Europeans are now longing for a “new economic order” that would be stressless. If such a one were feasible, it would be hapless.

Back to Square One. After the post-war decades of slow and uneven, but rewarding progress toward a better integrated world economy, less restrictive and red-tape-ridden, allowing more freedom of contract and more responsive to the ebb and flow of underlying change, it turns out that this was all a great mistake. The market “cannot regulate itself”. Politicians and educated opinion, with the French out in front, are again decreeing the “end of laissez faire“.

There are two distinct strands in this retreat to the past, or rather to the wishful image that is now made of it. One is technocratic, the other is popular and even frankly populist.

The technocratic view is that the dysfunction that was set off in August 2007 and has since grown to alarming proportions, was due to reckless deregulation of the financial system and more generally to the withdrawal of governments from their controlling and safeguarding role. Since the invisible hand has proved to be unsafe, let us once again put our trust in the strong hands of the state and let us, without procrastination and horse-trading, build a new regulatory framework that will preserve the strengths of free markets while ensuring their smooth working and protecting them from wild stress and strain.

It should not surprise us if future historians were to conclude that this reasoning was a typical case of post hoc, ergo propter hoc—the troubles came after deregulation, therefore they were caused by deregulation. In fact, the chain of causation was probably less pat and simple. An exceptionally low real interest rate spectrum due primarily to the gigantic East Asian excess saving has generated a housing price bubble in the United States, Britain, Spain and Ireland. It is very doubtful whether the Federal Reserve could have resisted this even if it had wanted to. At least partly if not wholly as a result of stimulation by public policies favouring home ownership by very low income groups, there was much overlending on mortgages, risky even if house prices had remained at their inflated level and loss-making if they turned down—as they duly did. Fannie May and Freddie Mac could not hold off the degradation of mortgage portfolios. The physical capital represented by the mortgaged housing stock was not damaged, but the securities that had big batches of both prime and subprime mortgages as their collateral (and that bankers allegedly did not even understand) were damaged by a loss of confidence that temporarily froze them into illiquidity. There were many would-be sellers but only a few “vultures” would buy, and they only at near-absurd prices. Securities whose mortgage collateral may have become 30 per cent non-performing and that percentage, in turn, would all end in foreclosure and permit, within a year or so, no more than 50 per cent of the mortgage debt to be recovered, would under these conditions have an intrinsic worth of roughly 85 per cent of their par value (a loss of 50 per cent on the 30 per cent of defaulting mortgages, i.e. a 15 per cent on all the mortgages). The “vultures” might buy some at 20 per cent of the nominal value which very few banks would willingly accept. However, in that case under the “mark to market” rule, they had no choice but to devalue their mortgage-backed securities to 20 per cent of the par value, declaring a truly frightening loss of 80 per cent. This was the trigger of the panic.

For two podcasts explaining credit default insurance and mortgage risk in the United States, see Arnold Kling on Credit Default Swaps, Counterparty Risk, and the Political Economy of Financial Regulation and Kling on Freddie and Fannie and the Recent History of the U.S. Housing Market with host Russ Roberts on EconTalk.

From then on, the rest follows fairly easily. Credit default insurance losses are a multiple of the mortgage-based losses, although they are matched by the gains of counterparties. In fact, all purely financial losses are matched by gains or avoided losses, the whole being a zero-sum game that impacts the distribution of wealth, but not its total, amount. However, at this point the effects on confidence enters the game. In particular the influence of modern, aggressive media on partly-informed opinion becomes decisive. “Things are really not too bad” is not a good headline but “things are catastrophic” is. August authorities, including the head of the IMF, get into the headlines and the evening news by announcing that much, much worse is to come. Such prophecies are self-fulfilling. Even the prudent customers who have no credit card debt will stop buying durable goods, and the financial mayhem infects the “real” economy. It is a perfectly open question whether more regulation could have prevented such an outcome. Quite possibly it might have aggravated it, and may yet make any recovery slow and awkward.

Be that as it may, the politicians and the technocrats will now pile regulation on regulation, making the economy more rigid and sluggish, because the groundswell of popular sentiment imperatively demands it. Reading of 11-digit bank losses and trillion-dollar deficits, of crisis and meltdown, and trembling for their jobs, people are stressed and dream of a “new economic order”, an escape from stressful and unpredictable capitalism. No matter that most of what they are told about such an order is hot air, they believe in it as they long for a world where they own their jobs and cannot be fired, where prices are “just” and do not fluctuate, where healthcare is free, pensions safe, and perhaps above all, nobody earns much more than they do. In most of Europe, the egalitarian obsession is becoming frenzied and a major source of stress.

The trouble is that a tolerably efficient economy generates stress and cannot be purged of it without going back to quasi-medieval and quasi-bolshevik ways. It is worth pausing a moment to see why this is so.

The defining feature of capitalism is not that workers are short-changed and speculators frolic with fashion models, though such things may occur as they would in any other conceivable order (as they did in the late socialist republics, too). Instead, it is that labour and capital are contributed to productive use by two different sets of persons. Talk of harmony, co-determination and reasonableness will not alter the fact that one of the two sets of people wants a high share for labour in total factor income and the other wants a high share for capital. The resulting stress could be lifted if the provider of labour and capital were the same person. This was the case in medieval times when the artisan owned his tools, the merchant his stock-in-trade and the serf or peasant farmer his draft animal. It was also supposed to be the case in Soviet Russia and Tito’s Yugoslavia where workers were told that all capital belonged to them—a claim beneath notice. Either way, Fantasyland without capitalism would be desperately poor.

Moreover, a stressless economy would be altogether predictable. As prices would have to be “just” or “fair”, they could not be allowed to go up and down and hence could not equate supply and demand. Producers, consumers or both would be left frustrated. Probably they would feel stressed when seeing how their neighbour resorted to the black market. As the market would be prevented from emitting signals, investment would have to be decided on criteria set by central planners authorised to do such things. French experience shows that the result might be a superb network of TGV lines built at astronomical cost, admired by all but yielding only a minuscule return on the capital investment before the numbers are corrected by creative accounting. (The same goes for nuclear power stations whose future de-commissioning cost, an utter unknown, is just not mentioned in polite company. French economic history is teeming with white elephants, dressed up as information technology or renewable energy, that help to explain the uninspiring performance of the economy despite its many favourable endowments).

Admittedly, much stress results from people comparing their own mediocre destiny with the greater success, higher income, prettier wife and cleverer children of a colleague or neighbour. Apparently, there is now hard medical evidence, showing up in tangible biochemical symptoms, that this is the case. It would be plausible anyway on a priori grounds.

Some of this stress-inducing inequality—such as unequal incomes, though hardly unequal wives—could perhaps be smoothed out by controls on salaries, bonuses and professional fees as well as taxes. The smoothing out would have to be radical, for even small inequalities can generate just as much resentment, envy and self-reproach as large ones. Hence egalitarian policies would have to be drastic to make Fantasyland stressless.

Too obviously, though, it would not and could not become stressless. The stress of living in a hapless, impoverished economy subjected to really radical equalising policies hardly bears thinking about. But how to tell this to the masses clamouring to be led to Fantasyland?


*Anthony de Jasay is an Anglo-Hungarian economist living in France. He is the author, a.o., of The State (Oxford, 1985), Social Contract, Free Ride (Oxford 1989) and Against Politics (London,1997). His latest book, Justice and Its Surroundings, was published by Liberty Fund in the summer of 2002.

The State is also available online on this website.

For more articles by Anthony de Jasay, see the Archive.