Sovereign is he who decides whether there is a state of emergency," wrote the German legal philosopher Carl Schmitt in 1922, on the eve of the Weimar Republic's great economic crisis. Authorities that can be bypassed in times of stress are not real authorities. Laws that are suspended when push comes to shove are not real laws. Whether this is true in all places and times, it is true for those Americans who believed, up until this week, that they were living in a capitalist country. Having been lectured that there is no such thing as a free lunch, they are coming to suspect that there is now no such thing as a free economy, either.

An extraordinary credit crisis that arose from a real-estate bubble, excess leverage and financial instruments too complicated to value has goaded the US government into action. It has begun a programme of economic interventionism more typical of socialist governments in moments of utopian zeal. In March, a Federal Reserve loan helped sweeten the sale of the dying investment giant Bear Stearns. Treasury took over the secondary mortgage giant Fanny Mae in midsummer. This week the Fed assumed a 79.9 per cent stake in AIG, the world's largest insurer, in return for an $85bn (£47bn, €59bn) loan. On Thursday, the Fed, the Treasury and Congress began discussing a plan, potentially costing hundreds of billions of dollars, to bail out homeowners with illiquid mortgages and the banks that hold them.

No use to say it is "only" housing, trading and insurance that is being taken under the government wing. The significance for socialism of the first big British nationalisations after the second world war is that they involved the engine of the domestic economy (coal) and the repository of the country's wealth (the Bank of England). What is the engine of the US economy? Financial services. What is the main repository of Americans' wealth? Housing.

In a sense, the public has willed its way into government intervention by entertaining socialist expectations of a capitalist economy. Housing values were not supposed to fall and neither were any of the investments for which they served as collateral. Once enough citizens collateralise their investments with the roof over their heads, and once it becomes impossible to disentangle mortgages from other investment instruments, then the ordinary, healthy working of creative destruction will drive thousands of small-time investors from their homes. Small-time investors won't tolerate it. Almost every institution in the financial sector, big or not so big, looks too important to fail.

The crisis is partly an epistemological one. Few people outside of the financial industry have ever understood how the new complex derivatives work. Were they hedges or means of multiplying leverage? It turns out that few people inside the industry understood either. The most astonishing stories of the past week have to do with AIG's final weekend, when teams of government analysts and accountants from the world's leading investment banks could not figure out how much cash the company would require in order to collateralise its credit-default swaps. Estimates rose from $20bn to $85bn. A lot of commentators have complained about the opacity of the Fed's moves. It was unclear as of Thursday whether and how much Lehman Brothers, which filed for bankruptcy on Monday, was drawing from the Fed, for instance. Nor is it clear even today what assets the government holds from Bear Stearns. But the opacity is in the nature of modern markets and the instruments that arose from them.

In the US it is probably Democrats who stand to benefit from this crisis. Not that they have original ideas for getting out of it. At the centre of Democratic economic policy are plans to provide $25bn in loans to Detroit automakers and $50bn in transfer payments to the poor. Barney Frank, House banking committee chairman, demands that the Fed be democratically accountable: "No one in a democracy, unelected, should have $800bn to dispense as he sees fit." Now that the Fed is allocating and targeting resources as well as controlling money supply, Mr Frank has a point. Since he is arguing for changing horses mid-stream, though, it will not get much of a hearing.

Republicans may suffer damage not because their remedies are worse but because a lot of their ideology about how markets work has been belied by events. Republicans are the party of rewarding people for risk-taking. If the government covers part of the losses, then the risks were illusory in the first place. (So, of course, were some of the rewards. A good percentage of the proceeds from the controversial Bush tax cuts was surely poured into this black hole of speculation and unknowability.)

President George W.?Bush, Fed chairman Ben Bernanke and treasury secretary Hank Paulson all declare their preference for free-market solutions and a desire to minimise moral hazard. But they sound like François Mitterrand in mid-1983 when he abandoned his socialist programme commun in the face of capital flight and a collapsing franc, all the while proclaiming his devotion to socialism.

Panicked actions speak louder than words - and have more lasting consequences. The financial era that started a quarter-century ago is drawing to a close. Since the instruments that permitted an extraordinary leveraging of assets have been discredited without really being understood, leverage itself will be regulated against. Once that happens, there simply will not be the profitability in investment banking to enable hundreds of well-connected Ivy League kids of middling talents to become multi-millionaires every year.

By the time the situation calms and memories fade, there is unlikely to be enough capital in the economy to fund a restoration. Right now, the oldest baby boomers are 63. The ratio of earners to dependents has been at an all-time high. A vast earner generation is about to begin its transformation into a dependent generation. Probably a more dependent one than anticipated.

Author: Christopher Caldwell

Source: The Financial Express