The Economy Part 1: It was the EU, in the library, with the candle stick.

Right now we are all feeling the pinch of the recession, not least the good people of Norwich North for whom negative equity is a reality. In this series of posts we will attempt to shed some light on how we got here and what we would do differently.

It doesn't take a genius to work out that if you lend out more money that you actually have, you're going to get into trouble. Generally, we're fine with people doing this. Actions have consequences. If bad businesses fail, good ones emerge in their place.

However the banking system is the lead domino in a chain and last year there was a justifiable fear that the collapse of one could have resulted in a cascade failure taking out the whole system on which our families and businesses depend. Generally speaking Libertarians do not approve of bailouts but in this instance the consequences of a wholesale overnight collapse were far too grave to consider or comprehend. Had the banking system collapsed it would have been a spectacular failure of government with unfathomable consequences. We were therefore in the uncomfortable position of using public money to prop up a failed system.

Some libertarians, particularly American, would flat out argue that the banks should have been allowed to fail. To me this is an absurd proposition. We were always in for a major crash and when so much depends on banking, any response would have had to be geared toward deflating the bubble at a manageable pace. A revaluation and downscaling of economic activity was inevitable but had we allowed it to happen overnight it would likely have been beyond our ability to manage. Shock therapy would have ruined many whose only crime was to be in debt.

The decision to intervene, therefore, was not a happy one, but it was the least worst option available. Though we may prefer to hold true to our principles, pragmatism dictates that we play the hand we are dealt. That being said, it is the breaking with free market principles that has brought us to this place to begin with.

Libertarians recognise the necessity for debt. It is an essential function of business. We also appreciate the necessity to take risks. However what we have seen in recent years is a gradual manipulation of the banking system to achieve political ends. This is not only a UK problem. It is global. What we have seen is not a failure of capitalism but a failure of regulation and the culmination of a series of politically motivated, populist interventions with socialist intent.

In the United States this began with the Community Reinvestment Act which essentially placed a government guarantee on all sub-prime mortgages so as to ensure minorities were given an the opportunity of home ownership. In other words, the natural equilibrium had been removed by government whereby risk was mitigated and the banks were given a licence to print money.

The second major component in our downfall was the CDO problem. This link explains it far better than I ever could. This then created a global contagion whereby banks and investment brokers had no idea what they were buying and subsequently banks asset portfolios became significantly overvalued. This is where much of the blame has been placed for our current predicament because it allows governments to blame the banks, but to my mind this demonstrates the ability of the private sector to innovate in designing rapid systems to dispose of "assets" they would not have had were it not for government intervention. But governments can't let that get in the way of a handy scapegoat.

In the classic tradition of government creating a problem and then attempting to resolve it with yet more intervention, rules were placed upon the banking system dictating the amounts they were allowed to lend. Rules at the time, implemented by the EU based on the Basel2 banking conventions (used also by the US), dictated that banks could only lend up to their actual asset value. But the rules stipulated their asset valuation could only be calculated based on their market value at the time. The infamous Mark to Market rules. Subsequently the banks found in the wake of the CDO induced panic that their assets were all of a sudden worthless and were unable to lend to each other, creating what we now know as the credit crunch. Subsequently house prices had to adjust to meet the amounts of money house buyers were able to obtain.

The the problem with Mark to Market is that it assumes that because the markets value asset bundles as worthless that they are without intrinsic worth. This is wrong. If an asset bundle is worth £50,000 on the market and there's 50,000 mortgages in it, it does not stand to reason that the valuation is accurate. There is no way anyone would value a house at £1. A simple rule change to Mark to Model whereby a more accurate system of valuation is used would have meant the asset value was more realistic and the bailouts would have been a fraction of what they were.

So why not just change to rules? Well, why not just abolish the Common Agricultural Policy? Because we have to get the agreement of 27 other countries. Successive attempts to reform it have failed for this reason. Banking is the same, for the FSA is not wholly a British institution. As ever it bears all the hallmarks of EU "subsidiarity" whereby we can create all the legislative bodies we like so long as they enact EU directives.

So why is the UK biting the turd sandwich harder than the United States? Well if you recall the first bailout bill was defeated by congress and passed the second time only on the proviso that the rules were reformed. Our parliament had no such luxury. In fact our own parliament was not even consulted. Mr Brown went off to Europe to get his marching orders.

But that is not to say this is all the EU's fault. Like the US, we implemented our own policies to encourage bad lending, not least to give the illusion of economic growth when in fact we were creating a debt bubble. We will examine this more in part two.

There are also wider agendas at work. Today we learn from The Daily Telegraph that "The Government has unveiled plans to give new powers to regulators to curb bankers' pay and clamp down on risky lending in the wake of the worst financial crisis in decades." And in so doing they show their true colours. It has used a crisis it created to award itself more control and more power to set wages and prices. Last month we had the announcement from the FSA that it was banning commission on the sale of retail financial products. This in itself will wipe out a whole industry to serve a populist agenda.

To conclude part one, it is our view that government creates more problems than it solves and the bigger the government, the less capable it is of responding to problems. So we would withdraw from the EU and ensure any regulatory body would be a single authority answerable to our own government and our government alone. We would resist the urge to meddle in affairs of markets and allow the natural elements of risk and loss to be the main regulator.

It is also our view that we are fatally weakened by a debt based society. We would therefore remove the various safety nets in our society which allow people to think that saving, fiscal prudence and personal responsibility are secondary to their own instant gratification. We will examine these issues in part two.