TOO BIG TOO FAIL UNDERMINES THE FREE MARKET FAITH / THE FINANCIAL TIMES COMMENT & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

January 19, 2012 7:28 pm

Too Big to Fail undermines the free market faith

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By Otmar Issing

Isn’t it strange? When the Berlin Wall fell and the Iron Curtain was raised, a historic competition appeared to have come to an end.

Observers saw capitalism triumphing over communism, free markets over central planning, democracy over dictatorship, Hayek over Marx. Francis Fukuyama even proclaimed the end of history – mankind had supposedly reached an optimum state, with no feasible alternative.


From the outset, this was a false doctrine. Whereas “real socialism” ended in disaster wherever it was tried, history teaches that the idea of a socialist society promising equality will never fade, whatever empirical evidence shows. Moreover, there was hardly a country in the world where capitalism had become established in a way that was satisfying in every respect. Historical determinism was the most absurd aspect of Fukuyama’s notion. No liberal philosopher would have embraced the idea of history being predetermined.

 

Competition between different ways of organising societies has continued since the end of the cold war. Socialism still suffers from the fatal blow dealt by its past collapse. As a consequence it is seen mainly in grassroots protests such as the Occupy movement. How this might be achieved remains totally unclear – the movement encompasses a variety of issues with one dominant element: an attack on the finance industry.

Looking at the evolution of the financial market crisis, the only surprise is that it took so long before a serious movement materialised. The crisis has provided strong arguments for opponents of the financial system.


Interventions to avoid its collapse have severely undermined not only confidence in financial markets but also in the market economy as a whole. Once a financial institution has become so big or interconnected that its insolvency threatens the stability of the system, politicians must intervene. The problem of “too big to fail” has made society – more precisely, the taxpayer – hostage to the survival of individual financial institutions.


As a result, the basis of free markets has been shaken. A market economy rests on the principle that individuals are free to act within boundaries set by a legal system. Individuals are invited to exploit opportunities and to assess risk. No other system can release the same amount of potential locked inside individuals. As Hayek explained, the market is the best discovery process.


The rules of the game should be clear. Those who succeed are free to take the profits (after taxation); those who make losses have to bear the consequences, with bankruptcy the ultimate sanction. Thus, “too big to fail” not only undermines a fundamental principle of market economies but also a principle of societies in which individuals are responsible for their actions.


The taxpayers’ billions committed to rescue supposedly systemic institutions has dealt a big blow
to confidence in the free market system – and has in turn become a threat to free societies. The threat has been aggravated by people expecting more from governments than politicians can actually deliver – while at the same time trust in politicians, it seems, has fallen almost everywhere to its lowest ever levels.

Meanwhile, the financial industry still fails to give a convincing
answer to fundamental questions: to what extent do its activities contribute to the welfare of society and are they indispensable for a dynamic economy?

It would probably be too much to expect the financial sector to respond by saying that, in fact, some parts of its businesses are superfluous or even dangerous. So, governments are confronted with the challenge of creating a convincing system of regulation and supervision that enables the financial industry to deliver services considered indispensable but, as far as possible, prevents it pursuing activities deemed detrimental to society.


Notwithstanding a number of encouraging improvements, such as higher capital requirements and greater transparency, this task is anything but completed. The challenge of strengthening the fundamentals of market economies and free societies continues. History never ends – except in the minds of those who believe in the inevitability of the Mayan calendar, which predicts the end of the world in December 2012.


The writer is president of the Center for Financial Studies and a former member of the European Central Bank’s executive board

Copyright The Financial Times Limited 2012.