Events over the past year have roiled the global financial markets and raised doubts in people’s minds about the efficacy of the global capitalist system. These doubts miss some very fundamental points: this crisis stems not from the full functioning of a free-market system but rather from an incomplete application of the free-market. With the US government’s massive intervention in the markets, with a $700 billion bailout package and the nationalization of several large financial enterprises, the current crisis is further complicated and exacerbated and the path is opened for all sorts of future problems.

The financial crisis in its current form could have been averted had the Federal government not intervened six months ago by extending a federal discount window to Bear Stearns and Lehman Brothers, which were in distress several months ago. Instead, the Federal government intervened, and extended cheap credit to Bear Stearns and Lehman Brothers instead of allowing them to fail when they should have been allowed to fail. The free-market works when the system allows for the efficient allocation of resources throughout the economy. When the government intervenes, either directly or through over-regulation, it subverts the efficient allocation of resources and allows companies which are grossly mismanaged to continue to function. Bear Stearns and Lehman Brothers were grossly mismanaged and their risk exposure was not properly accounted for; by extending a lease on their life, the Federal government compounded the problem and generated a true crisis of confidence in the markets.

Had these enterprises been allowed to fail six months ago, the global system would not face a run on the banks in its current form. Now we are faced not just with the demise / fire-sale of Bear Stearns and Lehman Brothers, but also of Merrill Lynch, Washington Mutual, and the US agency giants Fannie Mae and Freddie Mac. Delaying the day of reckoning only makes the problem that much more explosive when it resurfaces and rears its ugly head in the form of the biggest liquidity crisis which the market has experienced in decades.

We should also not forget that the root cause of the current financial crisis lies in the ill-thought of government intervention in 2000. Then, faced with a possible recession stemming from the deflation of the dot-com / internet bubble, the government moved aggressively to lower interest rates to spur investment in the broader economy. Lower interest rates and cheap credit led to over-leveraging, both by individuals (who borrowed to buy homes and go on a consumer spending spree) and by corporations (which borrowed to take advantage of cheap credit to expand). This over-leveraging led to the run-up in real-estate prices and the surge in the global stock markets. Investment banks, which were previously compensated for making smart, calculated risk decisions, now found themselves awash which cheap credit: they no longer had to be as discerning with their investment decisions.

This shell-game started to come to an end with the first shock to the real-economy coming from the tremendous increase in oil prices (which were driven first by the instability of post-invasion Iraq and second, by fears of a new war which would disrupt oil supplies out of the Persian Gulf). There was also a tremendous real cost associated with the wars in Iraq and Afghanistan, which have cost American tax-payers over a trillion dollars and exacerbated the government’s deficit-spending and lack of checks on its ballooning expenditures. Real-estate prices started to fall and the Fed desperately tried to avert this crisis by further lowering interest rates which was the original culprit in the build-up of the “finance bubble.” With interest rates already at historical lows, this desperate move had little impact. Additionally, with inflation beginning to rear its ugly head, the Fed would soon have to resort to raising rates to avert the danger of inflation.

The finance bubble burst, with catastrophic results. Investment banks and large global banks which heretofore had been considered infallible started reporting write-downs numbering several billions of dollars, and tens of billions of dollars in the worst cases. Where were these write-downs coming from? Essentially, cheap credit had masked and allowed for a tremendous failure in bank management to properly assess risks. Banks had given out billions of dollars in loans to home-buyers with bad credit, who lacked the ability to repay these loans. The banks had then bundled these mortgages into Mortgage Backed Securities (MBS’s) which were then packaged further into derivative products such as Collateralized Debt Obligations (CDO’s), collecting underwriting fees from the repackaging of this debt and selling them off to insurance companies and other end-buyers which were eager to collect premiums. This created a web of financial links, a house of cards if you will, which appeared profitable as long as home prices continued to increase. And once home prices stopped increasing, and God forbid, started to decrease? Well that’s what we’re seeing now…massive write-downs in the tens of billions of dollars…

This is not the end of capitalism; if anything, this crisis simply demonstrates the costliness of government intervention, not just to American taxpayers, but also to the global economy. This crisis was compounded and is more severe in its current manifestation because of too much government meddling. Had the government allowed Bear Stearns and Lehman Brothers to fail six months ago, we might have skipped the moral hazard of bad bank management and the current crisis of confidence but ultimately, we had to go through some pain because of the shocks stemming from higher oil prices and dropping home prices. Looking forward, the conclusion to draw is that LESS government involvement is the way to avert futures crises of this magnitude, not more government intervention. The massive government bail-out is simply a transfer of wealth of tax-payer dollars from Main Street to subsidize the failings and mismanagement of the Wall Street banks. The government needs to curb its spending, reduce the size of the budget deficit, avoid future costly misadventures and foreign entanglements like Iraq and Afghanistan, and allow mismanaged banks to fail.

In the long-run, the financial markets will correct themselves and rebound in a stronger fashion if the government stays out of the fray; if the government continues to intervene, things will only get uglier.

Abdullah Karatas, Vice President, Trading, Natixis.