Tuesday, May 19, 2009

No expenses spared (2): Market failure and political failure

Why are people so upset about the 'scandal' of MPs' expenses?

The scale of public anger has taken everyone aback. Aside from anything else, it more or less settles the next election, since Labour has taken the brunt of the hostility (despite the more entertaining stories of moat-cleaning, mole extermination and lightbulb-changing coming from the Conservatives).
As a few more sanguine observers have pointed out, the money involved is not an issue, especially in the light of the enormous sums looted by some bankers over the past few years. So why the fuss?

Here's my interpretation:
Most voters never believed in efficient, self-regulating markets, but a disturbingly large number of politicians apparently did. The voters were right on this one, and they're out to get the politicians who got it wrong.

What do I mean by that, and what has it got to do with MPs' expenses?

The pages of the FT have been dominated over the past few months by an argument about whether the financial meltdown is a failure of free markets - 'market failure', or a failure of government regulation - 'political failure'.

The stakes are high. If the crash was the result of the inherent instability of financial markets - a thesis with a distinguished pedigree, from Keynes, through Minsky, to Buiter, Krugman, Roubini today - then the answer most be to regulate the financial sector more, curbing activities like securitization, trade in insurance swaps, and over-leveraging which can cause systemic collapse. Even Alan Greenspan has begun to accept this, famously admitting the failure of the self-regulating market: 'those of us who have looked to the self-interest of lending institutions to protect shareholders' equity are in a state of shocked disbelief'. If we accept that self-interested rationality is not enough to stabilize the financial system, then political control is the only reasonable response. Greed isn't good: it has to be curbed, even suppressed, by government action.

If, on the other hand, we see the crash as the result of governments' incompetent regulation, then the bankers are off the hook. They were simply doing their job, and politicians and regulators failed to do theirs. The financial crisis is not a 'market failure', but a 'political failure'. As Leszek Balcerowicz argued in last week's FT: 'financial institutions and markets operate within the macroeconomic, regulatory and political framework created and maintained by public bodies, and it is empirically not difficult to point to the serious deficiencies of this framework that contributed to the present crisis'. For Balcerowicz (a Polish politician and central banker), excessively loose monetary policy and inappropriate rules were the main culprit. If government can't regulate effectively, asking it to regulate more is a recipe for disaster: 'individuals’ prosperity and dignity are best ensured under limited government'.

There is a sleight of hand in the 'political failure' argument: in the end it seems to recognize implicitly that markets need regulating, but that government just doesn't do it very well. But who else is supposed to regulate? And why don't efficient markets respond to loose monetary policy by protecting themselves from its predictable consequences? The 'political failure' thesis assumes the 'market failure' thesis, but just blames different people. By discrediting government intervention, they hope to resist greater regulation. No matter if it is a completely inconsistent argument - it's an argument that is out there, and still surprisingly influential.

But most voters, I think, don't buy it for a minute. Citizens in western democracies expect politicians to prevent financial meltdowns from happening, just as we expect them to protect us from floods, earthquakes, swine flu and traffic jams. Despite the prevailing 'small government' orthodoxy, people still have very high expectations of the political class. We're too busy to develop econometric models to help with planning our household finances. The government should guide us, and protect us from disaster. Why pay half your income in taxes otherwise?

So our MPs have failed us. They encouraged us to buy houses at inflated prices with close to 100% loan to value mortgages. If we were lucky enough to catch the boom, they encouraged us to draw down equity for conservatories, new cars, and foreign holidays (even, fatally, further property speculation). None of them (except Vince Cable) told us to be careful, that house prices always go up and down. None of them told the bankers to be careful, that excessive leveraging on the basis of volatile mark to market values could bring the whole system crashing down. None of them realized that there is no point in a 'golden rule' of fiscal stability that can be blown apart if we don't keep our eye on what the financial sector is doing.

And worse, while they were failing to protect us, they were riding the property boom, with our money.

In normal times, people would be angry at politicians on the make. These are not normal times. Our financial system has collapsed, and we are having to pay to put it back together again. Fred Goodwin bankrupted RBS and claimed a fat pension, but - doh - he's a banker! Politicians, on the other hand ...

Politicians are paid precisely to stop the Fred Goodwins from destroying our livelihoods. That's supposed to be their job. And unlike Fred Goodwin, we can punish them with our votes if they mess up.