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Does the financial crisis signal the end of free markets and a return to state intervention?

Shanta Devarajan's picture

At a recent videoconference with journalists, I was asked the question in the title of this post several times.   Does the fact that private banks in the United States are going bankrupt mean that the free market system is a failure?  Does the fact that the United States government is bailing out these banks and in some cases “nationalizing” them mean that state intervention is back?

In a word, “No.”  First, any financial system needs some form of government intervention, a point lucidly made by Bob Shiller.  The problem with some aspects of the financial system in the U.S. is not that there was no government intervention, but that it was flawed.  The solution is to improve government regulation of the system.  This however takes time.  Meanwhile, there is a danger of the system collapsing, which is why the government is bailing out various institutions. 

What are the lessons for developing countries in general, and Africa in particular?  In many countries, the extent of government intervention in the financial systems was so great to begin with that the system had become “stuck.”  Think of the various directed credit programs, where government banks lent only to politically-connected families, rather than the most productive people in the country.  In these circumstances, less government intervention, not more, would improve access to finance.  The key word here is “less”, and not “zero.” 

More generally, the discussion of state intervention and markets refers to other areas than finance, such as goods and labor markets, where also there are market failures but, as my friend and former colleague Bill Easterly points out, there are also potential “government failures”

Comments

Submitted by A.Mossad on

I find it very strange that the people are concerned about the intervention of the federal government of USA to bail out a huge banks that operated in the past for the economic development in the USA itself and the rest of the World. Free market should be remained a free market, it does not mean that it needs sometimes some help or assistance to avoid the bankrupcy.

The main issue here is: Can the World survive without the free market economy or finanical system?

I do personally believe in some case the Federal Government should act to (only) help those institutes, but not so deep interferance in their business. However, certain regulations can be renieuwed in order to face the new challanges and let the system function as it is.

If the institutes are in need for such help... the rest of the world badly needed. So, please no panic, but think about how we can survive in this difficult time not only the American Institutes, but for the rest of the world.

Submitted by Anonymous on
I find it strange that people aren't more concerned with this bail-out. It IS the proof that capitalism does not work. Give/Invest your money with private companies and this is what will happen every time. Joe Taxpayer picks up the bill for corporate greed and coruption every time. Socialism is not the enemy, it's the answer.

Submitted by Chris on

My suggestion then is that a Global Clearing House ('GCH') is formed to minimise Counter Party Risks. The GCH Clears ALL transactions around the World by guaranteeing the respective counterparty transaction.

The Country based members of the GCH are responsible for their country's Banks. Because the Country is guaranteeing their Bank's risk then they are responsible for the rating (analysis) of the strength of the respective Bank's Balance Sheet.

The Bank if endorsed by the Country are endorsed by the GCH and as such confidence boils down to the Country and not to the individual Bank. If the contract fails the Country's treasury is responsible for the payment of debt (lender of responsibility).

Any Country is allowed to be a member and it is the members themselves whom determine Soverign Risk. Foreign owned corporations are domiciled for risk.

The member Countries whom have determined Soverign Risk are responsible for each member if it defaults (World Lender of Last Resort).

Developing Nations could participate as well through acceptance by IMF / World Bank and support from other members. This would assist in the economies of developing nations to contribute to World Trade.

Submitted by Emmett on

The International Monetary Fund and World Bank held their annual meetings over the weekend in Washington DC. I wonder whether any talks of refunds or compensations to third world countries were on the table in regards to the failed policies of the World Bank and IMF that forced third world countries to decentralize and open up to a “free market” economy before getting any loans or grants.

Now that the great USA, leader of the capitalistic ideology and patron of both the World Bank and IMF is backing off on its “free market” and government hands-off sermon, going full swing into government ownership of private companies as well as new plans to “nationalize” the banking system, is the World Bank or IMF planning to give out any bailout money to those poor third world countries who unwillingly agreed to their “free market” and decentralization plans and are now disillusioned, reeling in debt and bankrupt?

Submitted by Anonymous on

Think Globally ,Act Locally ?! Every country must have 50 -50 Buffer or Limit of their Financial Reserved to enter a Global Market Economy. 50 % must be used for local market. The World Bank,IMF and Central Bank must have new regulation to protect the traditional markets in every country,because its of them are unique ! Can not be generalized ! Unity in Diversity ! Every nation and countries have their owned uniqueness . We can not forced them to become somebody-else.

Trust is the key how we run and build confidence in the Global Market. If the investor don't trust the institutions (my word is my bond ),the market will collapsed and become global economic crisis. Greed is the name of the Beast. The CEO and the professionals must have commitment and responsibility and code of conducts (fit and proper tests ) before they can enter the global markets. Now the Global Capital Markets are become " The Casino De Royalle" too many corporate (white collars)gamblers and speculators (wealth management/ fund managers ) for fees & commissions for every deal /transactions they made.

They don't care about the fundamental of savings and investments.The derivatives transactions and short selling jeopardized real investors. The Oceans can not only be filled just for WHALE ! So many different fishes and fauna lives in the oceans. Law of Nature Man ! Survival of the Fittest ! Fittest means Adaptation with the changing of climate and environment . Dinosaur T Rex were strong ,but they can not survived the climate changes. We must learned from that.

Submitted by Shuko Chunga on
Isn't it ironic that the very same hypocrites that preached liberalism and forced it down the throats of others; are now scampering to save their own economies via state intervention? Isn't this the time to prove that less government intervention is better? As for the swipe at African countries, I find it hard to believe that the people that own companies such as Morgan Stanley, Lehman Brothers, etc. do not have political connections and it would be folly to argue they are the most productive at least not on the evidence of this crisis

Submitted by Max Jean-Pierre on

How interesting! Now that it is the US we are talking about, yes, the regulations were flawed, let the government bail the banks out. Why wasn't the same justification be accorded to smaller countries who had similar problems? I remember in the case of Kenya when banks were experiencing similar problems, it "was shut them down or no IMF/WB assistance." Did I hear even a whisper from the two institutions this time round? Noo, of course not! Big brother cannot commit a sin, can he?

What about wrong lending priorities? Same thing, different words. I would be hard pressed to believe the US banks had no idea that the sub-prime mortgage market should have been a no-no. For the Africans it is political lending. Serious CEO in both cases know the exact consequences of risks they taking.

To me, whether we are talking about political lending or unwise mortgages, the bottom line is, ineffectiveness of the regulatory systems and greed (whether for making a financial killing or for buying political patronage. One for big performance bonuses and the other to retain one's job) are the causes of the problem and therefore same prescription should be applied to both the big and the small.

I am waiting to see how the IMF/WB will react when, God forbid, banks in some small country, especially African, experience the American-type problem.

Submitted by Paikea on

A more honest and accurate answer would be that the financial markets have been and will continue to be regulated markets - they have never been "free" markets.

Collins dictionary defines free as "able to act on will; not under compulsion or restraint." By definition a regulated market such as the financial markets is constrained and not free!

Please economists use simple English, rather than slogans and economic cant.

Submitted by Bisi Osungbesan on

Financial crisis has rocked the world economy in the last few months.It is observed that free market has be distorted, fell off equilibrium. On monday(13/10/2008)the global financial market have experienced recovery. The recovery cannot be possible without government intervention. From Great depression's experience, J.M. Keynes knew better that government intervention is required for recovery from depression or recession.

Government need to re-strategise the policy and regulatory framework. Regular review of the policy in line with economic enviroment is necessary. 100% free market(no government intervention) may be injurious while 100% government intervention is deadly, but mixture of both in the right proportion is better for the global market.

Submitted by Lefteris Botsas, Professor Emeritus on
Yes, indeed the current crisis marks the end of the post- Keynes market mechanism. The massive bailout that shifts personal responsibility for decision-making on mortgage and finance to the society at large is not what markets require for efficient operations. Moreover, what the market tells the individual or the firm is: “it’s up to you to succeed or fail.” This bailout says “be as stupid as you want, there are no failures in the system. You may not make a profit, but you cannot fail.” Forcing the real interest rate to a negative territory encourages consumption of both domestically produced and imported goods and services. Let the current-account deficit go sky-high. "Let the Chinese do the saving for us" is what the bailout says. The taxpayers will reward you even for stupid decisions. Let's make sure the AIG executives do not have to work for the rest of their lives.

Submitted by Daniel Chachu on

The simple truth is that no government ever fully subscribed to the ideals of free market economics. This is because in practice it does not work and it only takes common sense to understand this. It would only be hypocritical for anyone to make us believe that developed country government have just had to intervene in the market as a result of the current economic crisis. The fact is that Europe and the US have always practiced a mix of free-market economics and state intervention to serve their social, political and economic aspirations and interests.

What has been unfortunate is their attempts to push a one-line free-market ideology down the throats of developing governments. This is where developing country governments have to learn. Indeed China provides a classic example. The state must allow the invisible hand to work but stand ready to provide guidance and indeed leadership when and where necessary.

Submitted by CHUKU UDENSI on

Thia is an old argument, "each to his own, and God for us all." In underdeveloped, illeterate African cocuntries, the laissez faire economy has not produced any meaningful economic growth.

Some hands have proved longer, more powerful that the general notion that maximum of benefit was to be attained by the individual through the exercise of free, unfettered competition, and that if men were liberated from regulation and restriction in their business activities they would chose such courses of action as would to their greatest advantage, which woulld lead to maximum of benefits to the community as a whole. Is this correct?

Then let's add something else... abrogate all traffic laws and drivers, commuters to bring out their vehicles on to the road.. because they would ordinarily excersie reason.

Submitted by bellow on
I believe that in order to avoid crisis situations in the future, major financial institutions of any country should be under constant and close supervision of state authorities. Moreover, this process should be enshrined in law and constitutionally. Of course, this may increase the corruption of higher officials, on the other hand, it can prevent a complete collapse of the financial system.

This form of capitalism doesn't work, but you don't stop using a car because the engine is out of tune, you tune the engine properly. The deregulation has left the greedy CEO's and banks to do what they want and this has ruined the economies of the world (they should be in prison in my opinion). But this doesn't mean socialism is the answer. While socialism would help the very poorest, the world would soon stagnate due to a lack of competition, like in the former USSR.

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