede that they cannot win the point and argue, instead, if government is going to exercise this right against their sound advice and solid judgment in violation of the inalienable right of freedom that government intervention entails, then at least the government should not do it in the way Roosevelt did in his New Deal, but rather should do it in such a way as to enhance the efficiency of markets.  In their view New Deal Socialism is the source of all that is wrong in our society today and must be avoided at all costs. 

 

As a result, they offer an alternative program that they argue is in line with their free-market principles.  If the government has to intervene in the economy it should do so in such a way as to free markets and stimulate saving and investment.  Accordingly, taxes should be cut on businesses, especially corporate income taxes, the capital gains tax, and inheritance taxes so as to stimulate investment.  If taxes have to be raised they should be raised on consumption so as to stimulate saving.  If government has to provide a service it should not do so itself but rather should do so by using tax dollars to pay private businesses to provide the service.  And most important, every effort must be made to keep markets free by eliminating regulations and allowing market discipline to work, not “in order to form a more perfect union” but, rather, in order to form a more perfect market!  What they are arguing here is that if we do things their way we can make the real world economic circle more closely approximate their delusional world's economic triangle.

 

If you point out, again, these are the policies that have led us to the brink of  disaster, that these policies could lead to a collapse of the economic system, and if the economic system were to fail people would be devastated and this devastation would lead to social unrest, an increase in violence, and a breakdown of the social order, they respond, again, a breakdown of social order is a threat to freedom and violence must be dealt with forcefully by building more prisons and filling them with the criminals that threaten freedom and the breakdown of social order.  Why do they say this?  Again, because that's the way their delusional world's political triangle works.

 

Finally, when you point out that this is exactly what Hitler did in the 1930s; he subsidized businesses and built concentration camps to deal with the ‘criminals’ that disagreed with his policies just as they recommend for us to do, and the end result was World War II, (Shirer) they respond that if we had stuck with free-market principles in the 1930s and not taken a stand against Hitler and the Japanese war machine America would not have been drawn into World War II, and we could have avoided all of the consequences of socialism that have befallen us since World War II.

 

This may sound farfetched.  After all who in his right mind would argue that the United States should have abandoned the concepts of freedom and democracy embodied in the Constitution of the United States of America, and should have accepted the concepts of ‘freedom’ and ‘democracy’ that underlies the free-market ideology in order to have avoided World War II?  This is, of course, the essence of Patrick Buchanan’s latest book (Churchill, Hitler, and "The Unnecessary War": How Britain Lost Its Empire and the West Lost the World) which when taken in isolation is an academic exercise in historical analysis, but within the context of the free-market ideological debate it is just another argument against the concepts of freedom and democracy embodied in the Constitution.  I leave it to you to decide if Buchanan is in his right mind.

 

The Necessity of Market Regulation

As I have said, free-market ideologues are delusional and they are dangerous. They do not live in the real world.  In the real world unregulated free markets lead to dangerous foods, drugs, and other goods being fraudulently or negligently foisted on an unsuspecting public; unrestrained pollution of the air we breathe, the water we drink, and the ground on which we live; increasingly dangerous and harmful work environments; an inequitable distribution of income and wealth; and fraudulent and reckless behavior in the financial markets that bring about economic catastrophes that threaten the wellbeing not only of those that participate in these markets, but of innocent people that have no direct involvement in these markets at all.  This is the history of unregulated free-market capitalism, and this history is absolutely undeniable. 

 

At the same capitalism has proved to be the most powerful engine for economic growth and prosperity that mankind has ever seen.  For hundreds of thousands of years the vast majority of mankind lived in abject poverty.  Only during the last two hundred years, primarily as a result of Capitalism, have various societies been able to escape this fate.  This is also the history of Capitalism, and this history is also absolutely undeniable.  (Heilbroner Schumpeter Polanyi

 

But it is not unregulated free markets that has brought this about; it is regulated markets within a democratic system of government that has brought this into being. (Kuttner Amy Phillips)  It is the intervention in free markets by democratic government that has brought capitalism to serve humane ends.  In the absence of a powerful force to intervene in free markets to serve humane ends, capitalism promises to become a cancerous growth on humanity that will devour the very planet on which we live.  This is particularly so in today’s world with the threat of global warming hanging over our collective heads and the increasing rates of population growth throughout the world.  (Gore Sachs)  The only force available to intervene in markets to constrain them to serve humane ends is government, (Kuttner Amy Phillips) and it should be clear from the history of Capitalism, especially in light of recent events, that we deny this reality at our peril. 

Bibliography

Endnotes

[1] Since this piece was originally written in early 2009 two comprehensive studies have come out that that fill in the details of the broad outline presented in this paper of the causes of the financial crisis that reached its climax in September of 2008.  The first is The Financial Crisis Inquiry Report, Authorized Edition: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (2011) produced by the Financial Crisis Inquiry Commission.  The second is the Majority and Minority Staff Report of the Permanent Subcommittee On Investigations, WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse (2011). See also Where Did All the Money Go? and Understanding the National Debt,

[2] See Some Notes on Right-wing Propaganda, It Makes Sense if You Don't Think About It, and How Propaganda Works

[3] See A Primer in Economic Crises and Where Did All the Money Go?.

[4] See It makes Sense if You Don’t Think About It, How Propaganda Works, and Some Notes on Right-wing Propaganda

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