TightWind is written by Kyle Baxter. Stay Hungry. Stay Foolish.

The New Yorker’s John Cassidy describes the impetus for bubbles to build in the context of the 2007-08 financial crisis:

In a situation like this, what I do affects your welfare; what you do affects mine. The same applies in business. When General Motors cuts its prices or offers interest-free loans, Ford and Chrysler come under pressure to match G.M.’s deals, even if their finances are already stretched. If Merrill Lynch sets up a hedge fund to invest in collateralized debt obligations, or some other shiny new kind of security, Morgan Stanley will feel obliged to launch a similar fund to keep its wealthy clients from defecting. A hedge fund that eschews an overinflated sector can lag behind its rivals, and lose its major clients. So you can go bust by avoiding a bubble. As Charles Prince and others discovered, there’s no good way out of this dilemma. Attempts to act responsibly and achieve a coöperative solution cannot be sustained, because they leave you vulnerable to exploitation by others. If Citigroup had sat out the credit boom while its rivals made huge profits, Prince would probably have been out of a job earlier. The same goes for individual traders at Wall Street firms. If a trader has one bad quarter, perhaps because he refused to participate in a bubble, the results can be career-threatening.

This is certainly an accurate description of the self-creating nature of bubbles, but the piece runs off the rails. Cassidy goes to great lengths to detail the feedback-loop nature of bubbles, and then concludes that since this is inherent in the nature of unfettered markets, that the solution is to restrain this tendency.

The entire piece rests on that single assumption: that disastrous bubbles like the one we just passed through are purely caused by free markets. This assumption, however, is a poor one; convenient, because it means solutions are simple (regulate executive pay, regulate the risk financial firms can take, as he prescribes), but ultimately a shortcut that doesn’t accord with reality.

Speculative bubbles certainly are inherent to markets; that much is true. Centuries of history bears that out. But behind the most damaging ones often lies government support.

The subprime bubble did not happen in a vacuum — it happened with encouragement and financial support from the federal government. The federal government encouraged investment in the mortgage market through Fannie Mae and Freddy Mac’s legally-created market advantages over other firms1. The two GSEs ended up owning some 5 trillion dollars, nearly half, of mortgages by 2008. Moreover, they began buying subprime mortgage-backed securities in significant amounts in 2002, just as the market ramped up. By 2004 they owned 168 billion dollars worth of subprime mortgage-backed securities, almost half of the entire subprime mortgage-backed securities market.

Buying these securities took them off the originator’s balance sheets, thus allowing them to create even more mortgages and securities. In other words, the GSEs provided incredible liquidity in the subprime market through the federal government’s good credit, allowing it to really take off. This all supported government policy — increasing homeownership — but we all know the results.

Moreover, credit-default swaps, which caused uncertainty in September 2008 as to who owed who else and how much (and thus threatened to cause a cascade of failures), were created in 1997 to shift risk to get around regulatory capital requirements. Attempts to control how firms operate tend to result in more complex operations to get around it, which can make the situation even worse than the original one.

That is the flaw in Cassidy’s piece; ultimately it is an excellent description of bubbles, but his unwarranted (and ultimately false) assumption that this crisis is the result of the market makes its conclusions worthless.

1. The two GSEs could borrow capital at rates close to the rate the federal government borrows at, because the market assumed they were backed by the government. In effect, taxpayers were financing the mortgage market through the federal government’s good name. [↩]