Jul

5

The biggest political story today is the global ascendancy of state economic power and the fading of the free market as the world's big economic idea. Even here in New York City, former center of the financial universe, the subprime mess has supposedly discredited the philosophy that less regulation is better. This is all rot; the anti-free market trend will mainly serve, as it always has, to help ambitious would-be power-wielders to reach their career goals. Lack of regulation didn't do the financial system in. Plenty of blame has to go to the regulators themselves. A series of power grabs and subsequent attempts to control unintended consequences led to even more unintended consequences, until the threads were too tangled to follow.

Begin, for the sake of beginning somewhere, with Greenspan's attempts to be a hero for all seasons by turning the spigot off and on, again and again, and proceed to the subsequent heavyhanded attempts to eliminate all risk from pension fund portfolios after the Nasdaq crash and earnings fraud at Enron/WorldCom. Pension funds couldn't invest in stocks the way they had been doing — too risky! What could they do to meet their payout obligations? Wall Street had a wonderful new invention –top-rated mortgage and asset-backed securities. Unfortunately, they weren't exactly risk-free. Was lack of regulation the problem? No. And neither was the desire to get rich. The problem is that the bright minds of Wall Street can come up with contorted solutions when they have to satisfy their customers while dealing with regulations designed to eliminate risk. Unfortunately the whole debacle may become the excuse for a massive power shift to the federal government. Larry Summers had a piece in the FT last week calling for the government to save the economy with infrastructure spending. Sure, let's get the Army Corps of Engineers back to work redesigning natural waterways so they never work properly again. Back in the '80s, Reagan was attacked for his supposed simplemindedness, but in the '90s, his basic ideas had become the consensus. So much that as VP, Al Gore's main hobbyhorse was cost-cutting. Nowadays, it's hip in Manhattan to trash the free market. Our leadership abdication comes at a bad time, because the money nowadays is in the hands of people who care nothing for economic freedom. Nobody is aspiring to avoid the Road to Serfdom. China's free market is largely an illusion; prices for commodities are set by the government, not the market, the currency is still not freely convertible, the government still has a tight grip on far too much. The aspiring Mideast financial centers are being thrown up with royal-family money and control. Russia–
let's not even go there; the replacement of democratic aspirations with a systemic corruption is too sad to contemplate. Fortunately nobody can block people who want to be free forever. But there is no political freedom without economic freedom. Those pseudo-Socialist Realist posters of Obama that look like Che give me the shivers.

I am indebted to the brilliant Louis-Vincent Gave for some of the ideas set forth here, but any errors, misunderstandings or misapplications are mine alone.

Stefan Jovanovich replies:

Laurel should take heart. My niece, who hopes to join the regulatory clerisy by becoming a member of the California Bar, has just publicly declared Obama the savior. She has been infallibly wrong about American politics for almost two decades now, and the more emphatic she is (Bilbray doesn't stand a chance was her last vocal pronouncement) the more reason there is to take the other side of the trade. Money chases freedom; that is why it has been flowing west in this country for nearly two centuries. What has changed in California in the past two decades is that the desire for economic regulation has overcome the "Don't Tread on Me" spirit that allowed us to be the world's greatest collection of fruits and nuts. But, that is also changing. The Democratic candidates lining up to replace the Governator (who is term limited out in 2010) make lots of noises about how terrible things are, but they are careful to limit their tax-raising rhetoric to "closing loopholes". None has said a word about tax rate increases. Gavin Newsome, San Francisco's mayor, revived gay marriage as an issue after the California Supreme Court rewrote our State's constitution because it is a safe issue for the Democratic primary and not one that arouses any great passion among Independent voters. It also avoids the question of where the bureaucracy is going to get the money. The voters have already made it clear that the answer will not be from new taxes, even on the rich. The Sons and Daughters of Liberty are still alive and kicking and asking for lower tax assessments on their real estate.

George $oros wrote:

Because financial markets do not tend towards equilibrium they cannot be left to their own devices. Periodic crises bring forth regulatory reforms.  That is how central banking and the regulation of financial markets have evolved. […T]he reflexive interplay between financial markets and the financial authorities is an ongoing process. The important thing to realize is that both market participants and financial authorities act on the basis of imperfect understanding; that is what makes the interaction between them reflexive. […]

[Some people] blame market failures on the fallibility of the regulators and they are half right: both markets and regulators are fallible. […] The fact that regulators are fallible does not prove that markets are perfect.  It merely justifies reexamining and improving the market environment.


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7 Comments so far

  1. Michael F. Martin on July 5, 2008 5:44 pm

    The Larry Summers piece was indeed puzzling, arriving as it did after an earlier op-ed on “Regulatory Systems Theory,” which wouldn’t have offended Hayek or Friedman nearly as much. Perhaps he felt a need to appease some of his political colleagues?

    In general, I find this argument too pessimistic. The unintended consequences of central planning are still the same problem as ever; but it’s easier than ever to show a causal connection between paternalistic regulation and bad consequences. We really don’t have a choice anymore between paternalism and free-markets; free-markets are all that can persist in a globalized economy.

  2. master of none on July 5, 2008 7:26 pm

    Brilliant insights indeed. We can see from these comments on March ‘07 why paid research is worthwhile.

    http://www.dailyspeculations.com/wordpress/?p=1104

    “And interestingly, yesterday, we saw a number of stories in the financial press about how exaggerated the subprime mortgage story has been (for an example, see this article in Forbes). In addition, Lehman Brothers, the second biggest US underwriter of mortgage-backed bonds, came out and stated that the risks posed by rising home-loan delinquencies are “well-contained,” and that they will have little effect on the firm’s earnings.”

  3. Dan Costin on July 6, 2008 6:18 am

    Lower taxes are great! I want lower taxes! I also want a lower payment on my mortgage! Wait, what, I can get a lower payment? Option-arm? Negative amortizing? Sounds cool. Amazing what you can do with financial technology. OK, so you’re saying I can have more debt, and have lower payments (taxes/monthly payment). Nice, but why are you calling me subprime all of a sudden?

    California — The Subprime State

    Stefan, your niece has been wrong for two decades about political elections — how are we doing? Happy about where the economy is, where the moral center of the country is, what the values we project onto the world are? Imagine the reverse world, where you could go overseas and can say you’re American without the string of excuses and “but I don’t believe in…” afterwards. Following her voting pattern may get us to your goals faster.

    Laurel, I think pretty much everyone on this site is with you on the issue of regulation, no argument there. But just as the ultimate investor can make money when the markets are going up, going down, or going sideways, why not think of regulation as another variable in the global markets? Sure, China is not a true market-player. That should raise huge market arbitrage that can be explored. The last RMBS bailout (savings and loan debacle) made a lot of people rich — it would be an interesting list to see the Greenwich water-side properties that changed hands at a fraction of their previous price then (and how many will in the upcoming bailout).

    As traders who firmly believe in the value of the markets, any inefficiencies created by excess regulation should be more than welcome. All we need are the tools to explore these effectively.

  4. Lon Evans on July 6, 2008 7:07 am

    Ummmm . . . Ms. Kenner . . . ,

    Oh, never mind . . .

    lon

  5. Ronald Weber on July 6, 2008 1:33 pm

    I agree with you Laurel, I sense this negative talk on free markets around me and I think it is a dangerous path. We forget that free markets deficiencies led to radical political backlashes in Europe and Japan in the 1930’s and none of us wish that scenario again. I believe that free markets at their worst are still better than the other alternatives at their best. Someone getting a mortgage and defaulting on it is a better alternative than no mortgage market at all.

    A well functioning bureaucracy and property rights system where any individual can register a corporation in a few days instead of a few months or years and where you can claim your rights in court within a decent amount of time is well worth defending.

    Regarding the recent CDO mess I can only observe that free markets are the most efficient systems to uncover scams or other false promises than a state regime that could hide it forever. Markets did not punish much the ones who sold these products as it rather went after the ones who bought them and the ones who believed the stories of the ones who bought them (still with me?). Witness the former UBS fortress or the Enron scam! State pension funds were also caught as buyers of CDOs and don’t seem to be better at making sound investment decisions. Most large ivnestments decisions of Asian SWFs (Blackstone, UBS, Citi) also turned out to be flops!

  6. Joe Calhoun on July 10, 2008 5:26 pm

    The problem with blaming free markets for the problems that face the US economy is that we haven't had a free market for some time. In an interview recently George Soros blamed Ronald Reagan for advancing the idea that markets are self correcting. To prove his point, he detailed all the ways the government had intervened over the ensuing years (S&L crisis, LTCM, etc.) and then said see, markets aren't self correcting, the government intervened. I guess it never occurred to him that the government interventsions were the source of our current problems and that if markets had been allowed to work, we wouldn't be in the mess we're in now.

    The monetary manipulation of the Fed, esepecially during the Greenspan years, was anything but a free market. His distortions of the money market created incentives for smart operators to find new and inventive ways to turn those distortions to their advantage. They were merely responding to the incentives placed before them by the Fed.

    The source of most of these problems, in my opinion, is the monetary inflation created by the Fed to anesthetize the public to the pain of a self correcting free market. It isn't free market capitalism that has failed; it is government intervention in the market that has failed. Unfotunately, most of the public believes we live in a free market, capitalist society and therefore any problems should be blamed on the market. Nothing could be further from the truth.

  7. gabe on July 14, 2008 9:45 pm

    http://www.telegraph.co.uk/portal/main.jhtml?xml=/portal/2008/07/12/sm_china12.xml this 4-part journey will prove useful to balance the conclusions. is very well done.

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