Free markets caused the 2008-2009 global meltdown. I hear people say this a lot. How can “freedom” make people work against themselves? President Obama said in a speech that the recession resulted from the fact that “everybody was left to fend for themselves and play by their own rules.” Was it the failure of capitalism or a deviation from market economics that led to the crisis? Something in the system was terribly broken and the Western governments added fuel to the fire.
The first thing that started cracking as early as 2000 and finally broke down was the set of rules that are necessary for capitalism and free markets to thrive. Yes, even free markets need to be “governed”. The role of the government should have been to fix the broken rules. Instead, the government panicked and went against market economics. It was not just the US government, but officials across Europe, took market matters in their own hands, with the belief that they could make decisions regarding resource allocation much better than the market. The Western government stopped taking into consideration feedback from the market, which comes in the form of various signals and indicators. The result was inevitable… TOTAL CHAOS.
A case in point is what happened in Greece. There were strong market signals. The government choose to ignore these and look the other way. Greece collapsed financially and the euro was in crisis. The euro was introduced to increase efficiencies among the Eurozone nations. (Trade between nations involves currency risks. This is because currencies fluctuate, altering the price of an import in your home country. For instance, an Indian automobile manufacturer imports spare parts from Germany. If the Indian rupee suddenly declines against the euro, the manufacturer would have to pay much more for the German spare parts).
While the rationale behind introducing the euro was a sound one, there were inherent problems. Some nations in the Eurozone had stronger and more stable economies. It was in the interest of these nations (mainly Germany and France) to prevent weaker economies in the Eurozone from defaulting on their obligations, as this would work against a political union of Europe.
With this assumption, countries began borrowing money at very low interest rates. Over the course of the decade since the introduction of a common currency, nations like Greece, Portugal and Spain had just borrowed TOO MUCH.
There was widespread panic about whether Greece would be able to repay its debts. A huge bailout seemed to be the only solution. In response to this risk, investors began demanding higher and higher interest rates on Greek bonds. During the turn of the millennium, the interest rates on Greece bonds were not very different from German interest rates. By mid-2010, the interest rates on Greece bonds more than doubled, while what Germany paid actually declined.
What did the government officials do in response to these signals… they just turned their heads and looked in the other direction. The market raised alarms that Greece was living beyond its means. Instead of government cutting its deficits, it just fudged its books, trusting that a bailout would be the next government headache. In fact, Greece’s officials insisted that the country did not need support. But of course it did… and it got a bailout of $15 billion from other European nations. This was a case of too little, too late. Greek interest rates kept rising.
The governments neither resorted to guaranteeing sovereign debt nor allowed the nations reeling under debt to default. Instead, the government came up with the European Financial Stability Facility, under which some funds would flow in from stronger nations. However, Greek interest rates climbed even higher as the funds were clearly not enough. In 2011, Greece finally announced that its debts would not be paid in time and the interest rates would be revised from what had previously been agreed upon. Instead of accepting this as a default, government officials insisted that investors had agreed to a voluntary hit. Of course, investors had not anticipated this pretence from the government and the interest rates climbed even further.
By the end of last year, German and French officials were all over Greece, trying to impose a disciplinary model. Of course, there was resentment, as market signals and freedom were replaced by force.
The crisis in the US too resulted from the government’s attempts to block market signals. The US government pressurized and incentivised banks to keep lending until everyone (whether they could afford it or not) was a home owner. Government chartered Freddie Mac and Fannie Mae purchased dubious mortgages from banks. Moreover banks would not get the permission to expand if they did not lend to ‘weaker’ i.e., high risk sections of society. Bondholders and other lenders were put at great risk because the government worked against market discipline by taking over the decision regarding which investments were risky and which were not. The economic failure and the resultant crisis in the US and Greece cannot therefore be blamed on free markets, but on the faulty interference of the government in directing capital.