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Commentary By Nicole Gelinas

How The West Worsens Crises By Denying Market Signals

Before 2007, the rules necessary to govern a market economy broke down. Rather than fixing those rules, the West has repudiated market economics. No longer do Western governments use investor signals as feedback in devising policies; instead, they ignore or subvert those signals.

Start with the euro crisis. Thirteen years ago, the euro introduced a corruption into capital markets. Investors assumed that the euro’s champions — Germany and France — would never let a weaker eurozone country default. This belief enabled Greece and others to borrow too much too cheaply.

By February 2010, investors and credit-rating analysts were questioning whether lending money to these nations was really riskless. They demanded higher interest rates to make up for the risk.

European officials, rather than listen to that useful signal, scrambled it. Greece’s then-prime minister, George Papandreou, began a global search for bond buyers, insisting "we will not be needing help." In February, Merkel refused to discuss a bailout, noting, "Greece has never asked us for support."

Greece did need a bailout. Yet even as a $15 billion support package grew 10-fold between 2010 and 2011, rates on Greek bonds kept rising. The investors were sending a message: limited rescues aren’t enough to restore confidence in weak countries’ bonds.

Investors understood that there were two ways to end the crisis without destroying the currency. Europe could make explicit the euro’s long-implied guarantee of sovereign debt, issuing bonds backed by the Continent. Or Europe could create an orderly way for nations to default.

European leaders kept their ears stopped. Instead of guaranteeing sovereign debt or allowing countries to default, they conjured up the European Financial Stability Facility, a structured-finance vehicle through which Europe would pretend to spin a few hundred billion dollars’ worth of funds into a trillion dollars’ worth of guarantees.

Investors saw through the EFSF, and interest rates for weaker European nations’ bonds shot higher. The European Central Bank also tried to trick the markets, buying just enough bonds from weak nations to blur what their price, absent artificial demand, would be. After a year of standoff, a stronger effort to suppress market signals came in the summer of 2011. When Europe announced that Greece wouldn’t repay all its debt, European leaders pretended that this wouldn’t be a default. Rather, investors would take a "voluntary" hit.

This communique against reality pushed rates higher.

European officials remained deaf. By the end of 2011, they were resorting to centrally enforced discipline for Greece. Germany and France sent experts to impose an austerity plan, a model they promised to institutionalize throughout Europe. The Greeks responded to their minders with resentment. In the fall, a Greek newspaper ran cartoons of technocrats dressed as Nazis.

When markets can’t enforce discipline, people must — and citizens grow angry.

The American crisis was no more a failure of free markets. Just as investors signaled that something was wrong with the euro, they signaled that something was rotten in American finance. The rot remains. But Washington would rather block market signals than rely on them.

The financial system crashed in 2008 because checks on the financial industry had vanished. "Too big to fail" had governed the financial industry for nearly three decades. Bondholders to big financial institutions could look at precedent and know they would get bailouts when necessary.

The government further eroded market discipline by usurping markets’ role in deciding which investments were risky. In the ’80s, regulators determined that mortgage lending was safe; financial institutions that borrowed to buy mortgage securities could borrow more heavily. Regulators similarly determined that securities rated triple-A were safe.

America reaped the consequences when its financial system collapsed in 2008.

The government’s response should have been: clear rules to support markets. Instead, the Dodd-Frank Act reinforced government errors. Dodd-Frank directs regulators to scrutinize "systemically important" financial institutions and decide whether they’re too risky.

And if a "systemically important" institution fails, regulators can use taxpayer money to guarantee the company’s short-term debt or its derivatives bets. Dodd-Frank codifies favoritism.

At least Britain is doing it right. Right? Wrong.

British Prime Minister David Cameron, too, thinks the cure for government distortion is more government distortion.

The problem with the British economy, Cameron believes, is that a dysfunctional private sector is stifling revival. Banks won’t lend to small businesses, which prevents such firms from creating jobs. Banks won’t lend to home buyers without a hefty down payment. With housing prices stagnant, people won’t spend.

In November, the government proposed to make the "dream of homeownership" a reality: a sort of mini—Fannie Mae to guarantee mortgages for 100,000 borrowers who put down 5%. A few days later, Cameron announced a new National Loan Guarantee program, which encourages banks to lend to small businesses by letting those that do so benefit from the government’s triple-A sovereign rating.

Britain, like its allies, ignores market signals. If banks aren’t lending, Britain should ask: What’s wrong with them?

As part of 2008’s legacy, Britain still owns big stakes in two huge banks. That public ownership clouds the sector. Cameron recently bullied Royal Bank of Scotland chief Stephen Hester into refusing his bonus — even though the government brought Hester in to clean the bank up. Britain should get out of banking — even at a loss — and regulate the industry through simple, transparent rules.

Instead, Britain has slapped a tax on the banks — and the government wants to hike it by 28%. Britain’s banking industry has no idea what to expect from government. No wonder the banks are miserly.

The banks also have good reason to demand big down payments. Home prices are too high. The banks need a cushion against losses. And Britain’s "austerity" measures — including a 14% hike in the value-added tax — have snatched money from consumers’ pockets, reducing the profits of businesses, which then can’t borrow.

Somebody should say: The free movement of capital hasn’t failed. What has failed is the West’s persistent misdirection of capital.

This piece originally appeared in Investor's Business Daily

This piece originally appeared in Investor's Business Daily