Adam Smith Institute

As Milton Friedman pointed out, there's nothing so permanent as a temporary government program. Once again we see the proof of this.

Consumer groups hit out at the European Commission after it moved to extend anti-dumping tariffs on shoes imported from China and Vietnam, arguing that the duties raised prices for their ailing members.

Ths duties were originally imposed for two years but they are now being extended. We know why, of course. Those who would benefit from the lifting of them are all of us. A highly dispersed constituency and one that's also not all that interested as we don't actually see the cost nor is it very high individually.

Those complaints came as the Commission formally announced an extension of the duties, imposed two years ago, under pressure from Italian shoe manufacturers.

However, those shoe manufacturers are very interested indeed and are those motivated to lobby for the protections at our expense. The nett effect is a transfer of wealth, from us the consumers to those shoe manufacturers. And as long as we have a politically driven system that decides upon such tariffs then we'll always have such groups attempting to get such legislative picking of our pockets and many of them will succeed.

It's one of the arguments for free trade of course: that if the power to shaft the consumer via import restrictions just isn't there then the consumer won't get shafted by such import restrictions.

• Anti-redlining laws in the US, passed in 1977 and strengthened in 1995, forced lenders to give mortgages to people they knew might not be able to afford repayments. People who haven't had a full-time job in years were lent six figure sums.
• In order to manage the risk this exposed them too, lenders packaged these sub-prime mortgages up with other ones and traded them as derivatives (collateral debt obligations, or CDOs).
• People start to default on mortgages, but because the CDOs are so opaque, no one knows how much liability they, or others, are exposed to. So the banks stop lending to each other and the credit crunch begins.
• Now the banks which have overextended themselves – lending far more money than they have in deposits, and relying on being able to borrow cheaply to finance their business model – are in serious trouble. Ultimately, it's a cash flow problem.
• Word gets out and Britain witnesses the first run on a bank in over 100 years. Confidence evaporates on both sides of the Atlantic. Share prices plummet, as one bank after another is infected. Investment banks, which do not take deposits and therefore rely most heavily on the ability to borrow, are hardest hit.
• Two possible policy responses emerge. One, motivated by the idea of moral hazard, says that banks must be allowed to fail. If government bails them out, they'll behave even more riskily in future. Plus, why should the taxpayers fund a welfare state for bankers? The other school of thought stems from the idea of systemic risk, that allowing banks to collapse would endanger the entire financial system (and, by extension, the capitalist economy).
• Fears about systemic risk win out. Governments intervene to try and restore confidence. In the US, the Bush administration attempts to buy up all the bad debt, aiming to get banks lending to each other again.
• This what happens when a bubble bursts. For years, the availability of cheap consumer goods from emerging economies like India and China kept down inflation. This meant governments and central banks thought they could flood the market with liquidity (i.e. cheap credit) and get away with it. They couldn't. With too much money chasing too few goods, an asset bubble built up. House prices, in particular, were hugely over-inflated. It got worse after 9/11 when, facing an economic downturn, the US and the UK both pumped even more liquidity into the market. With breathtaking arrogance, politicians claimed to have abolished the economic cycle. In reality, they had simply swapped an immediate and relatively minor readjustment for a much harder landing several years down the line.
   

Worldwide central bank intervention might have calmed the financial sector a bit, but I still think that our present problems are due to too much government rather than too much markets. The rot started when the US authorities started forcing mortgage companies to make bad loans.

The Community Reinvestment Act 1977 had the laudable aim of trying to make sure that people in poor areas had access to loans. Strengthened in 1995, it forced lenders to give mortgages, even in areas where they thought the property market was dire and the risks of default were high. Sub-prime mortgages, as we have learned to call them. The banks packaged those bad loans to reduce their risk, but that just spread the disease to others. Institutions started failing, and even 200 regulators on the case couldn't save Freddie Mac and Fannie Mae. Great work by the regulators, that.

Meanwhile, Alan Greenspan at the Fed and Gordon Brown at H M Treasury were taking the credit for an economic boom. But it was a boom fuelled by easy money – low interest rates that induced people to borrow more and more, without thought to repayment – and Brown's reckless overspending. After 9/11 and the fears of what that might do to the world economy, even more credit was pumped in. But after ten years and more of this credit binge, some sort of hangover becomes inevitable.

Sure, markets are only human. They can't be perfect. They work fine most of the time, but like motorway driving, you do get the occasional shunt when someone doesn't see what's coming. And indeed the occasional multiple shunt. That's a good reason for the government to make sure people are fit to drive – it is no reason for the government to take over the driving of every car.

I can see the case for intervening to staunch a crisis of confidence, since markets are built on that very human necessity. But a hair of the dog never actually helps a hangover. Monetary authorities should stay focused on the threat of inflation, which is the biggest destabilizer of markets – obscuring real prices and so throwing future planning and investment out of kilter. Regulators should focus on the financial fitness of institutions, raising concerns at an early stage, and when inevitable failures do happen, facilitating their orderly wind-up. Frankly, the Bank of England would be better at that job than the bloated, distant Financial Services Authority. And when institutions do take too many risks and fail, what's left should go not to the shareholders, but to the customers whose trust has been breached.