Vaishak Kumar, University of Pennsylvania
4. The Precipitation
It was the 2008 financial crisis that showed the world how deeply neoliberalism was entrenched in the financial establishment. The trend of deregulation in the financial sector began with the Depository Institutions Deregulation and Monetary Control Act in 1980 which repealed the parts of the Glass–Steagall Act regarding interest rate regulation. During the Clinton presidency, The Financial Services Modernization Act of 1999 was passed resulting in the repeal of parts of the Glass–Steagall Act that required separation of commercial and investment banks. Alan Greenspan, the chair of the Federal Reserve from 1987 to 2006, was an advocate for deregulation. Greenspan fought against the regulation of derivatives along with Lawrence Summers and Arthur Levitt. They supported the passage of the Commodity Futures Modernization Act of 2000 that put over-the-counter derivatives out of the regulatory purview of any government agency. These decisions would eventually lead to the subprime mortgage crisis of 2008. When the Federal Reserve dropped interest rates to an all-time low of 1% in 2003, a class of investors with a pool of nearly $70 trillion in worldwide fixed income investments sought higher yields than those offered by U.S. Treasury bonds. However, the supply of the required investment opportunities was not enough to meet that demand. Wall Street’s answer was to meet this demand with products such as the mortgage-backed security (MBS) and the collateralized debt obligation (CDO). The strong demand for these securities and the low interest rates gave rise to fierce competition between mortgage lenders to originate new mortgages.
The cut-throat competition for revenue and market share among mortgage lenders led them to relax underwriting standards and originated risky mortgages to ‘subprime’ borrowers when they had exhausted the limited number of creditworthy borrowers. With major U.S. investment banks expanding lending to less creditworthy borrowers and increasing their market shares, government sponsored enterprises like Fannie Mae and Freddie Mac were forced to eventually relax their standards to keep up with competition. In the absence of an effective regulatory framework, competitive pressures contributed to an increase in the proportion of risky lending in the years leading up to the financial crisis of 2008.
The complex securitization of these new mortgages meant that mortgage originators were passing on the risk to the buyers. They were generating large fees while lend riskily without having to face the consequences themselves. The peculiar business model in which the very firms that issued securities paid private credit rating agencies — not some dispassionate government or nonprofit entity — to rate them ended up creating a serious conflict of interest.
Perverse incentives caused agencies such as S&P, Moody’s and Fitch to rate these bad mortgage-backed securities and credit default swaps as safe investments. Money market funds and pension funds — which are usually required by their charters to only buy triple A investments — took the bait and bought these securities. The Financial Crisis Inquiry Commission would find that of the over 900,000 mortgages issued from January 2006 to June 2007 barely half of them met the underwriting standards of their originators. Hundreds of billions worth of these securities would be downgraded by 2010.
When the crisis struck, it had devastating effects on the economy. Average U.S. housing prices had decreased by more than 20% by 2008 from their highest point only two years ago. As prices fell and interest increased, the string of defaults began as borrowers with variable rate mortgages could not refinance their loans and avoid higher payments. A 79% increase from its 2006 level, foreclosure proceedings were initiated by lenders on nearly 1.3 million properties which further increased to 2.3 million in 2008. Lehman Brothers Holdings Inc. filed for bankruptcy on September 15, 2008 amidst a liquidity crisis in the market. Soon, major money funds had their shares fall drastically after writing off debt issued by Lehman Brothers and other banks. The resulting investor anxiety caused people to redeem their holdings en masse in turn forcing funds to either liquidate assets or impose limits on redemptions. In response, the U.S. stock market as measured by the Dow Jones Industrial Average index slid down to approximately 6,600 points by March 2009 from its peak in October 2007 when it exceeded 14,000 points. Reaching its highest rate since 1983, the U.S. unemployment rate clocked at 10.1% by late 2009.
The belief that a market can regulate itself through competition and the protection of self-interest was what led to the financial crisis. The deregulation of derivatives paved the way for the “financial innovations” and risky lending behavior that would precipitate in the crisis. In a 2008 congressional hearing, Alan Greenspan said: “I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.” A congressman pressed him saying, “In other words, you found that your view of the world, your ideology, was not right, it was not working.” Greenspan admitted, “Absolutely, precisely” (“Greenspan Admits ‘Flaw’ to Congress”). Thus, the role that neoliberal ideology played in the 2008 crisis was an integral one by Greenspan’s own admission.
5A The Economic Flaws of Neoliberalism
While the 2008 financial crisis provides a dramatic example of the fallout of neoliberalism, its failures can be seen in many other aspects of our economy: the high prices of medical drugs due to monopoly power, the stagnation of real compensation of workers, and the continued reliance on fossil fuels at the cost of the environment. Empirically, these failures show that there are serious economic flaws in the neoliberal ideology and it is important identify them so we can move towards constructing a better alternative.
5.1 Elusive efficiency Friedman and other laissez-faire proponents held that maximizing individual utilities would yield an outcome that is optimal for society as a whole. While free markets do come closest to creating efficient organization of production among all possible systems, they often deviate significantly from this ideal — many times creating great distress in the economy. The premium placed on the individual’s utility makes civic virtue out of gluttony. Interestingly enough, individual utility maximization is an instance of a class of algorithms that make locally optimal choices named ‘greedy’ algorithms. Greedy algorithms are known to almost never achieve globally optimal solutions and laissez-faire is no exception. The cases when the market does not attain efficient equilibria are known as market failures and we will discuss these cases in which they occur and require government intervention to resolve them.
It is generally impossible for free markets to internalize externalities without strict government regulation. Without proactive regulation, firms will always find loopholes and exploit them to benefit their bottom lines. The competition among firms to produce goods at the lowest prices possible drove them to outsource production to countries with looser environmental protection standards. The result was cheap goods, higher sales and unchecked pollution. We need the government to impose taxes or other regulatory measures so that the cost of pollution is reflected in the cost of production.
Similarly, funding of public goods can be a challenge for markets. Individuals who seek to maximize their gains are not incentivized to contribute towards goods such as basic research whose benefits cannot be exclusively captured to profit from. In fact, such agents are more likely to leach off of public goods rather than contribute to them giving rise to the ‘free rider problem.’ A great deal of medical and technological breakthroughs from the 20th century onwards were funded by government grants. The economy as a whole has benefitted from these discoveries and
inventions, but their benefit was either not apparent or sufficient at the time they were made for the market to have funded such research. Hence, the state is required to enforce mandatory contributions towards public goods thus socializing the costs and benefits of externalities that cannot easily be quantified.
Competition forms the very crux of the neoliberal stand. While the claim that competition will force firms to provide cheaper and better products and services to consumers is a reasonable one, the presence of competition in all markets cannot be guaranteed. There are many sectors where the barriers to entry such as economies of scale and upfront capital investments are very high which prevent new firms from entering. This drastically reduces competition and creates monopolies or oligopolies. It is also possible that agents can accrue market power over time and block other parties from entering the market by steeply decreasing the profits till the competitor is either bankrupt or leaves the market. The formation of monopolies leads to higher prices causing lower access to products which is an inefficient equilibrium. Likewise, monopsonies – which are the sole buyers in a market – reduce prices and wages. It is important to note that a monopoly is rewarded for its rent-seeking behavior and not for productive work. To give an example, Mexican businessman Carlos Slim became one of the world’s richest men by rent seeking and not because of innovation or effort. Owing to a badly designed privatization process, Slim was able to buy Telmex, the natural telecommunication monopoly, from the Mexican government. With considerable market share on his side, Slim was able to keep prices high without having to worry about losing customers (O’Grady). Not only does the absence of competition reduce the utility of consumers but also incentivizes the perverse behavior of
rent-seeking. Thus, there is a case to be made for governments to create state corporations in such sectors, or nationalize existing monopolies, or break monopolies to encourage competition where possible.
5B Epistemological Argument
John Stuart Mill, who was one of the nineteenth century liberals that Friedman looked up to, argued that since we are the ones who are most invested in our welfare, we are the best judges about what is good for us. Friedman and his fellow economists model humans as perfectly rational agents who maximize our utilities. Therefore they argued, people must be allowed to freely choose what they would like for maximum welfare. However, the world is replete with examples of people making decisions that are detrimental to themselves even when the condition of perfect information is satisfied. Behavioral economists have found that our rationality is not perfect but instead that it is bounded. Human beings have many ‘cognitive biases’ that cloud our judgement and we use heuristics (mental shortcuts) to make our decisions instead of the maximization calculations that neoclassical economics champions. For example, a man who smokes a cigarette though he knows that it may cost him dearly in the future in terms of health and the money that he spends for his treatment can be explained by hyperbolic discounting – the propensity to disproportionately value present utility over that of the future. Nobel Prize winner Daniel Kahneman put it elegantly: “We can be blind to the obvious and we are also blind to our blindness” (Kahneman 24). Businesses, especially their marketing departments, have long been aware of these shortcomings and have exploited them to get us to buy their products. It is not unimaginable that this could be grounds for regulation to ensure that people are making rational decisions; taxing or banning cigarettes would be an example.
In accordance with Mill’s harm principle, liberals might challenge this saying that not only is freedom of choice a part of welfare but is also an end in itself. They would say that a person making decisions that might not be optimal for himself is not a sufficient justification for paternalism. In light of this objection, Cass Sunstein in his book Why Nudge?: The Politics of Libertarian Paternalism argued for governmental intervention in the form of “nudges” wherein the choice architectures (the backgrounds against which decisions are made) are engineered to make it easy for agents to make the “right” choice without coercing them to do so. Examples of nudges are graphic warnings on cigarette packs and changing the default rule of an employer’s retirement fund to be to enroll the employee i.e. making it opt-out instead of opt-in. Thus, Sunstein argues that a state is justified in helping individuals make better choices through choice preserving mechanisms such as nudges.
6. Ethical Arguments Against Neoliberalism
The ideology of neoliberalism not only leads to economically inefficient outcomes but also neglects important ethical considerations. Through an ethical examination of this ideology, we can get closer to understanding what values we need to enshrine in our economic systems to construct a better alternative to our present system.