In a new book, British journalist John Cassidy uses economic theories to analyse how free-market ideas interacted with history to cause the financial crisis.

“The idealised free market is a fiction, an invention: it has never existed and it never will exist,” he writes in “How Markets Fail: The Logic of Economic Calamities.”

Cassidy, who has covered economics and finance at the New Yorker magazine since 1995, explained the basic premise of the book to Reuters before giving a talk at the London School of Economics this week.

Hard to imagine with financial markets still buoyant and newspapers full of tales of bonus greed, but there is still the possibility that captialism will end.  At least there is according to prestigious investment consultants Watson Wyatt in their latest study called "Extreme Risks".

The firm listed the demise of the system of private ownership as one of 15 threats to investors and the global economy that probably won't happen but which it reckons are worth worrying about anyway. The idea behind the report is that such things as climate change, the break up of the euro zone and war are always worth being included in an investment risk management process.

As for the future of capitalism:

In our view, the most likely scenario is moving along from one end of a spectrum where market is king (minimum regulation) towards the other end, where we could see more onerous regulations and government intervention in, and control of, the economy. The extreme risk, however, is the demise of the capitalist system and the end of the market as the primary means of resource allocation.

And the impact:

The economy would be likely to run a higher risk of failure and economic growth would be sluggish in the long run due to lower productivity.  Centrally controlled economies tend to be characterised by shortages, which are inherently inflationary. Private investment activities would collapse or even be terminated. The end of capitalism is simply the ultimate extreme risk. The economy is likely to be associated with extreme uncertainty and a large amount of wealth destruction during the transition period.

Watson Wyatt does try to give its free market clients some hope, suggesting that buying gold may be one way to hedge against the propect of capitalism's demise. But it admitted that in such a circumstance investors would probably be more concerned about the return of their investments rather that the return on them.

(Illustration called The Communist Party, from Threadless)

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it “fair” value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for “risky” currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and “bubble” forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

- Philip Booth is editorial and programme director at the Institute of Economic Affairs. He is editor of “Verdict on the Crash,” a new book available from the IEA. His opinions are his own. -

In “Verdict on the Crash” we argue that government failure and not market failure is responsible for the collapse in financial markets.

It is now widely accepted that the boom and bust, culminating in the Great Depression of the 1930s, arose as a result of catastrophically mismanaged monetary policy. So, it is natural that we should start by examining monetary policy to see if it was a cause of the crash of 2008. And so it turns out to be.

Low interest rates led to monetary aggregates expanding, an asset-price boom, low saving and a boom in consumption. Higher asset prices raised the value of collateral against secured loans thus encouraging more lending and higher leverage whilst reducing the apparent risk faced by lenders and borrowers. Low interest rates encouraged unsustainable borrowing, consumption and investment and exacerbated the problem of global imbalances.

For six years from 2001, the U.S. Federal Reserve sent the message to participants in financial markets that, if the markets were to fall, the Fed would underpin them. No wonder any consideration of risk went out the window. Policy in the UK was also irresponsible and, though over a shorter time. Our current Prime Minister went round telling everybody that he had abolished boom and bust. Is it any wonder that people under-priced risk?

But, notwithstanding all this, why where the complex securitisation instruments that brought the banks down created and traded in such magnitude and why did they become poisonous?

Firstly, the U.S. Community Reinvestment Act, backed up by progressively tightening state regulation, more or less forced banks to lend to bad risks. By 2005, the U.S. mortgage giants had explicit targets to provide over 50% of their financing to people on below median incomes.

In other ways, government policy and capital regulation had a big part to play. Fannie Mae and Freddie Mac drove and developed the market in securitised mortgages. They were the creation of politicians and underwritten by government. The providers of capital knew that there was an implicit government guarantee if things went wrong.

Of course, nobody forced the British banks to buy these instruments. But international banking regulations led to two tragic consequences. They radically distorted the activities of banks, encouraging them to take on gearing in more and more complex ways – and to give the impression that they had offloaded risk through securitisation.

Secondly, they strongly encouraged the adoption of similar types of risk models throughout the banking system. Regulation has treated the system in such a uniform way that, if problems arose in one bank, the failure of the whole system was virtually guaranteed!

Readers should take a look through the FSA handbook. The full handbook contains ten sections. The section entitled “Prudential Standards” is divided into 11 sub-sections. The sub-section “Prudential Sourcebook for Banks, Building Societies and Investment Firms” is made up of 14 sub-sub-sections.

The sub-sub section “Market Risk” is divided into 11 sub-sub-sub sections. The sub-sub-sub-section on “Interest Rate PRR” has 66 paragraphs. This is what regulators call “principles-based, light-touch regulation”. As far as I could see, based on this example, there could be over 1,100,000 paragraphs. Remarkably, I could find nothing on liquidity risk, the main failing of Northern Rock.

The evolution of regulation over the last 20 years has encouraged the markets to pass responsibility to the regulator. The most important relationships are now between banks and their regulators. Sadly, shareholders gave up monitoring. They were encouraged to think it was not necessary.

Government regulation has created a welfare state for bankers. If big banks are told they are too big to fail, the both creation of megabanks and their failure are inevitable. What we need is not more powers vested in regulators - who have shown that they cannot remove whatever imperfections may exist in markets - but deregulation. This should be combined with some simple changes to the law to ensure that banks are held properly to account by markets and that bankers do not get rich at the taxpayers’ expense.

A longer version of this article will appear in the Yorkshire Post

-- James Saft is a Reuters columnist. The opinions expressed are his own --

The recession will soon be dead, laid to rest alongside the idea of the "Great Moderation", a set of hopeful assumptions that underpins expectations about economic growth and asset valuations.

This, when investors, bankers and executives ultimately realise it will cause them to pull in their horns, take less risks and be less willing to pay high prices for assets.

Economists, observing that since the 1980s recessions have been mild and short and expansions long and robust, developed the theory that better economic management, namely cutting rates in the aftermath of bubbles, globalisation and, get this, improvements in financial markets, had led to a sort of best-of-all-possible-worlds "Great Moderation", in which economic volatility fell and with it the risk premia required for holding financial assets.

This little theory has, needless to say, come somewhat unstuck during the current downturn which has been great but far from moderate.

This raises the uncomfortable possibility that the last 25 years of good times were just a bit of luck, or even worse, an artificially engineered consumption binge with central banks and governments playing a role similar to what Chicago tavern keepers used to do -- opening up early so last night's patrons can have a quick nip to take the edge off on the way into work.

It's a debate which is far from academic and its outcome will influence much more than the actions of central bankers and regulators.

While financial market volatility has been a feature during the past decades, the idea, or at least the feeling, of the Great Moderation has seeped into the culture, influencing the behaviour of actors across the economy.

A corporate manager is going to be more likely to leverage up and go for the big hit if he feels as if most recessions are mild and short, in the same way that a consumer will buy a boat on credit or an investment property for the same reasons. If the weather never gets that cold why waste money on insulation?

What if these people now decide that the universe is a less friendly place and that they ought to, heaven help us all, save a considerable amount against the day?

This is really about volatility, which, because it can tend to ruin you, is expensive. Most investment or economic management strategies have at their heart attempts to limit or cushion volatility. And so, if we really can expect more volatility in the economy we can expect it to find expression in a lower ceiling for economic growth, leverage and asset prices.

IT AIN'T NECESSARILY SO
Of course, the current debacle may be just one data point rather than a trend, a view financial markets seem to have adopted. That is more or less the argument of Larry Summers and the U.S. administration, who are betting that this is the kind of thing that happens only very rarely.

This is a version of the 100-year storm argument beloved of company managers trying to explain why their results are so poor; the implication is you could not have been expected to plan for a freak storm and once it is past it is back to the good times.

This thinking lies behind the strategy of making financial conditions so easy that people are tempted to borrow and invest. It just might work, and we just might have a sharp and long recovery which generates enough revenue to pay off the public debts we are now racking up.

But two other possibilities, both speculative, spring to mind.

One is that deleveraging proves to be not just an event but a state of mind. As in Japan, people may simply decide that they've had enough risk, thank you very much, leading to a weak recovery, a relapse and then a quandary about how best to pay off the bills we've recently run up.

The other is that the current mix of policy, deep cuts in interest rates, deficit spending and quantitative easing, the effects of which are little understood, ends up breeding volatility of its own, probably in inflation.

The cost of that volatility will be an unpleasant surprise to the investors now bidding up the prices of shares and managers now preparing to invest for expansion, and one that might lead them to at last act more conservatively.

Add to arguments for a new "Great Immoderation"  that emerging markets will almost certainly be more of a driver of global economic growth under most of the reasonable scenarios in the coming decade. Emerging markets historically are more volatile and if as they grow to be a bigger piece of the pie are likely to make overall growth more volatile.

None of this takes away from the essentially good news that the recession looks to be ending soon, but higher economic volatility will hang heavy over the recovery and the cycle to come.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.--

-- James Saft is a Reuters columnist. The opinions expressed are his own --

The good news that the United States cannot keep contracting the way it has been is not to be confused with a return to robust expansion, a point financial markets eventually will grasp.

Consumers, the mainspring of the U.S. economy, will see the cash from government stimulus slip through their fingers but will still face very ugly personal balance sheets and a brutal job market. Their party is not going to get started again for some time.

And falling interest rates will have a hard time sparking investment by businesses until they become convinced that a recovery in manufacturing will do more than just take inventories from nearly empty to barely stocked.

The basic hope for the U.S. economy, that inventories are being run down so swiftly that a turn in the cycle must come, has been more or less confirmed by recent data.

The ISM manufacturing index advanced to 40.1 in April from 36.3, and especially encouraging is a sustained rebound in new orders, a leading indicator of forward demand, which having been more or less moribund in the early months of the year, now is in a sustained uptrend.

Inventories are still being cut, but this, optimists argue, is setting the stage for a recovery when managers see that their depleted stocks represent the threat of losing out on business.

There was also a surprising 2.2 percent increase in real consumer spending in the first quarter, as opposed to the shocking fall of four percent in the second half of last year.

We simply can't fall at the same rate we have been if that keeps going. It probably will and we will probably see a sort of a recovery kicking off in the second half. Even now, billions in stimulus are sloshing through the U.S. economy. In May social security recipients will get an extra $250 and withholding rates for federal tax have been cut.

But the effect of government money will recede, and while stock markets have rallied, the balance sheets of many Americans are still very fragile. Remember too that the U.S. is aging, and many savers approaching retirement have seen zero investment gains in their portfolios over periods as long as a decade.

Their garages are full of junk they probably feel they don't now really need, their employment prospects are as bad as in living memory and they face a very long retirement due to expanding life expectancy. Wages and salaries have fallen by 1.2 percent over the past year, an all-time record, and hardly an incentive for the average American to start splurging again.

Savings is here to stay and consumption will have to take a back seat.

TOO MUCH PESSIMISM

So, can business spending in the U.S. take the baton from exhausted consumers?
It probably cannot. First off, businesses are less interest rate sensitive than consumers, and so the effects of the official policy of driving market rates down will have less impact among them.

And while inventories are still low, so is final demand and most corporate managers, having just lived through the most gut-churning time of their entire careers, will not be likely to stick their heads above the parapet and make a lot of speculative investments in new capacity simply because things have stopped looking worse.

This may get to the heart of the problem that the economy will have in making a robust recovery: psychology. Just as people were too optimistic before the crisis, they are likely to remain too pessimistic for a time afterwards.

There is also the matter of sheer scale. Consumption is about 70 percent of the U.S. economy  while capital expenditure at about 8 percent will have a hard time being the engine of a robust recovery. That 70 percent must fall and will outweigh everything else.

Perhaps the proof of a turnaround in business activity will be corporate profits, which across the economy are still falling. Corporate profits allow businesses to expand and give them the cash to do it and the evidence needed to secure credit.

And finally we have a banking and financial system that, while improving, is still not able to intermediate credit properly. That the Federal Reserve is taking matters into its own hands is on balance good, but they are likely to make some ghastly mistakes, not to mention putting their very independence in jeopardy.

Balance sheet recessions, when cutting debt is a priority, take a long time and are characterised by disappointments.

We are past the worst of the crisis, but now moving on to something not as dangerous but just as hard: building a more balanced economy.