This is the fifth installment of “Providing Relief
from the Crisis.” Read editor-in-chief R. Emmett Tyrrell, Jr.’s
introduction here.
The current financial crisis has led to unprecedented peacetime
government intervention in the national economy. Approximately $8
trillion of government purchases of equity in financial
institutions, loan guarantees, and other credit has flowed from
various federal agencies in a matter of weeks. Those who agree
with Hayek that government agents are unable to collect and
process the information that is necessary to direct a modern
dynamic economy, will wonder at the speed with which we have
moved towards what Ludwig von Mises called “planned chaos,” and
Hayek called “the road to serfdom.”
Regardless of issues, such as the risk to taxpayers, the real
concern should be that we are expanding government in a way that
Robert Higgs warned about in his 1987 book, Crisis and
Leviathan, while ignoring a simpler noninterventionist
approach.
There has been a good deal of literature on the cyclical effects
of regulatory capital requirements, and in particular,
mark-to-market accounting. In a 2004 paper, University of Chicago
and Harvard University professors Anil Kashyap and Jeremy Stein
concluded that enforcing exactly the same capital requirements
during the upside and downside of business cycles has the
potential to add significantly to cyclical behavior and results
in inefficient credit markets. An implication of their research
is that capital requirements should be lower in a downturn when
the cost of capital is high.
In the current credit crunch, mark-to-market accounting has
exacerbated the already pro-cyclical effects of capital
requirements. Wachovia having to sell its mortgage-based
securities at fire sale prices caused other financial
institutions to mark the value of similar assets down, requiring
them to raise capital, reduce their loans, or both.
As mortgage-based securities decline in value no financial
institution wants to hold them, the market becomes illiquid, and
the sales that do occur are under distress, further reducing bank
capital. Rather than reducing capital requirements in a downturn,
as suggested by Kashyap and Stein, mark-to-market accounting has
the effect of increasing capital requirements, leading to further
contraction of credit, a scramble for capital, and declining
economic activity.
Rather than the government buying banks and other financial
institutions, and lending trillions of dollars to whichever firm
shows up with the best lobbyist, a simple solution is to allow
financial institutions to account for their assets in a fashion
that allows for a value closer to the true value of the
underlying asset and yet is transparent, so investors and
depositors may make a rational choice as to whether to invest in
or make a deposit in the institution. Individuals acting
according to their own plan and taking responsibility for their
actions will outperform regulation. While there may be costs to
eliminating mark to market capital requirements, the alternative
of massive government intervention will be much greater in the
long term.
