Montreal, October 15, 2008 • No 260




Pascal Salin is an Economics Professor at Université Paris-Dauphine and the author of, among others, Libéralisme (Paris, Odile Jacob, 2000).




by Pascal Salin


          The current financial crisis is an occasion for many commentators to join in another chorus of capitalism’s chronic instability and the need to strengthen market regulation, which is referred to erroneously as regulating the financial markets. This was the creed espoused, for instance, by the French President in his recent remarks in Toulon. But it is a different lesson that should be drawn from the current crisis, namely that the best way to regulate the market (that is to say, to ensure its proper working) is to allow it to function freely and not to restrict it with statutory regulations.


          The essential cause of this crisis is, in fact, the extraordinary variability of American monetary policy in recent years. Now, this is evidently determined by public authorities and not by the market. The Fed went from an interest rate of 6.5% in 2000 to a rate of 1% in 2003. There followed a slow climb starting in 2004 to reach 4.5% in 2006. During the period of low interest rates and easy credit, the world was flooded with liquidity. In order to take advantage of this wonderful opportunity for easy profits, financial institutions gave out credit to borrowers who were less and less reliable, resulting in the subprime crisis. When interest rates returned to more normal levels, the excesses of the past were dragged into the harsh light of day, and the financial bubble burst.

          The harmful effects of this policy were aggravated by several phenomena. First of all, the sense of responsibility for undertaking risks was dulled because it was implicitly admitted that the public authorities would not allow major bankruptcies in times of trouble (which has been partially confirmed by the current behaviour of the American authorities). In particular, the two large purveyors of “subprime” credit, Fannie May and Freddie Mac—initially created by the American government—enjoyed privileged government guarantees that led them to undertake extremely excessive amounts of risk.

          Furthermore, financial regulations themselves are the source of unintended consequences. Take, for example, the obligation imposed on banks by the Basel II Accord to maintain a ratio of equity capital equal to 8% of their assets. Faced with the opportunity for tremendous gains created by the Fed’s low interest rate policy, banks wanted to develop their credit as fully as possible, all the while maintaining the ratio imposed by the regulation. With this goal in mind, they sought to circumvent the regulation—as is always the case—by transferring a part of their outstanding loans to other organizations, using investment funds and SIVs (Special Investment Vehicles). A part of the credit extended by the banks thus disappeared from their balance sheets, allowing them to increase their loans while appearing to respect the regulation.

"In the 19th century capitalist world, more stable than the current financial world, bank credit was the result of decisions made by bank shareholders. In our own, statist time, the exact opposite happens."

          Of course, it is desirable for equity capital to be “sufficient” with regard to amounts loaned. In fact, in the 19th century, equity capital most often represented 60% to 80% of banks’ balance sheets. Banks lent the funds that belonged to their shareholders and the high (and desired) ratio of equity capital was a formidable guarantee of stability both for those shareholders and for a bank’s clients. Bankers were therefore real capitalists—that is to say, owners of capital. As such, they were responsible.

          In our time, it is imagined that economic development can be based on credit instead of equity capital. Meanwhile, a large part of credit is created ex nihilo, through expansionary monetary policy, and not through voluntary saving. At the same time, the decline of capitalism—itself often a result of government intervention—has resulted in the fact that the major banks are no longer run by capitalists, owners of capital, but by managers who, not themselves assuming shareholder’s risks, are tempted to maximize short-term profits.

          In the 19th century capitalist world, more stable than the current financial world, bank credit was the result of decisions made by bank shareholders. In our own, statist time, the exact opposite happens. An arbitrary equity capital ratio is imposed that merely mimics a true capitalist world, but this leads to the emergence of financial bubbles. Credit institutions maximize their credit amounts and then, through manipulation, try to present an equity ratio that satisfies the regulation. A regulation that imposes a result will never be an adequate substitute for the free play of decisions made by responsible (that is to say, capitalist) human beings. This is why the constant appeals we hear these days in favour of stronger regulation of financial markets are unfounded.

          Of course, we can reproach financial institutions for not having been more prudent. This results from the institutional structures of our time that we have just gone over. But this also reflects the fact that information can never be perfect: a capitalist system is not perfectly stable, but it is more stable than a centralized, statist system. This is why, instead of condemning the supposed instability of financial capitalism, we should condemn the extraordinary imperfection of monetary policy. We can regret that the managers of major banks were not more clear-headed and did not more carefully evaluate the risks they were taking in a world where monetary policy is fundamentally destabilizing. But it is precisely and especially this destabilizing character of monetary policy that we must deplore. Let us then stop hurling groundless accusations at capitalism and instead search for a way to free financial markets from the grip of government.


1. The French version of this article was published in Les Échos (France), on October 1st, 2008. It was translated by Bradley Doucet.