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Crumbling conceit

Mahfuzur Rahman
***With such Biblical faith in the "extended order," coming "spontaneously," it was no wonder that he was opposed not only to socialism but also to government interference in the capitalist system in general. He called such interference a fatal conceit. In two decades, his ideas themselves were to look almost fatally conceited.***
THESE are dire times for the world financial system. With its fault lines in sub-prime lending in the US housing market, the crisis has spread like a tsunami throughout the world. Banks and other financial institutions, many of which were never supposed to fail, collapsed. Some of these swooned into the arms of their more solvent counterparts. Others were rescued by governments in operations of a scale never been seen before.
The first major casualty of the crisis was not a US institution, as might have been expected but a bank far away, in UK. In February, Northern Rock, a major British mortgage lender, had to be nationalised after a large credit infusion from the Bank of England failed to stem the run on supposedly rock-solid bank, showing once again that names matter little in this business. The bank had entered subprime minefield in a liaison with Lehman Brothers, the US investment bank. That proved fatal.
But the murderous tide returned with vengeance to its origins in the US. In what looks like merely a precursor, in March Bear Sterns, a major Wall Street bank, allowed itself to be taken over by JPMorgan Chase with active help and persuasion from the Federal Reserve.
Freddie Mac and Fannie Mae, the two giant government-sponsored mortgage lenders, were teetering on the verge of bankruptcy. The two are said to be among the prime suspects among those who brought on the sub-prime crisis in the first place through lending to millions of households that had little capacity to repay the loans. In September, both were taken over by the US government. By mid-September Lehman Brothers, one of the largest investment banks in the world, went bankrupt.
At almost the same time, another Wall Street giant, Merrill Lynch, supposed to be indestructible, let itself be bought by Bank of America to avoid bankruptcy. An arguably greater imponderable was the near collapse of American International Group (AIG), the giant insurer.
To let the institution sink was something unimaginable, and the Federal Reserve was forced to come forward with an $85 billion credit line in a virtual Treasury takeover of the Group. By midNovember AIG was asking for some more. The nationalised Freddie Mac and Fannie Mae were in need of massive government assistance.
The stock market reacted violently from the onset of the crisis. Among wild gyrations, there were sharp drops in stock prices throughput the world. In the US, the week of October 5 saw prices decline by some 18%, the biggest loss in the coun-
try's history. Despite spurts of recovery, most stock markets ended the month of October with declines not seen in two decades. In the first half of November, stocks throughout the world recorded fresh falls.
Government intervention of the scale just cited in the financial markets had never been seen. But much more was to come. A critical need was to clear "toxic" mortgage-backed securities that clogged the flow of credit from the banks' books. A S700 billion rescue package, christened Troubled Assets Relief Program (Tarp), was hurriedly if rancorously passed by the US congress to do exactly that. In an almost unbelievable turn of events, in November, Tarp was virtually abandoned and the money directed to capitalisation ofbanks and shoringup consumer credit.
This, however, was only a beginning. A breathtaking slew of action followed worldwide. In Britain, three of the largest banks were nationalised to prevent their collapse. In Belgium, France, the Netherlands and Switzerland, too, the governments rushed to the rescue of banks and Germany had to come to the aid of a large real estate lender. This was after the German finance minister had openly mocked the libera) Anglo-American financial model.
One of tire two urgent needs appeared to be a rapid recapitalisation of the banks in distress. Following a British lead on recapitalisation, the US government announced a $ 250 billion package to enhance the capita) base of selected banks, and by the end of October $125 billion had already been handed out. A spate pf rescue packages ensued in Europe, amounting to a staggering $2,500 billion.
The other, and closely connected, need was enhancing liquidity in the banking
system. Some central banks had already been cutting interest rates and lending enormous amounts of money directly to banks. In early October, six major central banks announced coordinated interest rate cuts. Further cuts followed soon enough by these banks as well as by others.
What is going on? A huge amount of hand-wringing has ensued in high places. And the dire times have led many to severe scratching of the head, the sound of which is almost audible around the world. The worry now is not just that the world finances are a shambles but also that the world economy is possibly descending into the deepest recession since the Second World War.
It has been only rwo decades since Friedrich A. Hayek, Austrian-born British economist, published The Fatal Conceit: the Errors of Socialism. Hayek was a fervent believer in the efficacy of an unfettered market system. That system, which he describes as the "extended order of human cooperation," resulted not from "human design or intention but spontaneously," and it "enabled (human society) to be 'fruitful, and multiply, and replenish the earth, and subdue it' (Genesis 1:28)."
With such Biblical faith in the "extended order," coming "spontaneously," it was no wonder that he was opposed not only to socialism but also to government interference in the capitalist system in general. He called such interference a fatal conceif. In two decades, his ideas themselves were to look almost fatally conceited.
Is the global economy in such a mess because of government interference in the system? This seems hardly likely. The decades since Hayek talked about conceit were ones of very significant deregula-
tion. In fact, the start of the Ronald Reagan-Margaret Thatcher era of deregu-lation predates Hayek's book. Deregulation has, thus, a fairly long history behind it.
Nowhere has liberalisation of the market been as sweeping and its consequences, with hindsight, seem as momentous, as in the financial markets. Liberalisation in this market, too, has a fairly long history, but the repeal, in 1999, of the Glass-Steagall Act of 1933, which had divorced investment banking from commercial banking operations, was a landmark. And it took a crisis of the present proportions to get even its most ardent exponents to wonder if faith in unfettered working of the financial markets wasn't itself conceit.
The most prominent among them must be Alan Greenspan, the former US Federal Reserve chairman. Mr. Greenspan has been credited, till recently, with having presided over one of the longest periods of economic prosperity in the United States. But he has also been blamed, particularly in recent months, for having kept interest rates too low, which contributed to the housing bubble. Most importantly, he has opposed regulation of the increasingly innovative derivatives markets that, among other things, allowed packaging and repackaging of mortgage-backed securities, including sub-prime ones.
The largely unregulated and increasingly complex derivatives markets ballooned to tens of trillions of dollars over the past decade. In a remarkable expression of mea culpa, Greenspan had this to say in his testimony before the US Congress in October: Those of us who looked to self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked
disbelief."
Only slightly less remarkable is this admission from John Reed, former chairman of Citigroup in a letter to the Financial Times: "(Among the misjudgments made by leaders of finance that date back to the 1990s was) to assume that markets could better manage and absorb risks than institutions.
Most of us believe that markets are the best at allocating capital. It is easy to take the next step and assume they will also be superior at managing financial risk." Such statements from the two chairmen do indeed suggest how overdone was the idea that an unfettered market was always right.
But how about the accusation, quickly made by right-wing Republicans in the US Congress, that it was the attempt to tamper with the housing market through government-sponsored agencies like Fannie Mae and Freddie Mac that led to the housing bubble and the sub-prime crisis in the first place? The former Fed chairman promptly punctured that idea. He was firmly of the opinion that Wall Street, rather these institutions, was far more to blame for the sub-prime crisis.
What now? It is perhaps safe to say that a new orthodoxy is beginning to emerge that will seek to regulate the financial market more stringently. The hope must be that, once the immediate crisis has been contained, policymakers will opt for better regulation rather than more regulation. Human ingenuity, derided by Hayek, could yet work out a system that preserves the fundamentals of the free markets but avoids their excesses -- and lookout forconceitsofitsown.
Mahfuzur Rahman Is a former United Nations economist and an occasional contributor to The Daily Star