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“Regime Uncertainty”

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There is lots of blame to go around for how our credit markets got into the current mess.

Counterproductive government regulations, poor judgment by investment bankers and mortgage brokers, and an irrational belief that housing prices never fall all played a major part in getting us to where we are today.  Do I even have to mention the easy money policies of the Federal Reserve earlier in the decade?

But it has become increasingly clear that the transformation of the credit problems of last year into the crisis of today has one main author – the federal government.

For months, the markets had been nervous about the fallout from the popping of the housing bubble, and rightly so.  Major financial institutions had taken a beating to their balance sheets and by early this year it was clear that some would not survive the shakeout in the industry.

It is unsurprising that the Fed and Treasury would try to head off a full-blown crisis by trying to ensure that the fallout from the expanding financial woes would occur in an orderly fashion.  That’s why they intervened in the Bear Stearns liquidation, and took over Fannie Mae, Freddie Mac, and AIG.  These moves were intended to ensure that “systemic risk” to the financial system was avoided by propping up indispensible players.

The problem is that it didn’t work – nor did the passage of the $700 billion bailout package.

Looking back there’s a pretty simple reason why these extraordinary measures failed to prevent the ongoing meltdown of the financial system: In the eyes of investors the federal government has replaced one systemic risk – the possible default of major financial institutions – with another – the sudden evaporation of their investment values through a government takeover of whatever financial institution they might choose to invest in.

Recent government actions have made private investment in financial institutions – precisely what is needed to recapitalize shaky banks and investment firms – extremely risky.  A government “bailout” can put your capital at risk just as much as any prospective failure of that same institution (just ask the stockholders of Bear Stearns or AIG).

By intervening so directly in the financial markets the federal government has caused what economist Robert Higgs of the Independent Institute called “regime uncertainty” in describing the perverse effects of government interventions in the economy during the Great Depression.

Under conditions of regime uncertainty investors stay on the sidelines because they are don’t know what the prevailing rules in the markets will be in the future.  Changes in government policy – especially changes that seem to occur in a rapid fashion – erode the confidence that investors need in order to decide whether or where to deploy capital in the market.

The great irony is that the actions of the Fed and Treasury that were intended to shore up confidence in the financial markets seem to have had the opposite effect.  What had been a serious but relatively slow moving problem morphed into a full-blown, fast-moving crisis.  It seems clear that whatever dangers the government saw in doing nothing, nobody anticipated that the results of the recent interventions would be such a catastrophic collapse of confidence in the market.

Regime uncertainty is surely at least partly to blame.  Until investors clearly understand the exact consequences of government interventions in the marketplace they would be irrational to jump right in and start investing their own money.  Even bargain hunting becomes irrational because a company that appears to be a bargain today might be nationalized by the government tomorrow.

By intervening in an ad hoc manner the federal government has destabilized the current financial regime without providing any clarity at all about what the new rules of the game will be.  It is vital that private investors get clarity about what those rules will be, because until they do private capital will remain mostly on the sidelines.

David Strom is president of the Minnesota Free Market Institute.

This commentary originally appeared in Volume 8 of "What's a Free Marketeer to Think?" 
Click here to read the entire volume.

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