Hayek, Deregulation and the Financial Crisis

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2 Hayek, Deregulation and the Financial Crisis

3 Table of Content Introduction... 1 Wigan s Credit Risk Transfer... 3 Hayek... 6 Ingnorance and Civilization... 6 Institutions of Freedom... 7 Progress and Inequality... 8 Considerations to Hayek Conclusion Bibliography... 14

4 Introduction The financial crisis or its projection, the national debt crisis is the front page of every news paper since The Euro crisis and now the questioning of Greece s membership are on the agenda of the G20. Until four years ago no one would have questioned the World Order because there had been a clear winner in the war of ideas between capitalism and communism. Undoubtedly no one denied the differences of wealth around the Globe but on the other hand there was a quite constant increase of wealth at least in absolute terms. Globalization is the subject of plenty of academic literature, but without any clear vision of its consequences. Weather it was an endless source of opportunities or it was the source of all the problems of the World, it was not clear, partially due to its multidisciplinarity. The financial crisis brings a change to all this. It does not define Globalization as an entirely good or bad phenomenon and I believe nothing will-, I just uncovers on more of the aspects of it. Globalization could exist without this economic disaster although probably this disaster could have not taken place without Globalization. Nonetheless, this debate is not to be open here. The financial crises got materialized in 2008 with the declaration of bankruptcy of the American entity Lehman Brothers, and it is today present in the current issues with the National Debt of all countries. The question of this paper is how does Hayek help us to understand the logic of the deregulation of the financial market, main cause of the current financial crisis? In the following pages, I am going to give an introduction to this phenomenon of banking deregulation based on Duncan Wigan s article Credit Risk Transfer and Crunches: Global Finance Victorious or Vanquished?. Afterwards I am going to present the ideas of Friedrich Hayek as one of the enhancers of the liberal theory which shapes the logic under deregulation works. Specifically I am going to focus in his trust in the unpredictability character of reality, the cumulative progress of civilization and the individual freedom of the individuals. Wigan s Credit Risk Transfer Professor Duncan Wigan considers the mile-stone of the deregulation of the financial market the Basel Accord. For this paper it is important because the public character of

5 this Accord implies that there was initiative from the Governments for deregulation, and it was not only a unilateral strategy from the banking entities. The Basel Accord were made by the Bank for International Settlement, entity born to deal with the payments of War (Reparations) imposed to Germany as the defeated side in the World War I. Afterwards it has became an entity for cooperation between central banks and other entities with the aim of monetary and financial stability 1. The Accord took place in 1988 were banks and regulatory authorities set up a International Banking Standards to secure this market, and its main point was that the banks had to maintain some percentages of the capital reserve to reduce systemic risk. The accord had some critics due to the lack of a portfolio approach to credit risk, non recognition of multilateral netting of contracts and that the capital charged on assets was based in the historic cost and notional value of the contract -irrelevant to derivatives, main protagonist of deregulation. In 1996 an amendment was incorporated to introduce Market risk, which shifted the regulation of risk to a constructed risk management by the private sector 2. The final result of Basel was a huge process financial innovation to down grade the risk of their assets artificially in order to escape regulation 3. Basel II on the other hand was a complementation in order to incentive the biggest of more sophisticated banks to transfer credit risk through financial technology such as credit default swaps or Asset-backed Securities 4. In Wigan s words, Basel instrumentalised s system of derivatives do that banks are valorised on the basis of an ostensibly robust construction of indifference to underline changes in the real economy 5. This just turn out a very questionably system in terms of transparency and efficacy and handed over a great deal of power to rating agencies 6. This agencies were the window to the public to all this amount of operable markets which otherwise would not be understandable. The problem is that these agencies have as their aim rent seeking, and not actual overview of the market. These rating agencies acquired so much power that 1 BIS History-Overview, Bank for International Settlement, 2 Wigan, Duncan(2010) 'Credit Risk Transfer and Crunches: Global Finance Victorious or Vanquished?', New Political Economy, 15: 1, P Ibid, Ibid 5 Ibid, Ibid

6 the sustainability of the national debt of the states depends in a great deal to them. The function of public authorities has shifted from managing risk to merely managing crisis 7. The promise of an optimising, efficient and stable financial system has evaporated. Private gains have elided into public costs and the structural role of a system of derivatives in socialising the costs of global circulation has led to further process of socialization. The state has stepped into guarantee and feed the system. This is in short crystallised the power of markets in defining who wins and who loses from financial innovation 8. The crisis therefore has enlightened how the relation between state and market has been turn co-constitutive through financial regulation and financial technology. The State has been left behind in the transformative process of financial innovation 9 and the market effectively socialised costs, so now the states, in their role of managing the crisis cannot have another option but fire-fighting measures such as decreasing target rates, injecting liquidity and the public purchase or insurance of failing (private) institutions and assets 10. This is nowadays is specially controversial because this socialisation of the cost was made through a deregulation undergone by the public sphere, and now the state has to support this collapsing financial machinery rather than addressing the social negative impacts of the crisis and controlling over again the financial sphere. This is one of the main reasons why the civil society is mobilizing against the governments in the developed countries; it is not random that one of the seven claims of the 11 M Movement is control over bank entities, inside of which there are two headlines demanding the denial of this fire-fighting measures and the return of all the public money spent in the banks. Under this environment, one wonders about the motivations of the state to engage in such a process of loss of control. These can be found under the neo-liberal perspective dominant both politically and academically during these years of deregulation. Although Hayek defines himself as a classical liberal, his thoughts were of great influence both in academic and political environments. 7 Ibid, Ibid, Ibid, Ibid, 119

7 Hayek This Austrian author was first a scholar in the Ludwig von Mises Institute from which he moved to London School of Economics were he succeeded importing the Austrian theory of the economic cycle. John M. Keynes challenges this perspective with his General theory becoming the predominant theory of the time that defined the macro policies of the states. After this down turn of his theory in Europe and some personal and political reasons led him to move out from Vienna, he joined the Committee of Social Thoughts at the University of Chicago in 1950 were he found his place and maintain relation with the Chicago School in, an important school of thoughts of the post-war period 11. Ignorance and Civilization Hayek has a conception of the human being as unable to control and understand everything surrounding him, the fate of mankind is always to ignore facts and therefore never achieve a complete knowledge of world. As a consequence, civilisation cannot have been created by man, or at least not in terms of design. The civilization for Hayek is the outcome of the action of man throughout uncountable generations. According to the Austrian thinker, this evolutive character of society makes it necessary to leave space for continuous revision of ideas necessary for further experience 12. It is important in this theory the focus on the individual. The man s mind is a product of civilisation but he is not aware because he has been transmitted though experience, and the knowledge manipulated consciously by the individual is just a small part of the knowledge that contributes to his success 13. The society as a whole is does not exist and there is only an aggregation of subjects. In this sense, social evolution for Hayek has nothing to do with the Darwinian conception of survival or struggle, but selection by imitation of the successful ideas (such as for instance institutions and habits 14 ): 11 Klein, Peter G., Biography of F. A. Hayek( ), Ludwig von Mises Institute Fredrich A. Hayek, selections from The Constitution of Liberty (1960, 2006), London & New York: Rutledge: The Value of Freedom, pp P Ibid, P Ibid, P53.

8 The growth of knowledge and the growth of civilization are the same only if we interpret knowledge to include all the human adaptations to environment in which past experience have been incorporated. ( )Our habits and skills, our emotional attitudes, or tools, and our institutions- all are in this sense adaptations to past experience which have grown up by selective elimination of less suitable conduct 15 This selection implies that once there is a more efficient tool available, it will be used without our knowing why it is better, or what the alternatives are. Here the concept of tools is quite wide because it includes both institutions and traditions 16. Institutions of freedom The view of the institutions by Hayek is shaped by the unpredictability of events and the little we can understand of the overall scheme of what surrounds us; the institutions are the result of hundreds of years of individual discovery 17. Institutions exist because this ignorance is obvious, and therefore the institutions nowadays have to let individual freedom so that the process can keep being carried on. Freedom is another of the central questions for this Austrian author. He claims that there are two types of conception of freedom one from English tradition, empirical and unsystematic; and the other from French tradition, speculative and rationalistic. The first one takes to freedom but not the second one 18. The misconception of freedom nowadays is due to the French tradition has displaced the English one. The English tradition considers the cumulative growth of civilisation the origin of the institutions morals, language and law, in terms of the survival of the successful 19. This survival is therefore a social evolution, and as I have already explained before, people taking part in it do not realise it. It is a part of social evolution, where we create through what we unconsciously learnt by imitation. Thus, institutions are a consequence of the liberty of action and thus, they must enhance freedom to provide the maximum opportunity for unknown individuals to learn of facts that we ourselves are yet unaware of and to make use of this knowledge in their 15 Ibid, P Ibid, P Ibid, P Ibid, P48 19 Ibid, P51.

9 actions 20. This conception of freedom affects all the aspects of society, and any attempt of design or constrain of these aspects it is going to be highly criticised by Hayek. The French model on the contrary has another view of civilization. The civilization for the Gallican view is found in its maximum exponent inside the frame of organization, so liberty can only be found in the government. In contrast with the English tradition here is implied the interference of the public power in the higher degree. The only difference in the result of this interference is only consisting in who is interfering at the moment 21.It is not share by Hayek the Cartesian view that there is and previous and independent human reason, an original wise legislator or social contract that gave birth to the institutions 22. This conception is based as well in naïve views such as goodness of man, natural existence of interests or natural liberty 23. So in conclusion, obviously Hayek positions himself and a liberal in the traditional English sense pre-bentham. Even he gets to call himself an Old Whig 24. This means he believes in freedom as not interference of the public power and focus in the individual as crucial for the growth of civilization. But, how can everyone benefit from the development of ideas and knowledge of the individual? Progress and inequality As simple as it can sound, Hayek considers that the whole benefit of his theory is because social activity constantly adjusts itself 25. This concept of self-adjustment is the central issue on his speech because is the base of his opinions over Progress. And Progress is the important because is the link between his theory of the human being and the political or economical reality. As he himself recognises by quoting Adam Smith, he believes in a progressive state always advancing for a further acquisition as the happiest condition for the poor 26. Without this very handy concept of self-adjustment, maybe he could not have been able to entitle the third chapter of his book The Constitution of Liberty as The Common sense of Progress. 20 Ibid, P Ibid, P Ibid, P Ibid, P Fredrich A. Hayek, selections from The Constitution of Liberty (1960, 2006), London & New York: Rutledge: Postcripts: Why I am not a Conservative, pp P Fredrich A. Hayek, selections from The Constitution of Liberty (1960, 2006), London & New York: Routledge: The Value of Freedom, pp P23 26 Ibid, P38.

10 Hayek claims Civilization is progress and progress is civilization 27. As far as it is such a universal truth and it is what defines us against the unknown and no one should question the effects and directions of progress. Thus, trying to design or just leave place for useful knowledge is nothing but impede progress. He is going to be especially critical with designing institutions. Design under this perspective implies that we should put into effect the ideas now guiding us 28, leaving no space for every individual possible to look for new knowledge, just a few. This would be highly inefficient and will constrain freedom. Talking about the possibility of the majority deciding what the individuals should do, Hayek writes: But majority actions is, of necessity, confined to the already tried and ascertained, to issues on which agreement has already been reached in that process of discussion that must be preceded by different experiences and actions on the part of different individuals 29 This discussion about whether to control the progress is brought because Hayek was not able to avoid the obvious issue of poverty. Poverty is a topic that, no matter under which perspective we take into consideration, it is always present and obviously no one has found a solution. None his beloved classical Scottish thinkers Adam Smith, David Hume or Adam Ferguson, could obviate this topic and neither did he. And it is exactly here were the legacy of the concept self adjustment comes just in time. Hayek admits it promptly: ( ) this does not mean that we shall like all its results or that we are all gainers 30 but indeed this inequality is not a problem; it is actually a unavoidable feature without which rapid economic advance would not be possible. There must be some individuals ahead.this is because development can be understood both in terms of accumulation of goods and equipment, and as an acquisition of new knowledge. New knowledge is unrestricted and once achieved becomes gratuitously available for the benefit of all 31, but some things we know are too expensive to be produced. That is why just some people can enjoy them before than the majority. In another way, knowing is unrestricted but enjoying the benefits of knowledge is not. The sentence he uses to expose this idea is particularly unclear: 27 Ibid, Ibid, Ibid, Ibid, Ibid, 39

11 And at an early stage they [the things we already know] can be made only through an outlay of resources equal to many times the share of total income that, with an approximately equal distribution, would go to the few who could benefit from them 32. More simplistically, this means that there can be benefit only by the people who have the resources to invest in the knowledge and get benefit from it. This reason, which indeed is just the reason for any business investment, is the crystallisation of the self adjustment of the society. This is how the idea of that the luxury of the few becomes available to the greater part of the people. This way there is a vertical connection between the rich and the poor because the first not necessary intentionally- discharge the cost of experimentation with new things that can be later made available to the poor 33.Surprisingly enough Hayek does not talk in this case about competition, like many liberals do, but just a mere acquisition of new knowledge. Poverty therefore is something relative rather than an absolute concept in his progressive society 34. As far as for Hayek poverty is just due to the lack of knowledge, it is not an issue because knowledge will be transmitted soon or later. Furthermore, this progressive society disregards the pain of unfulfilled desire arouse by the example of others. When this theory becomes a bit cruel Hayek just shifts to comparing it with socialist society, which of course he absolutely despises because it is the mayor attempt of designed society and therefore, stationary. Going back to the problem with designed society, is the turn down the efficiency of a society to progress. Consequently, in a socialist society would have to imitate Hayek s free society to eventually attain progress. Because according to his theory, there are two mayor ways to make a society stationary: imposing to all same average standards or allowing the most successful standards just a little above the average 35. The extremely designed societies would have to leave freedom just to a portion of the society -the party, some specific class, etc- and leave them try new things. So the process of inequality is so unavoidable that the ultimate difference between free and socialist society would be that in the second the inequality would be implemented by authority in 32 Ibid, Ibid, Ibid, Ibid, 44

12 contrast with the first one where is the ( ) impersonal process of the market and the accident of birth and opportunity 36. Considerations to Hayek First of all it calls my attention that one person as Hayek that has witnessed the World War I, the World War II and the Cold War does not leave space in his theory at all for politics, relation between individuals, etc. His theory, as any other liberal has a high grade of abstracts but he never talks bout Secondly it is ironical that Hayek demands himself A great effort of imagination 37 to understand his process of social adaptation and cumulative progress. The financial crisis is an obvious counter argument to this luxury of the few commodity of everyone in a future. The progress of the Western society development could depend on the pursuit of the most gifted men in Hayek terms 38 - of new ideas. These gifted men should be no constrained by law or government because they knew what they were doing; they were creating a lot of wealth through their financial innovation that otherwise would have not been possible with the coercion of the regulatory authorities. This could be backed up by the great amount of money these derivatives were creating: in comparison with the 60 trillion American dollars of goods and services created in 2010, 601trillion American dollars where exchanged through the trading of derivatives 39. Third, did this inequality self adjusted and returned benefits to society? Even without taking into consideration the financial crisis, the answer is no. The fact that the movement called Occupy Wall Street claims that the 1% of the World population holds most of the wealth of the Globe does not mean that this fact is just linked to the crisis. The crisis just turns down the conditions even more of the other 99%. Hayek was very critical with rationalistic believes in goodness of man, natural existence of interests or natural liberty, calling them naïve. I consider equally naïve Hayek s self-adjustment of the society. 36 Ibid, Ibid, Ibid SPIEGEL Staff, The Destructive Power of the financial Market, Spiegel Online International.

13 Hayek s linkage between responsibility and liberty I stress, understood as no interference or design of public powers- is not a fact. The financial crisis is not one of those Innumerable accidents the Austrian thinker talks about 40 ; it is in my opinion a transmission of public power to subjects that had no perspectives of their actions over society. It is under my perspective a fraudulent act from both regulative authorities and deregulated entities. The fact that now states are have lost power in advantage of the markets it should not be forgotten that it were the governments who handed in the power believing in cumulative growth and adjustment. Now the power handed is even reacting against the states: The markets take advantage of every weakness and every rumour to speculate against one country after the next 41. The market is not unpredictable knowledge that we cannot control. The market is people, and not something supernatural. Finally, I think the institutions are no merely tools of society as Hayek would claim. Institutions in my opinion are as well a part of society. It is true that there is unpredictability surrounding the human being, but this does not mean that we are shaped by it. One simple metaphor could be the earth quakes: we cannot predict them but we build buildings that can resist them. Conclusion The deregulation follows a logic based on the freedom of the individuals as core of the progress of civilisation. This freedom is defined as the not intervening of the public powers into any aspect of human s life, but with stress on the economics. Constant progress and linear development are the grounds to which all this concepts are attached. The World financial crisis, that is shaking the World to a level that for first time in its history the European Union s availability is in question, shows that those liberal propositions do not work. The few member of society who were supposed to acquire new knowledge from which the other population would benefit from just engaged in a process of socialization of costs and virtualization of assets to accumulate more wealth. 40 Fredrich A. Hayek, selections from The Constitution of Liberty (1960, 2006), London & New York: Rutledge: The Value of Freedom, pp P63 41 SPIEGEL Staff, The Destructive Power of the financial Market, Spiegel Online International.

14 I think the development of the society cannot be measured just in terms of trade of assets, even more when those are separated from the real economy, in Duncan terms 42. The institutions are obviously just a tool for progress; institutions have, in my opinion, a great deal of responsibility over their population. Without discussing the origin and the process, I think the modern states are based in a nation-state system. As such, the state has power but also duties over the population. Furthermore we should not forget that ultimately the economical and political power of every country is hold by the society and the real economy. The crisis makes obvious that has turned over some power that directly affects this two elements. One clear example is Spain, with a constantly increasing unemployment rate since the crisis started. 42 BIS History-Overview, Bank for International Settlement, 42 Wigan, Duncan(2010) 'Credit Risk Transfer and Crunches: Global Finance Victorious or Vanquished?', New Political Economy, 15: 1, , P114

15 Bibliography URL - Fredrich A. Hayek, selections from The Constitution of Liberty (1960, 2006), London & New York: Rutledge: The Value of Freedom, pp 21-62, the Monetary Framework pp , Postscript: Why I am not a Conservative, pp On Compendium for Classical and Contemporary Thinkers in international Political Economy (Department of Business and Politics, Copenhagen Business School, fall 2011) BIS History-Overview, Bank for International Settlement, (Acceded in November 2011) Klein, Peter G., Biography of F. A. Hayek ( ), Ludwig von Mises Institute. Acceded November 2011 Wigan, Duncan (2010) 'Credit Risk Transfer and Crunches: Global Finance Victorious or Vanquished?', New Political Economy, 15: 1, (Published on-line in 30 March 2010).