Financial Crisis 101: The market giveth, but don’t let the market taketh away. 

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It’s hard to imagine another Depression. The specter of bread lines, mass unemployment and bank runs belongs to a distant age.

Yet, recent events force us to reconsider: the failure of Bear Sterns, Lehman Brothers and Washington Mutual; the nationalization of Freddie Mac and Fannie Mae; the bailout of AIG and the sale of Wachovia; and most recently, the $700-billion plan to bail out the financial sector, which failed after days of high drama in the U.S. House of Representatives.

Americans’ visceral opposition to the plan stems from the perception that they were asked to rescue the very people who created this mess. One congressman reported his constituents evenly divided: Fifty percent said “no,” the other 50 percent said, “Hell, no.” Moreover, the proposed bailout represented a fundamental shift in policy and a disintegration of the free-market ideology that has guided U.S. economic policy for 30 years.

We are told that profit is the reward for risk taking. But there is little risk when government bails out those who need it least.

Politicians and economists alike clung to the ideas of Adam Smith: markets work; the best governments govern least and so on. Smith’s ideas, however, were forged in the fires of 18th-century England, an economy dominated by “the butcher, the brewer and the baker.” Freddie Mac, Fannie Mae, AIG and other behemoths dominate the world today; their failure would not merely disrupt our dinner, but alter our lives.

Free-market ideology is ill-suited to the complexities of the modern world. Laissez faire is dead, if it ever existed. Even sheepherders have sheepdogs to keep the wolves at bay. We should have learned our lessons. But as John Maynard Keynes observed, “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

Free, unregulated markets are prone to crises, an observation supported by recent history: the Savings and Loan fiasco of the mid 1980s, the Mexican crisis in 1994, the Asian crisis in 1998 and the failure of Long Term Capital Management—which had positions in assets exceeding $1 trillion—also in 1998. All pale compared with the current crisis.

To find something comparable, we must look to the Great Depression of the 1930s. Keynes’ insights regarding Wall Street of the ’20 and ’30s apply equally well to the Wall Street of 2008. “Speculators,” he wrote, “may do no harm as a bubble on a steady stream of enterprise. But when the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill-done.”

The current crisis has its source in the rise of consumer capitalism in the late 20th century. Consumers represented a relatively untapped opportunity for generating profits. Rising incomes, home ownership and retirement accounts provided consumers new sources for financing their spending. For the financial sector, consumer borrowing provided new sources of profit. In 1959, profits accruing to the financial sector comprised 1.5 percent of our Gross Domestic Product (GDP). By 2006, that number had increased to 3.7 percent. Over the same time period, consumer debt rose from 49 percent of GDP to 124 percent.

This could not continue. A nation cannot survive by debt alone. In 2007, homeowners were spending 18 percent of their disposable income servicing debt; renters were spending 26 percent. In 2004, 12 percent of all families were putting more than 40 percent of their income toward paying off debt.

The financial sector—banks, hedge funds, insurance companies, and so on—assumed consumers could repay their debts. Income flows would be sufficient for the industry to earn a tidy profit, while it repaid the money those banks had borrowed to finance consumer purchases—particularly homes. The sticking point? The inability of millions to repay their debts.

Normally, banks can borrow from other banks, borrow from the fed, or merge with more profitable banks. If banks are undercapitalized, if banks cannot borrow, then they must liquidate assets to raise cash to pay their obligations. The fall in asset values forces others to sell, creating a downward spiral, potentially precipitating a debt-deflation depression.

To avert depression, the Bush administration proposed a massive bailout of the financial sector. It represented a last-ditch effort to save the corporate welfare state. Welcome to Goldman Sachs of America, welcome to Bush’s brand of socialism: bail out the rich and wealth will trickle down to the poor. The market giveth, but don’t let the market taketh away.

Obviously, something must be done to avert catastrophe. But saving the richest Americans to help the rest of us seems at best disingenuous. Rather than bailing out the 1 percent of Americans who own 40 percent of the wealth, perhaps we should help those people struggling to pay their mortgages. Neither policy is pretty. But isn’t helping those who need help preferred to enriching those who don’t, especially those who created this mess?

John Watkins is a professor of economics at Westminster College, whose research interests are in history of economic thought and political economy. Holly Mullen will return next week. Respond to

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John Watkins

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