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Misconceived intervention to blame for US sub prime failure

By Leon Bertrand - posted Tuesday, 9 December 2008

Two of the biggest lessons learned from the 20th century were that pure socialism, in all its forms, is an oppressive social system, as well as an economic system which fails to generate as much wealth as capitalism. In the 21st century, there is no question that capitalism is a superior economic system: the only disagreements between reasonable people concern how much government intervention is desirable.

But even on the issue of how much regulation, it is clear that those who have favoured less government participation have generally been more correct than those who have favoured more. This is why capitalist nations such as Australia and the United States have become more capitalist, with policies such as freer trade, privatisation and labour market flexibility all contributing to strong economic growth during the last 16 years.

Meanwhile, nations that have returned to heavy-handed government intervention, such as France and Germany, have suffered economically as a result. In countries such as Sweden, unemployment rates are approximately 25 per cent when you take into account all the young people completing mickey-mouse courses instead of working.


As a result, the evidence clearly shows that although regulation is necessary, it should carefully avoid destroying the wealth-creating power of the market. Unfortunately, however, there those today who are less interested in the evidence and more interested in pushing their anti-capitalist agendas.

These haters of capitalism tend to emerge during periods of economic bad news, or increasing alarmism over global warming with "I told you so", as though the system they despise is clearly the true culprit for the current problems. They are the modern day heirs of the numerous Western intellectuals who supported Stalinism and Communism in the 1950s and 60s: their hatred of markets blinds them to facts and reason. One example is Robert Manne, who during the recession of the early 1990s had the following prescient prediction:

The economic reform agenda in Australia has failed and will lead to permanent high unemployment, with real figures in the order of 15 to 20 per cent … (After the economic reforms of the 1980s and early ‘90s) the nation witnessed before its eyes the black cloud of economic rationalism casting its pall over the economy and its future ... The cost of economic rationalism, at the end of the day, is the 1990s permanent recession.

As Andrew Bolt stated many years later "Imagine where we'd be if Manne really was influential". But the same applies to his fellow travelers, who have emerged after nearly two decades of economic sunshine to arrogantly declare that the US sub prime collapse has demonstrated that capitalism has now been discredited, and that we should presumably go back to protectionist trade policies, highly centralised industrial relations systems and government control of major industries.

First, how the failure of US financial market exposes the flaws of free trade, the private sector as a whole and industrial relation systems is never explained. Logically, if one part of a system is flawed it doesn’t mean the rest of the system is flawed. If a tube on a pushbike has a puncture, does that mean that the entire bike should be thrown out? According to the reasoning of some, the answer is yes. Their “proof”' that capitalism as a whole has been defeated is based only on the alleged failure of one part of the system.

To find out exactly what went wrong in the United States, we should look at the facts.


It is already known and understood that the sub prime mortgage crisis was caused by excessive borrowing, as well as a decline in housing prices. Sub-prime loans are loans which are considered risky because they are made to individuals or organisations with low incomes or bad credit histories. In order to compensate for the increased risks, financial institutions charged higher interest rates. So while sub prime loans were risky, they were also often highly profitable.

As interest rates rose, mainly due to monetary policy, a high number of defaults occurred. Easy initial credit terms were followed by harder ones and this also contributed to defaults and foreclosures. In the third quarter of 2007, subprime variable mortgages were only 6.8 per cent of mortgages in the United States, but they also accounted for 43.0 per cent of foreclosures over the same period. There is hence no doubting the central role played by subprime loans.

In the housing market, an increase in foreclosures led to a drop in the price of housing and the bursting of the “housing bubble”, which in turn meant that foreclosures often led to financial institutions not recovering all or most of the amounts owed to them. This not only affected the profitability of institutions, but also their very survival. Hence the collapse of a number of institutions, including Lehman Brothers and Washington Mutual.

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About the Author

Leon Bertrand is a Brisbane blogger and lawyer.

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