Financial regulation and the moral hazard

Economics Economics Questions
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1

So, again, as is usually the case, I’ve been having a youtube argument with a statist. I just couldn’t resist responding to his blatantly erroneous post:

“The Austrian School of Economics with it’s theory of ‘Perfect Markets’ that are self-correcting and don’t ever need government regulation damn near burned down the house in September of 2008 and plunged the world into this depression…the Austrian , or Chicago School as it’s called in the US, movement is officially deader than fried chicken..”

I responded:

“Are you being sarcastic? We had plenty of government interference in the market before and up to Sept. 2008. That’s what caused the bubble and subsequent crash. The Fed was manipulating interest rates and enabling financial institutions to take risks they wouldn’t be able to under free-market conditions. That led to artificially high consumption and rising prices in the housing market. In an Austrian style free-market, the bubble would have never occurred because the Fed wouldn’t exist let alone encourage mal-investment.”

To which he responded:

“I guess an unregulated Wall Street pumping out trillions in unregulated junk loan securities into the World’s financial bloodstream probably played no role …and AIG’s Financal Products Division insuring this junk but calling it a ‘Default Swap’ so it wouldn’t be regulated as insurance had nothing to do with this… or the SEC loosening regs which allowed Wall Street banks to increase their leverage to 40 to one was just an unhappy coinsidence…”

To this I replied:

“This is a result of the moral hazard. A long history of government bailouts and crony capitalism in the financial sector created an environment where excessive risk taking that wouldn’t be safe in a free-market became a viable business model. So the firms went ahead knowing full well they’d be bailed out if they screwed up. Now by bailing them out, we’ve just reaffirmed this message again.”

Now, the problem is, I’m not sure if I was correct in my last argument. I understand the big picture as far as Austrian economics goes, but when it comes to the specifics of our complex system of financial institutions I get a bit intimidated because as a newb to economics and finance I get intimidated by a lot of financial terms like “junk loan securities.” My question is twofold: 1. Was my last response accurate and relevant? and 2. What would you have said in addition or instead of what I said?

Thanks for all the help, guys. This community has really been invaluable in helping me learn more about economics.

2

Moral Hazard was a major aspect of the boom time behavior but wasn’t the main cause of the boom itself. The boom itself is caused by a credit expansion unsupported by an increase in real savings, thus lowering interest rates. Entrepreneurs, seeing the new low rates, take out money to start new projects for which there isn’t enough consumer demand to support long term (that is, they are malinvestments). In this case this money went into the housing bubble. When the credit dries up the malinvestments are exposed and those who started the bad projects go broke. This behavior was exacerbated by the “Greenspan Put” (Greenspan’s implicit promise to bail out any failing big institutions) but would have happened at least in a lesser extent had the promise of a bailout not existed.

3

Cool, cool. I understand how easy credit policies encouraged and carried out by the Fed and Freddy and Fannie created the bubble by spurring malinvestment, but how did firms like AIG and Lehman Bros. fit into the picture? Why did they collapse?

Thanks again!

4

Their assets were tied up in the malinvestments. When the housing bubble burst, so did they.