Intertwined with bad monetary policy has been an atmosphere of crony capitalism. If LTCM (Long Term Capital Management) had not been saved, there would have been a small financial crisis, possibly a recession and most importantly financial market participants would have realised that there is a price to be paid for being on the wrong side of a risky gambit. By bailing out LTCM (ostensibly to help the system), Greenspan and his friends gave a dangerous signal to all participants in financial markets — that they could ignore counter-party trading risks.

There have been other worrisome happenings. As treasury secretary, Robert Rubin backed the deregulation necessary for Citicorp and Travellers to merge. After he retired as treasury secretary, Rubin became a highly paid director of the merged company which has had none too stellar a performance. Henry Paulson, the ex-CEO of Goldman, being treasury secretary has also been a matter of concern. Years ago, the Nobel laureate George Stigler published his empirical findings that senior managers in railway companies became railway regulators and vice versa. Guess what — rail fares went up to higher levels after regulations were introduced to control them. Stigler’s prescient warning that it is dangerous to let the economic actors who are being regulated enter regulatory office needs to be re-emphasised. Walter Wriston, who was one of the greatest American bankers of the 20th century, neither sought nor accepted office involving government oversight. His is the example bankers need to go back to.

Banks face justified criticism for providing their managers with bad incentives that encourage them to focus on short-term gains and indulge in excessive risk-taking. But let it not be forgotten that bad monetary policy and regulatory confusion were the root causes. Defenders of free and well-functioning financial markets are on the defensive today because we have acquiesced in lax monetary policy and incipient crony capitalism. Let us remember that bad money (remember Gresham?) and crony capitalism are greater enemies of free markets than leftwing critics can ever be.

... contd.