The Financial Market Crisis in the Light of the Social Market Economy
In 2007 and 2008 the US housing market almost completely collapsed. The crisis was brought about by a combination of state- and market-failures that intensified each other. The failure of the capital markets was a result of extensive deregulation. The principle of liability was violated. Failure risks were passed on without making transparent the actual risk of a security for the buyer. The rating agencies did not assume any liability for faulty assessments.
THE FINANCIAL MARKET CRISIS IN THE LIGHT OF THE SOCIAL MARKET ECONOMY
By Jorge Althammer
[This 2009 article is translated from the German on the Internet.]
The financial market crisis has a firm grip on the global economy. Caused by the collapse of the American housing market, assets amounting to $1.4 trillion were destroyed over night so to speak. To prevent a complete collapse of the banking system, Germany alone spent 500 billion euros to support the credit system. In addition, there were many supporting actions for the real economy. This year all the national economies of the EU zone will massively violate the deficit-criteria of the Stability and Growth Pact. For 2009 the Federal Republic of Germany will post a record new indebtedness of 50 billion E. The financial market crisis also leaves behind its traces in the real economy. The year 2009 will record a growth collapse of -6% and the deepest recession since the founding of the Federal Republic of Germany.
The financial market crisis is certainly the most massive but not the only economic crisis that shakes the market economy. Four incisive crises can be identified in the history of the Federal Republic of Germany which have had considerable effects on the economic location and the social state. In the middle of the 1970s and the beginning of the 1980s, the two oil prices crises occurred that confronted Germany after a phase of full employment with the phenomenon of long-lasting and structurally-fortified mass unemployment. The degree of employment in Germany seriously worsened in only a decade. The unemployment rate rose to over 10% in 1983 starting from the full- or over-employment that prevailed up to the middle of the 1970s. In the 1990s, the labor market situation was marked by the continuing crisis of the East German labor market. Germany experienced a recession of unparalleled duration in the years 2001 to 2005.
This brief glance at recent economic history shows that economic cycles with crisis-laden characteristics are a firm element of the free enterprise system. The idea that market economies are inherently stable, that completely deregulated labor-, commodity- and financial markets tend automatically to a stable equilibrium is found in introductory economics textbooks and texts on dogmatic economic history [The assumption of a "pre-stabilized harmony" was defended by classical economists of the 18th century and is found in the general balance theory. In modern economic theory, the balance approach is only the starting point for analyzing real markets.]. All modern economic models explicitly consider frictions in the adjustment processes and the possibility of market failure. The theoretical approaches are considerably different as to the causes that led to this crisis-laden phenomenon and regarding the extent of the breakdown that the market provokes compared to the frictions that state action induces. These approaches come to very different answers in the question "market" or 'state."
Joseph Alois Schumpeter (1942) already described the market economy as a process of "creative destruction" (cf. also Hayek 1971). Products and production processes are replaced by new technologies; current businesses are displaced by innovations. This innovation- and repression process can appear in phases that erupt in mega-economic recessions. A subsequent upswing- and boom phase follows every recession that leads society altogether to a higher state of development. With all endogenous crisis susceptibility, the market economy according to Schumpeter is far superior economically and socially to a centrally controlled planned economy since only the market economy and the pursuit of profit of individuals on the markets is the basis for innovation and economic and social progress.
Marxist crisis theoreticians also interpret economic crises as general laws of capitalist systems. They derive very different conclusions from this. For them, recessive phases are evidence for the inefficiency of the free enterprise system from which follows the necessity for overcoming the system. Over-accumulation and worsened exploitation conditions of invested capital (the "law of the falling profit rate") are inevitable side-effects of the capitalist production method. These crises could be mitigated in the short- or medium-term through an expansion of the sales markets. However this ultimately leads only to a globalization of the crisis. In the long term, the capitalist system strives for its self-mastery.
The political-economic concept of ordo-liberalism takes an essentially different position in explaining crisis phenomena. Like Schumpeter, ordo-liberals assume that the market economy is economically and ethically superior to centrally controlled administrative systems. To channel competition and individual pursuit of gain, the markets must be subject to a state or public system. The Hayekian "spontaneous order" leads to monopolization, cartel formation and suspension of competition, not to the genesis of competitive markets. Therefore the state has the task of ensuring a functioning competitive system. From that point of view, competition is a state arrangement. A "strong state" is necessary that stands above the particular interests of individual actors - including powerful market actors - and enforces universal, generally accepted rules. Far-reaching dislocations like the recent financial market crisis are results of misguided political framing conditions and are not necessary67 side-effects of free enterprise systems.
2. THE THEORETICAL CONCEPT OF THE SOCIAL MARKET ECONOMY
The social market economy can be defined as a combination of economic theory and Christian social teaching. Christian social teaching goes back to the idea that the economy is a sub-system of society that must be formed socially. The economic process cannot be seen independent of political goals. The market economy, competition and economic progress are always obliged to the public good and are not final political goals. Inspired Christian social teaching emphasizes the instrumental character of the market. The market mechanism represents an efficient instrument needing organization for realizing high social goals (according to Mueller-Armack's definition, the social market economy's goal is to join free initiative on the basis of the competitive economy with social progress secured by free enterprise achievement). On the question of the concrete arrangement of the economic order, advocates of the social market economy rely chiefly on the constituting and regulating principles of Eucken's ordo-liberalism. According to this understanding, the conversion and compliance with these principles are necessary presuppositions for free enterprise systems to remain permanently functioning.
Guaranteeing private property and freedom of contract are counted as the constituting principles of free enterprise orders. A transport-economy controlled by scarcity prices would be impossible without these fundamental institutions. In addition, there is the constituting principle of liability. Independent of the economic system, economically efficient and economically sustainable outcomes of individual actions can only be expected when decision-making authority coincides with individual liability for these decisions. When those who make decisions need not answer for the consequences of their decisions, economically absurd decisions will be made and high risks will be shifted irresponsibly. Unhindered market access is guaranteed to them. Only the possibility of market entrance of potential rivals ensures that market actors will act competitively in the long run.
These four principles - freedom of contract, guaranteeing private property, coincidence of decision-making competence and liability and openness of markets - form the institutional framework of the market. This basic platform is "framed" by the political principles of "primacy of monetary policy" and "constancy of economic policy." The primacy of monetary policy obliges the central banks to a stability-oriented monetary policy with the goal of guaranteeing price stability. Market prices can only fulfill their indication- and guidance function under the conditions of a stable price level. The principle of constancy of economic policy obliges state actors to strict rules and allows little margin for political measures. Political-economic measures must be "market conforming," that is they cannot annul the free price-forming mechanism.
However the ordo-liberals around Eucken recognized that markets could fail under certain conditions. Even with functioning markets, the free enterprise process can lead to undesirable distribution outcomes. Therefore they demanded measures restricting the market with a catalogue of "regulating principles." The demand for internalizing external effects (Eucken speaks of a "macro-economic calculation), state control of monopolies and an active income policy was crucial. They see the "notoriously imperfect" labor market as very endangered. To prevent a harmful under-bidding wage competition, they urged establishing a low-wage state or collective bargaining limits. Despite these demanded state incursions, the economic concept is supported by a fundamental market optimism. So the expectation existed that problems of the labor market and income distribution could be solved "automatically" so to speak in the course of economic growth. The necessity of a monopoly control should be put aside by keeping the markets open and internalizing external effects by expanding the liability principle. The regulating principles would not need to be implemented with sufficient economic growth and corresponding application of the constituting principles. On the other hand, advocates of the social market economy, Oswald von Nell-Breuning, Alfred Mueller-Armack and Winfred Schreiber were skeptical about the efficiency of the market and stressed the necessity of a stronger political organization of the market economy.
3. THE CAUSES OF THE FINANCIAL MARKET CRISIS FROM AN ORDO-ECONOMIC VIEW
3.1 THE CAUSES OF THE FINANCIAL MARKET CRISIS
No comprehensive analysis can be given of all the factors that led to the greatest global crisis of the financial sector since the Second World War. Rather the essential elements should be briefly explained which provokes the financial crisis in its global extent.
The global financial market crisis had its beginning in the crisis of the American mortgage market, the so-called "sub-prime crisis." In the past years, the American housing market was marked by a high dynamic. While the index of American housing real estate rose only 10% from 1975 to 1995, it skyrocketed almost 40% between 2000 and 2003 (Mortgage credits without first-rate credit-worthiness are called "sub-prime."). This strong ascent led more and more investors to jump in this market and the issuance of mortgage credits increased explosively. Credits were increasingly awarded to debtors of low credit-worthiness in the course of the real estate boom. These credits were vested and sold on the capital markets to limit the risks for mortgage banks. Since the credits seemed secured by property assets, the corresponding securities were mostly appraised with the highest credit-worthiness rating.
In 2007 and 2008, the US housing market almost completely collapsed. The real estate index lost over 34% in these two years. Since numerous borrowers of low credit-worthiness could not pay their mortgage debts any more, the corresponding securities drastically lost value and now burdened the balance sheets of commercial banks as "toxic" assets.
This crisis was brought about by a combination of state- and market-failures that intensified each other. The failure of the capital markets was a result of the extensive deregulation of international capital transactions. Through inadequate regulation of the financial markets, credit institutes could found so-called "special purpose entities" (conduits) whose goal was to take over failure risks for a credit-portfolio of a bank (so-called credit default swap). Since these conduits were not consolidated with the mother firms in a technical way as to their balance sheets, this led to risky investments of securities within the credit system being covered with too little of their own capital. This process was supported by the securitization of claims and bundling claims into "hybrid" securities (When certain risks exceed the capacities of an individual financial action, it is sensible to diversify these risks, to spread them to "several shoulders" through the market. Nevertheless a buyer of such securities should be informed about the risk that is taken. That did not happen with the above-described securities.). This ultimately violated the principle of liability.
Through securitization and reselling claims, failure risks were passed on without making transparent the actual risk of a security for the buyer. In addition, the private rating agencies with the task of rating the credit-standing of these securities systematically underestimated this risk. This systematic underestimation occurred because only the failure of individual debtors was included in the models on risk simulation. This failure of individual borrowers should be balanced by bundling mortgages of different credit-worthiness so the structured securities altogether obtained a very good risk rating. However these models did not consider the risk of a collapse of the whole real estate market. As a consequence of this market breakdown, the higher credit-standing of debtors was cancelled and the structured securities altogether lost value. These structured securities as "toxic securities" now burden the balance sheets of the banks. Secondly, the systematic underrating of risks can also be explained in that the rating agencies were advisory councils for issuing bank houses and did not only rate financial products. They obviously had an incentive to assess securities in the sense of the issuing bank house, that is to show the highest possible credit-worthiness. Finally, another reason for overrating securitized claims lies in the fact that these assessments were regarded as legally informal recommendations, not as legally binding assistance. Thus the rating agencies did not assume any liability for faulty assessments.
These reasons illustrate why the banking world was handed over relatively defenselessly to a "bursting" of the speculative real estate bubble. However they do not explain excessive over-ratings on the American real estate market. Two factors are decisive here that explain the state failure: an extremely expansive monetary policy of the US Federal Reserve on one side and a very ambitious social housing scheme of the American government on the other side.
Because of a very generous liquidity grant by the US Federal Reserve, the lending interest in the US was always under 1.5% between 2001 and 2005. With this expansive monetary policy, the Federal Reserve sought to fight the economic recession and keep private consumption at a high level. (The US Federal Reserve depends to a high degree on politics and therefore is ready to implement political targets. The US Federal Reserve is not politically independent like the European Central Bank.) Economic money-supply goals were consciously ignored. The goal of price stability - the primacy of monetary policy - was consciously violated. The strong growth of the money supply made itself felt in an intense rise of property prices, particularly real estate prices. At the same time the American savings rate that was already low anyway hit an all-time historical low.
The real estate boom in the US was stimulated by a social homebuilding program of the American government. The Bush administration set the goal of giving property to low income earners and households with insufficient securities. However this project attempted to realize this goal in the scope of "minority home ownership plans" through a state subsidy of mortgage credits instead of raising the savings inclinations of low income earners through incentives. In addition, benefits were made available for investors who provided housing to persons with low credit-worthiness. Thus a direct intervention in the pricing mechanism - mortgage credits - occurred, connected wit6h specific control targets for investors on the real estate markets. Thus social policy was pursued with market-conforming instruments.
3.2 THE CRISIS BECAME INTERNATIONAL
Securitizing and storing mortgage credits had the goal of diversifying the risks of mortgage banks. To that end, the new securities were transferred to the international capital markets and traded there. The international diffusion of these securities and the spreading of the risk were already elements of the original financing strategy. For Germany, private banks were less affected by the sub-prime crisis than the state-controlled financial institutes. The institutes endangered in their existence - alongside Hypo Real Estate (Hypo Real Estate can be regarded as a private enterprise precursor of a "bad bank"... In the course of the sub-prime crisis, Hypo was insolvent and could only survive through state relief in the billions. "Nationalization" of this institute did not occur.) are the IKB Deutsche Industrial Bank and the regional banks. This counter-intuitive phenomenon can be explained in a political-economic way. These financial institutes were under enormous political pressure to pursue a stable investment policy and to gain the targeted yields comparable to the targets of private commercial banks. The public credit institutes tried to solve this goal conflict by being more active than other institutes on the market for securitized credits. This promised a high yield with simultaneous good credit-worthiness for capital investments.
3.3 RATING AGENCIES
Nearly all constituting principles were violated on the eve of this crisis when the financial market crisis is seen retrospectively. The falling apart of decision-making authority and liability was a central cause. The securitization of mortgage credits helped relieve the balance sheets of mortgage banks and extended the risks through the capital market. The special purpose entities (conduits) that served to dodge the capital holding requirements and the liability rules of the capital market had a very problematic role. That the rating agencies regard their credit-worthiness assessments only as "recommendations" and therefore assumed no liability for flagrant mis-assessments was also problematic. Reducing information asymmetries and creating transparency are vital on a complex and non-transparent market like structured securities. A state regulation seems overdue since the market obviously cannot solve this problem under its own steam.
This crisis was also caused by errors of state economic policy. The intensively expansive monetary policy of the US Federal Reserve that continued for years can be named first of all. To artificially stimulate growth, the "primacy of monetary policy," stability-oriented monetary policy, was consciously violated. The extraordinarily low capital market interests first made possible the quick rise of mortgages and led to an artificial rise of housing prices. The inflation-conditioned rise in interests from 2006 led to the collapse of this financial constellation.
Finally, the crisis worsened in that a correct social-political goal - promoting home ownership of wide population sectors - was pursued with false instruments. The attempt was made to quickly lift the ownership rate by artificially lowering the price of mortgages instead of strengthening the savings capacity and savings tendency of low income earners by awarding house-building bonuses. This fueled the demand for sub-prime mortgages. These mortgages could not be paid anymore after the interest hike and now strain the balance sheets of the commercial banks.
The dramatic crisis on the international financial markets fundamentally upended trust in the market economy. Critics of free enterprise systems use the financial crisis and the continuing growth weaknesses of developed market economies as reasons for questioning the free enterprise system altogether.
All highly-developed free enterprise economies are showing a clearly slackening economic growth. This slowing down of the growth process is an economic necessity. No one can expect national economies with a high per-capita income to grow at the same rate as threshold countries or the Federal Republic of Germany in the phase of reconstruction. That this growth process occurs in cycles is a system-conditioned necessity. Knowing that these cycles are primarily exogenous, avoiding these cycles cannot be the goal of state economic policy. Rather the challenge of state economic- and social policy is to keep these fluctuations as low as possible and cushion the social consequences of the recession. This should happen through the automatic stabilizers of the system of social security. Massive crises like the present crisis on the financial markets are results of misguided political-economic framing conditions. Thinking back to the foundations of the social market economy, particularly to the principle of private liability, can help prevent dislocations of this magnitude in the future.
Marc Batko, "Alternative Economics: Reversing Stagnation," 159 pages, Smashwords, April 2016, https://www.smashwords.com/books/view/627516
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