Saturday, May 23, 2009

Why Keynesianism Fails

The Economist is a relatively excellent periodical. They claim to promote “a sever contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress.” There are times where this is not displayed in full measure. Such is the case in a recent article exposing the errors of banks and what can be done about it.

There are two solutions they propose: increase regulation and capital. The last is an absolute must because the events over the last year and half have exposed banks as extremely undercapitalized. The inappropriate marks of assets and liabilities led to the miscalculation of risk. Mathematical models underpriced risk and an undue qualitative judgment of the market environment compounded the problem. Concerning regulation, however, this solution is misaligned. Lack of regulation was the least of the causes that led to the bubble implosion. Subprime mortgage originations, for instance, increased in the earlier part of this decade like never before due to Fannie Mae and Freddie Mac’s interference in the market. These institutions would encourage banks to extend loans to less credit-worthy individuals by subsidizing some of the costs involved in the transaction.

But the most troubling part of enacting additional regulatory burdens as a means of preventing future crisis is the inherent assumption in this action. It requires an omniscient government. Make no mistake, regulation is an absolute must for any market to work efficiently. Nevertheless, more importantly there must be a sense of respect of the law. Regulators are responsible for ensuring market participants are adhering to them, and those that aren’t must be subjected to the appropriate punishments. This is critical and indispensable. Beyond a certain amount of regulatory measures, however, this process becomes burdensome and ineffective. Like any type of business, banking is best practiced under free-market competition. The “too big to fail” de facto policy must disappear. This simply distorts market incentives. Moreover, politicians are ripe to consider “campaign donations” from financial firms in order for the passage of favorable legislation. In other words, the corporate/state nexus would strengthen. As the article points out,
“Smarter regulators and better rules would help. But sadly, as the crisis has brutally shown, regulators are fallible. In time, financiers tend to gain the advantage over their overseers. They are better paid, better qualified and more influential than the regulators. Legislators are easily seduced by booms and lobbies. Voters are ignorant of and bored by regulation. The more a financial system depends on the wisdom of regulators, the more likely it is to fail catastrophically.”

The article was written by a Keynesian supporter, which often without realizing it endorse contradictory statements. Whenever someone supports two views that counter one another, that individual suffers from schizophrenia; or said differently, he/she is confused. This is the core of Keynesianism and why it ultimately fails.

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