What the failure of Fannie and Freddie means for capitalism

I read a very pithy letter to The Telegraph the other day that made me chuckle. Referring to a story about Fannie and Freddie's nationalization, the correspondent asked: "Why didn't your headline 'World's biggest mortgage bail-out' read 'Capitalism fails'?"

Like many of the best headlines, it's witty and to the point. That almost makes it a pity that it's also completely wrong. It's also worrying that far too many other people also have this perception.

Because of course, the reality is that Fannie and Freddie were invented by the government in the first place. The reason they were able to dominate the market to the extent they did was because everyone knew they were government organisations, even when there was still some vague charade that they weren't.

In fact, all this miserable little episode in economic history tells us is this - the market will get you in the end, even if it takes 60-odd years to do so...

What the failure of Fannie and Freddie means for capitalism

As Simon Nixon points out in this week's edition of MoneyWeek (out on Friday), it was in part, the birth of Fannie and Freddie after the Great Depression in the 1930s (Freddie came later, but its roots were in that crisis) that has led directly to the current upheaval in the financial markets.

Fannie and Freddie had the implicit backing of the US government. That meant they could borrow money almost as cheaply as the government. That meant they could buy up more loans than anyone else. That's why they now dominate the US mortgage market. And that's why the government - which first created them - has now had to bring the prodigals back onto its balance sheet.

In other words, the biggest player in America's mortgage market has always been the public sector, complete with unaccountable, overpaid bosses, and dodgy book-keeping. It's only now that the majority of the population realises it.

So the 'failure' of Fannie and Freddie - or rather, the fact that the US government has finally had to admit it always owned these things - says nothing about capitalism. What it does show is that attempts by the government to buck the market are doomed to eventual failure.

It's the exact same story with attempts by central banks to set interest rates. There's a massive gap between what central banks generally say the cost of money should be, and what it actually is just now. And that's because the market has finally reasserted itself and said - this can't go on.

Why the credit crunch is 'the start of the solution', not the problem

As Leigh Skene of Lombard Street Research puts it (and I'm going to give the full quote here, because it's an unusually perceptive summary of what's going on): "The credit crunch is the start of the solution, not part of the problem. The problem is too much household debt, and it took the credit crunch to halt the hysterical borrowing / lending spiral. The crunch will be over when people understand that they should be looking to repay debt, not borrow."

That hits the nail right on the head. What needs to happen now is that people start rebuilding their savings, and companies rebuild their balance sheets. That's the way the market is pointing too. But what's the one big thing attempting to stand in the way of this vital process? That's right - the governments of the world.

Governments hate downturns. That's because voters tend to prefer good times to hard times, unsurprisingly. A government that presides over house price growth and full employment comes in for plaudits, regardless of how that growth was achieved.

The basic ideas behind how to run an economy for a long time now, have been rooted in Keynesian economics. The idea is that governments can take an active role in managing the economy through various tools, including setting the interest rate. You try to make sure the economy doesn't overheat during the good times, and in the hard times, you make money a bit more available, and maybe increase public spending too, to compensate for the downturn in the private sector and "stimulate" the economy.

There is very little the government can do to stop this downturn

Does it work? Who knows? Because while it sounds good in theory, what you actually get is a government that keeps pressing the "stimulate" button for as long as it can get away with it. The British economy has been flooded with cheap money and public spending even when times were good. It's over-inflated the economy, and left us with nothing to fall back on during the hard times.

With the coffers empty, there really is very little any government can now do to stand in the way of this downturn. But that won't stop them from trying. They won't make things any better. But as a long and grim history of price controls, currency market interventions, protectionist laws, and good old Fannie and Freddie demonstrate, they might just make things worse.

Turning to the wider markets...

The FTSE 100 closed at 5,366, down 49 points after a poor showing by banks - affected by their American counterparts' troubles - and miners. Among the risers were ITV, up 6.55% and BAE Systems, up 4.29%. For the latest stock market news and charts, click here.

In Europe, the Paris CAC closed at 4,283, down just 0.2%, and the German Xetra Dax finished down 0.4% at 6,210.

Over in the US, energy stocks were boosted by Opec's decision to restrict output, while financial shares were hit by worries about the future of Lehman. The Dow Jones closed up 38 points at 11,268; the wider S&P500 was up 0.6% to end at 1,232; and the Nasdaq Composite rose 0.9% to 2,228.

And in Asia, the Nikkei-225 was also hit by fears about Lehman, with Nomura holdings down 5.9%. The index closed at 12,102, down 2%.

Brent spot was trading at $96.17 a barrel this morning, with crude oil in New York at $101.76 a barrel. Gold spot was at around $740 an ounce; silver at $10.62 an ounce; and platinum $1,118.00 an ounce.

In the forex markets this morning, sterling was trading against the US dollar at 1.7498 and against the euro at 1.2569. The dollar was trading at 0.7191 against the euro and 107.06 against the Japanese yen.

This morning, owner of Argos and Homebase, Home Retail Group, revealed how badly it has been hit by the consumer slowdown. Second quarter same-store sales fell 5.8% at Argos, and 8.3% at Homebase in the three months to August 30th. Earlier this week, the British Retail Consortium said wider High Street sales were down 1% in August.