In contrast, many Austrian economists reject both forms of intervention. They argue that the free market would respond in the most efficient manner possible after a major disruption (such as the 1929 stock market crash or the housing bubble in our own times). As we shall see, the U.S. experience during the 1920–1921 depression—one that the reader has probably never heard of—is almost a laboratory experiment showcasing the flaws of both the Keynesian and monetarist prescriptions.

The 1929–1933 Great Contraction

Despite what many readers undoubtedly “learned” in their history classes as children, Herbert Hoover behaved like a textbook Keynesian following the 1929 stock market crash. In conjunction with Treasury Secretary Andrew Mellon, Hoover achieved an across-the-board one percentage point reduction in income tax rates applicable to the 1929 tax year.

Hoover didn’t stop with tax cuts to bolster “aggregate demand”—though analysts at that time would not have used the term. He also signed into law massive increases in the federal budget, with fiscal year (FY) 1932 spending rising 42 percent above 1930 levels. Hoover ran unprecedented peacetime deficits, which stood in sharp contrast to his predecessor Calvin Coolidge, who had run a budget surplus every year of his presidency. In fact, in the 1932 election FDR campaigned on a balanced budget and excoriated the reckless spending record of the Republican incumbent.

It wasn’t merely that Hoover spent a bunch of money. He spent it on just the types of things that we associate today with Roosevelt’s New Deal. For example, he signed off on numerous public-works projects, including the Hoover Dam. Of particular relevance today is the Reconstruction Finance Corporation (RFC) established under Hoover, which quickly injected more than $1 billion to prop up troubled banks that had made bad loans during the boom years of the late 1920s—and this was when $1 billion really meant something.

It is true that Hoover eventually blinked and raised taxes in 1932, in an effort to reduce the federal budget deficit. Today’s Keynesians point to this move as proof that reducing deficits is a bad idea in the middle of a depression. Yet an equally valid interpretation is that it’s horrible to hike tax rates in the middle of an economic disaster. After the bold tax cuts pushed through by Andrew Mellon in the 1920s, the top marginal income-tax rate in 1932 stood at 25 percent. The next year, because of Hoover’s desire to close the budget hole, the top income tax rate was 63 percent. Given this extraordinary single-year rate hike, it is no wonder that 1933 was the single worst year in U.S. economic history. (For what it’s worth, the FY 1933 budget deficit was still huge, coming in at 4.5 percent of GDP. Despite the huge rate hikes, federal tax revenues only increased 3.8 percent from FY 1932 to FY 1933.)

So we see that the standard Keynesian story, which paints Herbert Hoover as a do-nothing liquidationist, is completely false. Yet Milton Friedman’s explanation for the Great Depression is almost as dubious. Following the stock market crash, the New York Federal Reserve Bank immediately slashed its discount rate—how much it charged on loans—in an attempt to provide relief to the beleaguered financial system. The New York Fed continued to slash its discount rate over the next two years, pushing it down to 1.5 percent by May 1931. At that time, this was the lowest discount rate the New York Fed had ever charged since the establishment of the Federal Reserve System in 1913.

It wasn’t merely that the Fed (along with other central banks around the world) was charging an unusually low rate on loans it advanced from its discount window. The entire mentality of central bankers was different during the early years of the Great Depression. Writing in 1934, Lionel Robbins first noted that during previous crises, the solution had been for central banks to charge a high discount rate to separate the wheat from the chaff. Those firms that were truly solvent but illiquid would be willing to pay the high interest rates on central-bank loans to get them through the storm. Firms that were simply insolvent, on the other hand, would know the jig was up because they couldn’t afford the high rates. Yet this tough love was not administered after the 1929 crash, as Robbins explained: “In the present depression we have changed all that. We eschew the sharp purge. We prefer the lingering disease. Everywhere, in the money market, in the commodity markets and in the broad field of company finance and public indebtedness, the efforts of Central Banks and Governments have been directed to propping up bad business positions.”

We therefore see an eerie pattern. When it came to both fiscal and monetary policy during the early 1930s, the governments and central banks implemented the same strategies that the sophisticated experts recommend today for our present crisis. Of course, today’s Keynesians and monetarists have a ready retort: They will tell us that their prescribed medicines (deficits and monetary injections, respectively) were not administered in large enough doses. It was the timidity of Hoover’s deficits (for the Keynesians) or the Fed’s injections of liquidity (for the monetarists) that caused the Great Depression.

The 1920–1921 Depression

This context highlights the importance of the 1920–1921 depression. Here the government and Fed did the exact opposite of what the experts now recommend. We have just about the closest thing to a controlled experiment in macroeconomics that one could desire. To repeat, it’s not that the government boosted the budget at a slower rate, or that the Fed provided a tad less liquidity. On the contrary, the government slashed its budget tremendously, and the Fed hiked rates to record highs. We thus have a fairly clear-cut experiment to test the efficacy of the Keynesian and monetarist remedies.

At the conclusion of World War I, U.S. officials found themselves in a bleak position. The federal debt had exploded because of wartime expenditures, and annual consumer price inflation rates had jumped well above 20 percent by the end of the war.

To restore fiscal and price sanity, the authorities implemented what today strikes us as incredibly “merciless” policies. From FY 1919 to 1920, federal spending was slashed from $18.5 billion to $6.4 billion—a 65 percent reduction in one year. The budget was pushed down the next two years as well, to $3.3 billion in FY 1922.

On the monetary side, the New York Fed raised its discount rate to a record high 7 percent by June 1920. Now the reader might think that this nominal rate was actually “looser” than the 1.5 percent discount rate charged in 1931 because of the changes in inflation rates. But on the contrary, the price deflation of the 1920–1921 depression was more severe. From its peak in June 1920 the Consumer Price Index fell 15.8 percent over the next 12 months. In contrast, year-over-year price deflation never even reached 11 percent at any point during the Great Depression. Whether we look at nominal interest rates or “real” (inflation-adjusted) interest rates, the Fed was very “tight” during the 1920–1921 depression and very “loose” during the onset of the Great Depression.

Now some modern economists will point out that our story leaves out an important element. Even though the Fed slashed its discount rate to record lows during the onset of the Great Depression, the total stock of money held by the public collapsed by roughly a third from 1929 to 1933. This is why Milton Friedman blamed the Fed for not doing enough to avert the Great Depression. By flooding the banking system with newly created reserves (part of the “monetary base”), the Fed could have offset the massive cash withdrawals of the panicked public and kept the overall money stock constant.

But even this nuanced argument fails to demonstrate why the 1929–1933 downturn should have been more severe than the 1920–1921 depression. The collapse in the monetary base (directly controlled by the Fed) during 1920–1921 was the largest in U.S. history, and it dwarfed the fall during the early Hoover years. So we hit the same problem: The standard monetarist explanation for the Great Depression applies all the more so to the 1920–1921 depression.

The Results

If the Keynesians are right about the Great Depression, then the depression of 1920–1921 should have been far worse. The same holds for the monetarists; things should have been awful in the 1920s if their theory of the 1930s is correct.

To be sure, the 1920–1921 depression was painful. The unemployment rate peaked at 11.7 percent in 1921. But it had dropped to 6.7 percent by the following year, and was down to 2.4 percent by 1923. After the depression the United States proceeded to enjoy the “Roaring Twenties,” arguably the most prosperous decade in the country’s history. Some of this prosperity was illusory—itself the result of subsequent Fed inflation—but nonetheless the 1920–1921 depression “purged the rottenness out of the system” and provided a solid framework for sustainable growth.

As we know, things turned out decidedly differently in the 1930s. Despite the easy fiscal and monetary policies of the Hoover administration and the Federal Reserve—which today’s experts say are necessary to avoid the “mistakes of the Great Depression”—the unemployment rate kept going higher and higher, averaging an astounding 25 percent in 1933. And of course, after the “great contraction” the U.S. proceeded to stagnate in the Great Depression of the 1930s, which was easily the least prosperous decade in the country’s history.

The conclusion seems obvious to anyone whose mind is not firmly locked into the Keynesian or monetarist framework: The free market works. Even in the face of massive shocks requiring large structural adjustments, the best thing the government can do is cut its own budget and return more resources to the private sector. For its part, the Federal Reserve doesn’t help matters by flooding the shell-shocked credit markets with green pieces of paper. Prices can adjust to clear labor and other markets soon enough, in light of the new fundamentals, if only the politicians and central bankers would get out of the way.

Related posts:

1. The Great Depression According to Milton Friedman
2. The Great Depression and World War II
3. The Great Depression

“Unlike all other property paper,” de Soto writes, “derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them.”

Hence: “Government’s main duty now is to bring the whole toxic environment under the rule of law where it will be subject to enforcement.”

I largely agree with de Soto’s diagnosis of the problem, but not his solution. When I worked in the financial sector in early 2007, my boss said his associates in New York were getting nervous because nobody knew how much leverage their trading partners had. It was thus pointless to run the standard “value at risk” and other calculations they teach finance grads, because no individual participant—even a large hedge fund or investment bank—could see the big picture in deals involving complex derivatives. Indeed, after everything blew up, I talked to one credit analyst at an insurance company who said, “Have you ever actually tried to read one of these credit default swap contracts? Nobody really knew what they did.”

Free Markets Don’t Mean Omniscient Entrepreneurs

I bring up these anecdotes to bolster my view that the market critics are probably (at least partially) correct to blame the financial bust on overextended firms that horribly miscalculated the risks they were assuming. I would be willing to go even further and say that innovative financial products that appeared to mitigate risk at the individual level might have paradoxically made the entire system more vulnerable.

But the market critics and de Soto go wrong in concluding that only governments can fix the problem. These advocates of increased regulation fail to realize that the case for the free market does not rely on omniscient entrepreneurs. Fans of the market should not be embarrassed to admit that sometimes even well-established companies screw up royally and lose billions of dollars.

Or at least, that’s what would happen in a true profit-and-loss system. The self-regulation of the market only works when profits and losses are allowed. When trying to make sense of why so many large firms were so careless with their investments, we can’t ignore the perverse incentives the government had created in a multitude of ways.

For example, the ratings agencies didn’t need to worry that they would be ruined if their AAA ratings on mortgage-backed securities turned out to be absurd. If any private-sector actors can be directly blamed for the financial debacle, it would be S&P, Moody’s, and Fitch. Yet these rating agencies are still in business because government regulations require banks and other institutional investors to hold bonds and other securities with a certain rating, and (of course) the regulations cartelize the rating industry. Specifically, SEC regulations require that institutions receive their (legally mandated) ratings from a “nationally recognized statistical rating organization” (NRSRO). But lo and behold, it is very difficult for any outsiders to attain this exalted NRSRO status. Since the big three agencies have a guaranteed demand for their services, is it any wonder that they were careless in granting the desired ratings to the complex securities being pushed by their big clients during the boom years? And let’s not forget the government-induced shaky mortgages at the foundation of those derivatives.

The fundamental problem with de Soto’s analysis is that he thinks politicians and bureaucrats can be trusted to improve financial transparency. This is the height of naiveté. Has de Soto flipped through the U.S. tax code recently? Doesn’t he realize that seemingly every week Treasury Secretary Geithner announces another convoluted plan to use tax dollars to encourage leveraged investment in precisely these “toxic” assets?

Markets Produce Laws

Apparently, de Soto thinks the virtue of Western governments over the centuries has been to create an orderly body of laws within which the free market can flourish. I would argue that it was the relative impotence of Western governments that allowed a market-driven law to emerge, which these governments then codified.

Economists such as Bruce Benson, David Friedman, and Edward Stringham have thoroughly documented the spontaneous development of legal customs and financial rules without any enforcement from the state. The entire body of English common law, too, was not centrally designed by legislatures, but instead emerged out of myriad individual rulings given by judges, as did the Law Merchant, the early modern global commercial law. 

Had the government minded its own business, the private financial sector would have learned from its mistakes during the housing boom. There is no reason to suppose that Geithner or anyone else employed by the government can come up with a solution that private analysts couldn’t discover. Quite the contrary. In fact, every move the government has taken during the crisis has expanded its power over the private sector and its ability to shower literally trillions of dollars on powerful beneficiaries. Doesn’t de Soto see the immense scope for corruption if the government gains more discretionary power over financial transactions?

Ironically, it is the government’s response to the initial crisis that has led to less transparency not more. Had the troubled firms been allowed to fail, bankruptcy proceedings would have ascertained which companies were holding which assets and how they should be valued. But at least since December 2007, the Federal Reserve has artificially propped up insolvent firms by accepting their “toxic” assets as collateral on short-term loans. In this environment, of course the most leveraged firms will string their investors along and carry derivatives on their books at inflated values.

Regardless of what caused the crisis, government efforts to regulate derivatives will only lock in undesirable aspects of the current market and ensure that politically connected players reap artificial gains. It is absurd to ask politicians to promote financial integrity and sound accounting. They are the worst violators of these principles on the planet.

Related posts:

1. Did Deregulated Derivatives Cause the Financial Crisis?
2. The Subprime Crisis Shows that Government Intervenes Too Little in Financial Markets? It Just Aint So!
3. Free-Marketeers Should Welcome Regulation?

Officer and Hayes admit up front that oil speculators aren’t the ones manipulating oil prices. Rather, they blame the oil producers for rigging the market, allegedly through the use of futures contracts:

The price of oil reported in the news is actually the price of oil in the futures market. In this market, traders do not exchange physical barrels of oil, but instead trade contracts which obligate them to exchange oil at a quoted price at a specific date in the future. . . . Such a contract allows companies to hedge positions by locking in prices early. . . . It’s all about reducing risk and uncertainty. But what if oil suppliers were instead buying oil futures, compounding their own risk and reaping enormous profits from the explosion in the price of physical oil?

An interesting possibility, to be sure, except for one nagging problem: If an oil producer is buying a futures contract from himself, that is equivalent to taking future supply off the market. To use a simplistic example, suppose a major producer estimates that he can sell 100,000 barrels of January 2010 oil at $90 per barrel or raise the price to $100 per barrel if he restricts his output to 75,000 barrels. The authors want to argue that he has a third option: “selling” 100,000 future barrels at $100, holding the price up himself by entering the futures market and snatching up those excess 25,000 barrels of January 2010 oil.

But in this third approach the producer is still extracting the same deal from his actual customers: They are giving him $100 each for 75,000 barrels of January 2010 oil. Since the producer himself bought the other 25,000 barrels, it is rather irrelevant that he received a high price for them; he can “pay himself” $100 a piece, if it makes him feel rich, but that still leaves him just as wealthy—and with just as much oil—as if he had simply cut his January 2010 output to 75,000 barrels. The existence of the futures market doesn’t give our producer any more ability to gouge his customers than his ownership of the oil in the first place gives him.

Final Consumers Have the Final Word

There is no getting around this basic fact, try as the authors might to bring up subtleties of the futures market.

They argue, for example, that only “Hedge funds, oil companies, OPEC—the very people who profit from massive, consistent increases in prices,” have access to the futures market. From this they conclude that, “we as oil consumers don’t set the prices.”

That’s simply untrue. Hedge funds can’t force refiners to buy more oil than they want to at a given price. If the “fair” price of oil, as determined by the “fundamentals” of supply and demand, is $80 per barrel, but the greedy hedge funds and OPEC buy up futures contracts and push the price up to $120 per barrel, then there will be a glut. That is, more physical barrels of oil will come to market than the actual end users will purchase. Oil inventories would grow larger every day, as producers kept pumping more oil than consumers burned.

Incidentally, this outcome is certainly possible. For example, if a group of rich speculators foresaw an imminent attack on Iran, they could rush to buy up oil futures. This would push up the futures price, which would lead producers to lower current output and devote more of their finite supply to the future (where the new demand was). The reduction in current supply would drive up the spot price, forcing consumers to economize on oil in the present.

Maybe High Prices Aren’t Such a Bad Thing

Let’s carry this scenario just a bit further. Suppose the speculators were really convinced that war with Iran would happen within a few months and that the price of oil at that time would skyrocket to $200 per barrel. Then the speculators would continue buying futures contracts, so long as the futures price were below $200. Oil producers would be overjoyed at this incredible demand, and would gladly sell more and more futures contracts. At some point, the producers would realize that they had promised as many barrels in future months as they could physically pump. Then it would become profitable to pump oil in the interim and physically warehouse it.

Thus the speculators’ actions would a) drive up the spot price of oil to cause consumers to restrict their use of oil in the present, and b) induce stockpiling of oil. Notice that these effects are exactly what we want to happen. If the speculators were right and war broke out, the spot price would not jump as sharply because it would have been pushed up already. The larger stockpiles of physical oil would help ease the crunch when Iran stopped exporting.

Pumping Out Evidence to the Contrary

To return to the Time article, the authors have spelled out a mechanism through which rich institutions could push up the price of oil. But they haven’t followed out the implications of their thesis and checked to see whether this was actually happening. Unfortunately for their claim, oil inventories have been fairly constant over the last several years, and—most damning of all—world oil production increased from 2007 through 2008, exactly the period when prices skyrocketed. (See my article “Oil Speculators: Bad or Good?” for more details.)

To repeat: Consumers still decide how many barrels they want to buy at a given price. If outside parties push up the price (and they can, if they are willing to risk enough money), then consumers will buy fewer barrels. Therefore, if the high price of oil were due to manipulation, we would observe either a restriction in output and/or accumulating inventories. We see neither.

In reality, all prices are determined by supply and demand, properly defined. Outside investors with lots of money can certainly influence prices, but there are always risks. Funds that had large “long” bets on commodities took a bath as oil fell from its July 2008 high of $145 down to well below $50 a few months later. Futures markets allow producers and consumers to hedge against needless risk by locking in prices, and they allow speculators with superior foresight to improve the allocation of resources over time. Our Time authors think they’ve shown that the oil market is rigged, but it just ain’t so!

Related posts:

1. Rising Oil Prices Create Inflation? It Just Ain’t So!
2. Whom Should We Thank for High Gas Prices?
3. High Gasoline Prices Are Your Fault? It Just Aint So!

How wrong I was. By the time of this writing, the mainstream press had delivered the “consensus” judgment that blind faith in the free market fostered the housing bubble. Jacob Weisberg’s Slate column, “The End of Libertarianism,” sums up this official verdict: “We have narrowly avoided a global depression and are mercifully pointed toward merely the worst recession in a long while. This is thanks to a global economic meltdown made possible by libertarian ideas. . . . [A]ny competent forensic work has to put the libertarian theory of self-regulating financial markets at the scene of the crime.”

Just to make sure that the free market got the blame for the financial meltdown, Alan Greenspan himself testified to Congress that he had been “shocked” that self-interest (in the absence of paternalistic regulation) did not compel financial institutions to adopt adequate risk controls. Greenspan—viewed by the average pundit as a staunch libertarian—went so far as to say that he “found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”

I will argue that government interventions, not laissez faire, caused the housing bubble and the ensuing financial crisis. In addition to describing some of the general factors involved, we will focus specifically on the blame attributed to the “unregulated” market for credit default swaps.

Despite their confident judgments of guilt, critics such as Jacob Weisberg point to very few specific regulatory changes that (allegedly) fostered the housing boom and the related vulnerability of so many financial institutions to the ensuing crash in home prices. The only two concrete examples I have seen are the gradual repeal of Glass-Steagall throughout the 1990s and the Commodity Futures Modernization Act in 2000. To his credit, Weisberg candidly admits that he can’t point to a smoking gun: “[N]eglecting to prevent the crash of ’08 was a sin of omission—less the result of deregulation per se than of disbelief in financial regulation as a legitimate mechanism.”

Generally speaking, Weisberg and others accuse Alan Greenspan, Phil Gramm (former chairman of the Senate Banking Committee), and SEC chairman Christopher Cox of willfully ignoring, for ideological reasons, warnings about the growing market in credit derivatives.

At this point, we note that even if this were the whole story, it wouldn’t necessarily prove that these men (and other policy makers) were mistaken in their actions. Two exaggerated analogies will illustrate the point: Suppose an environmentalist group had lobbied for the government to ban all new house construction starting in 2002, or suppose a Marxist organization had lobbied for the nationalization of all real estate in 2002. Either of these moves, in retrospect, probably would have averted the housing bubble and its related consequences. But surely that doesn’t mean government officials back in 2002 would have been wrong to reject these proposals.

By the same token, Greenspan and others had valid reasons for resisting new regulations on the evolving markets in derivatives. As we will explain below, these complex assets can promote efficiency through risk transference. In other words, the world economy grew faster than it otherwise would have because of the proliferation of derivatives. So even if Weisberg and others are right, and the financial crisis is the fault of unregulated derivatives, it is still an empirical question whether avoiding the housing boom and bust would have been worth more than the extra consumption made possible all over the world from the market-driven growth in derivatives.

Government Mistakes: Sins of Commission

In contrast to the vague declaration that “someone should have done something!” offered by the critics of the Invisible Hand, proponents of the free market can point to specific government interventions that fostered the excesses of the housing boom. Most obvious is Greenspan’s handling of the Fed funds target rate and the growth of the monetary base following the dot-com crash. Greenspan’s easy-money policy coincided with the upswing in the housing boom. When the Fed began raising rates, housing prices tapered off and then began plunging. The connection between Fed policy and the housing bubble is so obvious that even mainstream analysts endorse the theory.

Other possible culprits include the Community Reinvestment Act (CRA), a Carter-era measure that was strengthened in 1995 and used to pressure banks and thrifts that enjoyed deposit insurance into lending in all neighborhoods where they accepted deposits, including low-income, weak-credit areas. Many analysts have also placed at least some blame on the Federal Housing Administration as well as the government-sponsored enterprises Fannie Mae and Freddie Mac. Through explicit or implicit federal backing, these agencies were able to bolster the secondary market for mortgages and allow applicants who otherwise would not have qualified to obtain mortgages.

When cataloging government interventions that may have contributed to the housing boom, we should mention the existence of the Working Group on Financial Markets—also known as the “plunge protection team”—that was established in response to the 1987 stock-market crash, as well as belief in the “Greenspan put,” the Fed’s perceived promise to provide bank liquidity when needed. As we will see, the financial crisis of 2008 was largely the result of institutions failing to protect themselves from (what seemed to be) improbable but catastrophic scenarios. Even though writers such as Nassim Nicholas Taleb have been famously warning about “fat tails” or “black swan” events, investors could quite rationally have downplayed these warnings. “After all,” high-level managers could have reasoned in the midst of the housing boom, “in the event of an absolute meltdown, the federal government will swoop in to save us. They couldn’t possibly stand back and let the entire investment banking industry collapse.” The bailouts engineered by Paulson and Bernanke have vindicated this belief. In retrospect it is not obvious that firms such as Lehman Brothers and Bear Stearns behaved foolishly. If politicians tell a man playing roulette that he can keep all of his winnings but will only suffer 20 percent of his losses, is it really irrational for him to borrow large sums of money to wager on the game?

Credit Default Swaps

The poster child for the (alleged) failure of the deregulated financial sector is the market for credit default swaps (CDSs). These contracts are traded over the counter, so no one knows exactly how much exposure they contain, but estimates place the worldwide notional value of all CDSs in the neighborhood of $50 trillion at the end of 2007. It was largely because of its issuance of CDSs that the giant insurer AIG needed a government bailout. The AIG episode showed that the financial panic was not limited to firms that foolishly overinvested in mortgage-backed securities but also could spread to those companies that had issued credit default swaps on the bonds of these now at-risk firms.

Although in practice CDSs can be complex, the idea behind them is simple. The seller of a CDS agrees to compensate the buyer in the event of a “credit event,” such as GM’s defaulting on its bonds. In return, the buyer makes periodic payments to the seller. The obvious analogy is to an insurance contract, but the difference is that people can buy a CDS on GM bonds even if they don’t own GM bonds. It is as if someone bought fire insurance on his neighbor’s house.

One reason these contracts are structured as “swaps,” rather than standard insurance, is to evade the regulations governing traditional insurance products. For example, if AIG wanted to sell life insurance to a man in Florida, it would have to set aside reserves according to Florida law in order to make it more likely that AIG could fulfill the policy if the man died a week later. In contrast, if AIG sold a Florida man protection against a bond default by GM, then the government allowed AIG much more discretion in how it handled this new potential liability on its books.

It is easy to see why critics of pure free markets have such disdain for the credit-default-swap market. This seems to be a clear case where short-term greed led to reckless behavior, which would have been prevented by prudent government oversight.

Yet matters are not so simple. After all, the shareholders and creditors of AIG were presumably not complete idiots. Did they care less about protecting their wealth than politicians in D.C. did? Did they understand derivatives less well than government bureaucrats understood them? Looking at the matter from a different angle, why would the buyers of

CDSs simply assume that the counterparty would make good on the contracts if government regulations did not enforce the same safeguards applied to traditional insurance?

It turns out the Invisible Hand did lead everyone to seek safety. Although all the details are not yet available, as of this writing it appears that AIG’s risk models (primarily developed by academic consultant Gary Gorton) were not to blame for sinking the company. Rather, AIG was driven into the arms of the government because its large clients (such as Goldman Sachs) insisted on larger and larger amounts of collateral as the financial crisis continued.

Plagued by Illiquidity

In other words, Gorton’s models may still prove to be fairly accurate. AIG was not crippled by a string of unexpected credit events (and consequent payouts). What actually happened is that the holders of CDSs issued by AIG became scared about its ability to honor its contracts, and AIG could not continue to operate while satisfying all of the growing calls to put up more collateral against these outstanding time bombs. In short, AIG was plagued by illiquidity, not necessarily by insolvency. It is true that AIG executives failed to prepare adequately for this contingency, but it nonetheless removes some of the mystery behind its failure when we realize that AIG may very well have correctly assessed the risk of its positions—it just failed to predict correctly how its customers would assess this risk, in the midst of a global financial panic and also during a period when there was a “credit crunch” among large institutions.

The case of AIG also reinforces our earlier point about government intervention muting the potency of market incentives. It takes two to tango. The problem of AIG on the eve of its rescue was the fault not just of AIG’s managers and shareholders, but also of the counterparties who had bought billions of dollars worth of CDSs from the insurer. In a completely free market, these counterparties would be subject to the hazards of a potential AIG bankruptcy. In reality, however, huge firms such as Goldman Sachs could rely on the U.S. government to rescue them from their reckless exposure to AIG. In fact, the New York Times reports that Lloyd Blankfein, the current CEO of Goldman Sachs, was the only investment bank executive in the room when federal officials decided to rescue AIG—and this was mere hours after they had decided to let Lehman Brothers fail. (As for Goldman’s demands for more AIG collateral, even “too big to fail” companies exercise some caution—just not enough.)

People Make Mistakes in the Market

In situations such as the present crisis, there is a temptation for libertarian economists to look for specific government interventions that “caused” the problems. This is understandable, and indeed we have listed some of these factors. Yet we should also remember that failure is a normal part of the market process. Investors and entrepreneurs are not omniscient. Bankruptcies do not signal the inefficiency of the market any more than the overthrow of Newtonian physics proved the weakness of the scientific method—let alone that government should take charge of all scientific research.

In addition to the definite contributions of government policies, it is also true—and proponents of the free market should feel no shame in admitting—that many institutions were seduced by fancy mathematical finance models. Part of what happened is that the whiz kids from MIT and other top-flight programs made simplifying assumptions on the underlying probabilities of various events. For example, Moody’s might have rated a particular mortgage-backed security as extremely safe, since it was composed of thousands of small bits of mortgages spread all over the country. Before the housing crash, the conventional wisdom held that “real estate is local.” It was considered virtually impossible that all markets—from San Francisco to Las Vegas to Miami to Chicago—would experience a large spike in mortgage-default rates simultaneously. Nobody had ever seen such a correlated fall, so it seemed like a reasonable assumption. The models, based on this assumption, produced results confirming the safety of mortgage-backed securities.

When confronted with this reality many free-market thinkers want to blame a government policy. In the case of the ratings agencies, we do have some contenders. The most obvious example is that the dominant firms (Moody’s, Standard and Poor’s, Fitch) benefit from government regulations placed on banks and other institutions. If a bank or insurance company wants to invest in bonds the government insists that these bonds meet a certain level of safety. Of course, the bank can’t simply hire Joe the Bond Rater to slap “AAA” on them. The regulations insist that a reputable ratings agency meet certain criteria. In practice these rules ossify the ratings market, and partially protect Moody’s and the others from the repercussions they would have suffered after their disastrous evaluations of mortgage-backed securities during the housing boom.

But even if the critics were right and the present crisis was largely caused by faulty forecasts made in the private sector, it would not prove a crushing defeat for free markets. After all, there are plenty of examples of horrible business decisions made by private individuals. The Edsel and “New Coke” flops, Decca Records’ 1962 rejection of the Beatles because “guitar music is on the way out,” and the rejection by a dozen publishers of the initial Harry Potter manuscript are all examples of stupendous entrepreneurial error. Given the advantage of hindsight, it is easy enough for us to laugh at the businesspeople who made such boneheaded calls, and critics of the marketplace could easily enough infer that the free market can’t be trusted with the task of innovation.

However, the mere existence of entrepreneurial error is not an indictment of free markets. People can only achieve bold successes when they take risks. The virtue of the market is that it allows individuals the freedom to risk their own money—or that of investors whom they can convince to fund them voluntarily—reaping the rewards if they succeed and bearing the losses if they fail. There is no reason to suppose that government bureaucrats would have designed better models of risk assessment. Indeed, two Fed economists wrote a paper in 2005 claiming that there was no housing bubble!

What is truly ironic is that the government’s rescue efforts—supposedly made “necessary” by the “unregulated” market—only ensure that market discipline will be weaker. Not all major institutions were taken in by the derivatives hysteria during the housing boom. Warren Buffett famously warned his own investors in 2002 that derivatives were “financial weapons of mass destruction” that would at some point wreak unexpected havoc. The takeovers of AIG, Fannie, and Freddie, as well as the $700 billion bailout, reduce the relative strength of those firms that behaved more sensibly during the boom. If and when the next crisis occurs, it will be in part because the government has just shown that playing it safe and adopting a long-term perspective doesn’t pay in U.S. financial markets. It’s much more profitable to go for the risky yet lucrative payouts, and then run to the government if things turn sour.

Amidst the efforts to “control the narrative” and assign blame for the financial crisis, fans of the free market should not lose sight of the real benefits of derivatives. Futures contracts on oil, for example, allow producers and major consumers such as airlines to lock in guaranteed prices and confidently engage in long-term projects that would otherwise be too risky. Even the much-maligned credit default swap allows the transfer of risk in mutually beneficial trades. Especially in an uncertain financial environment, CDS contracts allow certain firms to raise cash more easily—because those lending them money can buy CDSs on their bonds—and the price of a particular CDS contract itself communicates information about the market’s view of the firm being insured. These benefits will all be seriously muted if the government stampedes in and imposes top-down regulations.

Despite the claims of their critics—and even of some of their fair-weather friends—unregulated markets are not to blame for the systematic mistakes of the housing boom. Yet even if private errors were the primary cause, it still would not follow that government bureaucrats would make wiser decisions in the future.

Related posts:

1. Government Must Keep Track of Derivatives?
2. The Fed Should Inflate to End the Financial Crisis? It Just Ain’t So!
3. The Subprime Crisis Shows that Government Intervenes Too Little in Financial Markets? It Just Aint So!

What is especially noteworthy is the process through which the American public has been desensitized to the explicit expansion of state power in eight short years. It is a virtue that humans adapt quickly to new environments, but this strength can be turned into a weakness by clever politicians.

The housing boom and bust was a product of interventionist monetary policy, namely Alan Greenspan’s decision to slash interest rates after the dot-com crash. The crash in real-estate prices has in turn led to large defaults on mortgage payments, inflicting billions in losses for investment banks and other large institutions that had bet heavily on mortgage-backed assets. The heavily regulated financial sector was vulnerable to these unexpected events. What should have been a large hit to real estate and a few institutional investors has now spread and is currently threatening the global financial system itself. (We should keep this episode in mind whenever someone claims that the free market is too unstable and requires wise government oversight to promote stability.)

Villains and Saints

A panicked citizenry looks about for villains and saints, and the government is only too happy to dispense the labels. The villains are predatory lenders, short-selling speculators, and “do nothing” officeholders and regulators allegedly blinded by their laissez-faire faith, while the heroes (naturally) are the populist politicians who promise to clean up the greed and irresponsibility of the nefarious financial industry. If citizens would just suspend their abstract aversion to nationalization of large sectors of the economy, the government could keep them safe from further economic harm.

The Federal National Mortgage Association—FNMA or Fannie Mae—was founded as an agency of the federal government as part of the New Deal in 1938. Its function was to create a secondary market for mortgages, meaning that Fannie Mae, rather than originating loans to homebuyers, would buy mortgages (and their expected payment streams) from community banks and thrifts. In 1968 Fannie Mae was transformed into a private-sector company with shareholders, and its official connection with the government was transferred to the Government National Mortgage Association (GNMA or Ginnie Mae). The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered in 1970 as another government-sponsored enterprise in the secondary mortgage market; it too is owned by shareholders.

The ostensible purpose of Fannie and Freddie is to promote homeownership. The two GSEs buy mortgages and bundle them into mortgage-backed securities, which are sophisticated derivatives that slice and dice the incoming monthly mortgage payments such that outside investors can (in theory) limit the risk of their real-estate investments. By providing a huge and liquid secondary market for mortgages, Fannie and Freddie make it more lucrative for others to originate mortgages. Make no mistake about it: The official mission of Fannie and Freddie is to cause banks to lend to applicants who would be rejected in the absence of government meddling. This point needs to be stressed as analysts wonder, “Why did banks make so many bad loans?”

All of this raises an obvious question. How exactly do Fannie and Freddie achieve their goal of promoting more mortgage origination than would have occurred in a free market? The answer is that these GSEs enjoyed implicit—and now explicit—government backing. Until quite recently, the official position of the federal government has been that Fannie and Freddie were private companies, earning private profits to be distributed to private shareholders. No taxpayer money stood behind them. However, investors suspected the GSEs were too big and too symbolic to be allowed to fail. Consequently, investors were willing to lend money to Fannie and Freddie—by buying bonds issued by these two GSEs—at lower interest rates than these same investors would have charged a truly private firm that performed Fannie’s and Freddie’s operations. Because their bonds were presumably guaranteed by the “full faith and credit” of the U.S. government—meaning the IRS and printing press—Fannie and Freddie were able to gain a huge share of their market; they directly owned or guaranteed roughly $6 trillion in mortgages. To repeat an earlier observation: The vulnerability of the overall system to a few giant firms is itself a product of intervention in these markets. If the government suddenly promised that it would use tax dollars to make creditors whole if Apple defaulted on its bonds, then we would expect it to become more “profitable,” cut prices, and gain market share from Microsoft.

It is worth pointing out that plenty of insiders got rich during the good times. Former Fannie chairman Franklin Raines earned some $90 million in compensation from 1998 to 2003. Even during the “bad times,” things weren’t so tough for the people running the two politically connected firms. As part of its takeover, the government ousted CEOs Daniel Mudd (Fannie) and Richard Syron (Freddie), yet they are entitled to compensation packages that could be worth up to a combined $24 million.

A Culture of Recklessness

Besides the implicit backing of their debt, the GSEs also enjoyed less regulation than their purely private counterparts. This bred a culture of recklessness and short-term thinking. To hit targets and trigger bonus payments to top executives, Fannie Mae manipulated its earnings over the period 1998–2004. Yet even when it was “caught,” Fannie was only fined $400 million in what was an $11 billion accounting scandal. Furthermore, one suspects that the full $400 million penalty did not fall entirely on the executives who defrauded their own investors, meaning the gamble was well worth it from their narrow point of view. Students of political economy know that regardless of the official motivation for a new government agency or program, once it is up and running, politicians, bureaucrats, and corrupt businesspeople will find ways to enrich themselves at taxpayer expense.

What is particularly insidious about government debt guarantees and rescue loans—whether the implicit backing given to Fannie and Freddie for decades or the explicit guarantee given to the Mexican government during its own credit crisis in 1995—is that they can often seem costless. Indeed, the U.S. Treasury actually made money on its “bailout” of Mexico because the Mexican government didn’t default on the bonds it had sold to investors around the world. In similar fashion, it didn’t cost the government anything for its implicit protection of the GSEs when housing prices were booming in the mid-2000s.

All of this changed, however, once house prices began sharply falling. Speculative buyers and those who had planned to refinance out of ARMs were now caught with mortgage payments they couldn’t afford, and so they began walking away. The stream of monthly payments into the bundled securities created by Fannie and Freddie was now drying up, and so the giants began losing money because as part of their normal operations they had guaranteed some of these payments. From the fourth quarter of 2007 through the second quarter of 2008, the two reported combined losses of $11.7 billion. Now the cost of the government’s backing would be evident.

Parsing Paulson

It will be instructive to parse the actual announcement of the Fannie and Freddie seizure. Right out of the chute, Paulson explained:

Note that the Congress didn’t send a bill to President Bush asking to nationalize the two corporations. On the contrary, it merely gave the relevant agencies the legal permission to take such actions if deemed “necessary.” This latter strategy is far harder to contain, because who could possibly object to giving the executive branch options? That seems to be a different issue from the question of which options were good ones. Thus members of Congress can truthfully say that they merely voted in the interest of preparedness for a takeover. The president and his minions can take the blame or praise for the specific exercise of the powers so delegated.

Paulson went on to say:

Since this difficult period for the GSEs began, I have clearly stated three critical objectives: providing stability to financial markets, supporting the availability of mortgage finance, and protecting taxpayers—both by minimizing the near-term costs to the taxpayer and by setting policymakers on a course to resolve the systemic risk created by the inherent conflict in the GSE structure.

The problem here is that the “critical objectives” are incompatible. When Paulson talks of “supporting the availability of mortgage finance,” this means making mortgages more available than they would be in a purely free market. To achieve that objective, then, the government must expose taxpayers, and the skewed incentives will necessarily distort the financial markets. Again, there is no way around this. If the government induces lenders to make loans that they originally thought were too risky, then the government has obviously made the overall system more volatile.

After Paulson’s opening remarks, he turned the podium over to James Lockhart, director of the new regulator, the Federal Housing Finance Agency. Lockhart explained that the GSE structure was inherently flawed because private shareholders pocketed gains while the taxpayers were ultimately on the hook for massive losses. Even so, Lockhart further explained that as part of the takeover, Fannie and Freddie would expand their portfolios of mortgage-backed securities before reducing them steadily starting in 2010. As usual with government, when something isn’t working, the solution is to make the problem grow—call it a “surge” in mortgage portfolios. No doubt future administrations will continually revisit whether conditions “on the ground” warrant a reduction in the monstrous agencies.

Lockhart also revealed that in exchange for its guarantee, the Treasury received senior preferred equity shares and warrants (similar to call options) that entitle the Treasury to purchase up to 79.9 percent of the common stock of the two companies under certain conditions. (To the best of my knowledge, those “certain conditions” were not revealed to the public—it’s not merely that reporters have omitted the precise details out of laziness.)

It is significant to point out that the preferred and arguably even the common shareholders were robbed in this procedure. The Treasury’s “senior preferred equity shares” bump the original preferred shareholders down a peg, forcing them to absorb losses before the Treasury takes a hit. On the other hand, if things turn around and Fannie and Freddie stocks recover, then the Treasury would find it profitable to exercise its warrants and thereby dilute the values of the other shareholders. For these reasons, the term seizure is far more accurate than rescue to describe the government’s actions with respect to Fannie and Freddie.

The government cannot create wealth. Although he is very smart and understands financial markets, Henry Paulson cannot centrally plan the mortgage market to improve on the spontaneous outcome of voluntary interactions among millions of professionals in the private sector. The fundamental causes of our current financial crisis were mortgages granted to unqualified applicants, as well as investors making very risky bets on assets derived from these mortgages. The bailout of those who lent to Freddie and Fannie, and the easing of the GSEs’ regulatory limits, will only sow the seeds for a potentially worse crisis down the road.

The Trend Toward State Socialism

Beyond the harmful effects on the real-estate and mortgage markets, the seizures of Fannie and Freddie—as well as the bailout of AIG the following week—reinforce the trend toward outright state socialism. Investors are looking less at fundamentals and more at government announcements. The idea that these moves are encouraging “stability” is ludicrous, as the once-mighty Lehman Brothers was allowed to fail in between the two massive bailouts.

During normal economic times, if the government began seizing firms and disbursing hundreds of billions of dollars to particular institutions, and furthermore if each action were discretionary and impossible to predict even one week in advance, then everyone would recognize these policies as incredibly destabilizing. Yet this destabilizing effect still exists when laid over a backdrop of massive losses, and in fact hurts even more because of the victim’s initial weakness.

Hard as it is to believe, the best course of action would have been for the government to allow these troubled firms to fail. This would be akin to pulling the Band-Aid off quickly, which is temporarily painful but soon forgotten. But with the possibility of federal bailouts and other novel techniques to revive the housing sector, troubled firms have been postponing the inevitable, hoping for a reversal of misfortune. As the financial crisis has now entered its second year, Bernanke and Paulson are pulling off the Band-Aid very slowly indeed.

As government-sponsored entities, Fannie Mae and Freddie Mac allowed their private executives to profit greatly from implicit taxpayer support over a period of decades. However, now that their excessive risk-taking has finally caught up with them, the GSEs’ shaky balance sheets have been absorbed by the federal government, which at the same time has announced that the two failing giants will take on even more obligations. Besides the further bilking of the taxpayer, the seizure is an ominous sign of just how much power the executive branch has accumulated. The takeover of Fannie and Freddie will do nothing to promote stability in the financial markets in the long run, but it will serve as a precedent for further “necessary” expansions of government control of the economy.

Related posts:

1. Bailing Out Statism
2. Bailing Out Statism
3. Can the Feds Save the Housing Market?

With oil prices setting records every week and gas prices topping $4 per gallon, voters are getting increasingly angry. This naturally makes the politicians nervous, so they do what they can to divert blame from themselves at all costs. Two easy targets are “Big Oil” and speculators. In this article we’ll see that the politicians’ accusations against these scapegoats are nonsensical, while the corresponding policy recommendations will only push oil prices higher.

Before exploring the errors of the political charges, we should first understand exactly what’s happening in the oil market. The simple explanation for high prices is: supply and demand. Global oil output has been roughly flat since 2005, while demand in developing economies such as China and India has been growing quickly. In a market the only way to reconcile these facts is for the price to rise; if China is consuming more barrels per day while producers aren’t churning out more product, that means other countries have to cut back their daily consumption. Rising prices do just that, without anyone consciously orchestrating the worldwide coordination involved.

To add nuance to the explanation, we should note that the sinking U.S. dollar has played a role. From June 2007 to June 2008, the price of oil—measured in dollars—more than doubled. Yet 15 percent of this rise can be attributed entirely to the sinking dollar, which fell 15.6 percent against the euro during the same interval. Because oil is a fungible commodity traded on a world market, changes in foreign-exchange rates translate immediately into changes in the price of oil (quoted in dollars).

If politicians want to “do something” about record oil prices, the answer is simple: Enact policies that boost supply and/or reduce demand—and this prescription indirectly includes policies that strengthen the dollar. For example, opening up the Arctic National Wildlife Refuge (ANWR) and the outer continental shelf (OCS) to drilling would boost (expected future) supplies of oil, causing producers with excess capacity today to ramp up current production. The feds could also start unloading the Strategic Petroleum Reserve, which currently has some 700 million barrels stockpiled. As the early Reagan experience showed, large marginal tax-rate reductions would boost the dollar on the foreign exchanges. And as far as reducing demand, foreign governments could stop subsidizing gasoline prices for their populations.

All these policies made sense even five years ago when oil was trading around $30 per barrel. Now that oil is flirting with $150 per barrel (as of this writing), such policies are imperative. Unfortunately, as we’ll now discuss, the suggested remedies coming from Washington will have the exact opposite impact.

Likely driven more by politics than sound economics, Republicans have increasingly endorsed expanded drilling on domestic land and in sea areas controlled by the federal government. For various reasons the standard Democratic response has been to dismiss these proposals as gimmicks that won’t solve America’s long-term “addiction” to fossil fuels. In this context the rhetorical lengths to which some politicians have gone are simply astounding.

The best (or worst) example concerns statistics on federal land-leasing that have served as talking points during the presidential campaign. The congressional Committee on Natural Resources prepared a report (http://resourcescommittee.house.gov/images/stories/Documents/truth_about_americas_energy.pdf) intended to derail the enthusiasm for more drilling by “Big Oil.” According to the report:

Even if increased domestic drilling activity could affect the price of gasoline, there is yet no justification to open additional federal lands. . . . Combined, oil and gas companies hold leases to nearly 68 million acres of federal land and waters that they are not producing oil and gas [from]. . . . Oil and gas companies would not buy leases to this land without believing oil and gas can be produced there, yet these same companies are not producing oil or gas from these areas already under their control.

If we extrapolate from today’s production rates on federal land and waters, we can estimate that the 68 million acres of leased but currently inactive federal land and waters could produce an additional 4.8 million barrels of oil and 44.7 billion cubic feet of natural gas each day.

Now this is truly astounding. It’s hard to know what would be worse: Do the authors of this report—and the politicians who repeat the accusations—actually think this is how the oil industry works, or are they consciously throwing out ridiculous “facts” just to win votes?

If we are to believe the figures in the quotation above, oil companies have the ability to produce an extra 1.75 billion barrels of oil per year (4.8 million x 365), which at $140 a barrel would yield around $245 billion in extra annual revenues. It’s true, they would have to pay a lot more in wages and equipment costs, and the price of oil would certainly drop with that much additional production. Even so, it is ludicrous to think the oil companies are staring at that much money on the ground (or in the ground) and ignoring it.

In reality the situation is far less sinister. The oil and gas companies pay the federal government to lease some of the land where it is currently legal to do so, areas they believe are the best prospects for finding oil and gas deposits. Obviously they don’t know beforehand exactly where the best sites will be; they have to lease the land and explore. After doing so, they begin drilling in the areas with the most promise. With record-high oil prices, the companies are naturally going to cast a wide net (insofar as the feds give them legal permission to do so), and so the proportion of leased land that actually ends up being classified as “producing” will be much lower than 100 percent.

Ironically, the higher the fraction of leased land that is producing oil, the more suspicious we should be that the oil companies are purposely holding back. After all, assuming they found oil, why would they pay the government to lease lands on which they didn’t plan to drill?

Contradictions from Big Oil’s Critics

Here we run into yet another nonsensical aspect of the official story from Big Oil’s critics. Let’s suppose for the sake of argument that the accusations are correct and that opening up ANWR and other federal lands wouldn’t lead to more drilling. Then what in the world is stopping the politicians from accepting the oil companies’ money? In these hard times, why not take billions from ExxonMobil and all the rest? If they don’t end up drilling—as the harshest critics allege—then people in Alaska, Florida, and California don’t need to worry about their coastlines being soaked in crude spills, now do they?

Things get worse. It’s not merely that the conspiracy-charging politicians deny companies access to federal lands that have the potential of major oil and gas discoveries. They want to swing the pendulum in the other direction with so-called “Use It or Lose It” legislation, which would penalize energy companies that lease federal land if they don’t begin producing within a specified time.

Putting aside the arrogance of politicians telling oil-industry experts how to run their businesses, such legislation would merely present an additional risk to domestic exploration efforts. As it is, an oil company runs the risk of paying to lease a certain area and finding nothing. The proposed legislation would increase the hazards, causing companies to become more conservative in where they explore.

This sorry episode underscores the flaws with government ownership of land. There are legitimate concerns over environmental quality, just as there are obvious concerns over high gasoline prices. But the political process is a terrible way to settle disputes. If the federal government auctioned off its massive landholdings to the private sector, oil companies and conservation groups alike could make bids and channel resources into appropriate ends, guided by the price system.

As it is, we have the worst of both worlds, where valuable oil and natural-gas deposits are arbitrarily placed off-limits and where oil companies are given rights to develop in certain areas without local owners exercising oversight to ensure that the mineral extraction occurs with the appropriate level of attention to long-run resource and environmental value. The “use it or lose it” mentality already prevails when politicians sell access rights to the vast lands they temporarily control—though economists know that this mentality is conducive to economically inefficient exploitation, rather than the wise husbandry that would develop under truly private ownership.

Besides large oil companies, the other popular villains are financial-market speculators. According to the official story, oil prices are as much as $70 higher per barrel than the “fundamentals” justify. Hedge funds, pensions, and other institutional investors have flooded the futures markets, looking for a piece of the action. These investors have gambled on rising oil prices by increasing their holdings of oil futures contracts. The result (we are told) is a self-fulfilling prophecy, where institutional purchases push up futures prices, which in turn drive up spot prices. The speculators get richer while the average motorist pays at the pump for their fat profits.

There is so much wrong with this story that it’s hard to know where to begin. As always, when people accuse market participants of making profits through “manipulation” we can ask: What took them so long? Why was oil $30 back in 2003? Were investors back then more altruistic than they are today?

To unpeel the issues in oil speculation, we need to first review the mechanics of the futures market. Futures contracts allow producers and consumers to hedge against the risk of price movements. Oil producers can sell futures contracts—which are promises to deliver physical barrels of oil at a future date, for a pre-specified amount of money—while major consumers, such as airlines, can buy futures contracts to lock in a guaranteed price for the massive quantities of oil they will need for operations in the coming years. Futures markets thus promote efficiency, as producers and consumers can concentrate on their core businesses and make investments that would be far too risky if they were completely exposed to volatile spot prices.

The True Effects of Speculation

Contrary to popular belief, futures markets do their job much better in the presence of savvy speculators. When successful, speculators speed price adjustments, and actually make prices less volatile than they otherwise would be. After all, the speculator buys low and sells high (or shorts high and buys back low). These very actions are countercyclical, and keep prices within a narrower band than if the speculators had stayed on the sidelines.

In this environment, large institutional investors provide liquidity to the physical hedgers. It is ironic that while the government takes steps to prop up Fannie Mae and Freddie Mac—whose investors certainly don’t plan on living in the houses they finance—politicians and commentators wail about the evil investors who buy oil futures even though they don’t ever plan on taking delivery of physical barrels. With large investors willing to pick up the slack, as it were, the traditional hedgers in the oil futures markets can use these contracts more liberally, because they can unload them in a more liquid market.

Markets and Speculation

Up till now we have seen the benefits of speculation. It is true that if speculators are wrong, they can distort markets—the housing bubble is a prime example. (There were government policies that encouraged speculation in real estate, but that is another story.) But the market has a handy way of enforcing discipline on speculation. If speculators guess prices will rise, but instead they fall, then the speculators lose money in exact proportion to how wrong their forecasts were. There is no need for government to tack on additional penalties, so long as contracts are enforced and the losers are made to bear the full brunt of their mistakes. The irony is that there is no hard evidence that speculators have been driving up oil prices. Thus we have been defending speculators for a “crime” that they don’t seem to have even committed.

If it were really the case that the “sustainable” market price of oil that balanced the fundamentals of supply and demand was $80, while speculators had driven the price up to a bubbly $150, we would see a large surplus. Even though supply and demand in the oil market are notoriously inelastic, surely the growth in quantity supplied, and the drop in quantity demanded, from a $70 price hike—especially one that was years in the making—would show up in a sizable excess of crude hitting the market.

This would make perfect economic sense, incidentally. For example, if certain speculators became convinced that an attack on Iran would drive oil to $400 per barrel in the coming months, they would rush to buy futures contracts. This would push up the futures price such that refiners and others with the requisite know-how would find it profitable to sell futures contracts (at the sky-high prices) and buy oil on the spot market. They would literally warehouse the oil for a few months, then unload it when the futures contracts matured.

The Stockpiling Story

Although those stockpiling oil would be doing so for personal gain, the Invisible Hand would ensure that everyone else benefited. Their purchases of spot oil would drive up spot prices, leading to conservation in the present. And of course, when war with Iran interrupted imports, the stockpiled oil would be a blessing.

However, this story doesn’t seem to be playing out when we look at the data. The “yield curve” on oil has been in backwardation—where spot prices exceed futures prices—for large portions of oil’s record price run-up, making it difficult to see how investors in futures contracts are pulling up spot prices. Moreover, official inventory data don’t show any stockpiling occurring in the last few years.

Now there are ever more convoluted stories that certain economists are spinning to explain away this lack of evidence. For example, it’s possible that investors pushed up futures prices, which in turn led Saudi Arabia to scale back its output. This drop in supply then led to rises in spot prices, which explains the lack of massive contango (where spot prices are below futures prices) during the last year. Further, we see no stockpiling in inventory data, because the Saudis are stockpiling the oil under the sand by not pumping.

Even here, the data do not really fit such a story, though admittedly OPEC figures are not as trustworthy as those issued by privately held companies. The Energy Information Administration estimates that OPEC output did drop from 2005 through the first quarter of 2007. But since then it has been steadily rising, reaching all-time highs in the first quarter of 2008. If we’re trying to explain the doubling of crude prices over the last year, a complicated story involving speculators and OPEC restrictions gets ever harder to square with the facts.

In any event, whether or not speculators are responsible for rising oil prices, we can confidently state that proposed regulations to restrict pension and other institutional investors from participating in the oil futures market would do nothing but harm the average American. If millionaires want to bet on rising oil prices, they will still be able to do so, either through hedge funds or in foreign markets. But schoolteachers and assembly-line workers typically do not have the money or savvy for such strategies. Instead, the only way they can hedge themselves against skyrocketing gasoline prices is for their pension- or mutual-fund managers to gain exposure to oil prices. Yet this is precisely what some members of Congress want to crack down on.

Americans are understandably becoming furious over record oil and gasoline prices. In response, the politicians have pointed fingers and proposed fixes that are based on faulty economics. If these odious measures pass, the result will be higher and more volatile oil prices and more exposed consumers. The truly sad thing is that even if this all comes to pass, most voters won’t understand what happened, and will believe the politicians when they blame $200 oil on anybody but themselves.

Related posts:

1. Oil Prices Are Rigged? It Just Ain’t So!
2. High Plains Drifters: Politicians’ Lucrative Protection Racket
3. The Brady Report: Threat to Stock Market Stability

In this environment, it’s natural that the government—and in particular the presidential candidates—are offering their “solutions.” As we’ll see, most of these proposals would only make things worse. To see why, we first need to understand what went wrong in the housing market.

To put it simply, there was an unsustainable bubble in home prices. From June 2001 to June 2006, the ten-city composite index mentioned above rose a whopping 89 percent. Now an average annualized return of over 13 percent isn’t bad, especially when you can live in the investment or rent it out for income. Consequently, more and more people entered the housing market. Some bought more expensive homes than they otherwise would have, and others even began buying homes purely as investments to “flip” once they had appreciated. As in any market, when prices exploded producers began cranking out more product—homebuilders were very busy, and their stock did very well during this period.

Another important part of the story is the revolution in financing that blossomed at the same time, which both benefited from and exacerbated the housing boom. In a traditional arrangement people in a community deposit funds with the local bank, which pays them a low interest rate in return. Then the bank takes this large pool of individual deposits and grants mortgages to qualified applicants, charging them a higher (but fixed) interest rate to compensate both for the bank’s overhead and the possibility of default. To make sure its loans went to responsible borrowers, and to align everyone’s incentives, the bank would insist on a hefty down payment, often 20 percent of the price of the house.

Yet things didn’t always happen this way during the recent housing boom. Rather than conventional fixed-rate mortgages, eager buyers were granted adjustable-rate mortgages (ARMs) that offered low upfront rates, which would then reset down the road. This allowed people to buy much more expensive homes, because they could handle the monthly payment at the “teaser” rate. Many buyers figured they could either flip the house before the ARM reset, or they could refinance at that time into a fixed mortgage.

Besides ARMs, other unorthodox practices occurred. People might be granted interest-only mortgages, where the borrower treads water with each payment, or even “negative amortization” ones, where the principal owed to the bank actually grows over time. Naturally, people signing up for all of these low-pain mortgages didn’t have money for a down payment, and here too the banks were very obliging. Before discussing the innovations on the mortgage-holder side of the market, I should stress that the above patterns aren’t as crazy as they now appear in retrospect. If home prices had continued their double-digit rates of appreciation, these practices all made perfect sense. It was only when the housing market collapsed that the borrowers were caught with their pants down.

On the banking side, here too practices deviated from the old ways. Rather than keeping mortgages on their balance sheets, local banks would sell them off to middlemen, who would ultimately pass them on to the giant investment banks headquartered on Wall Street. These organizations would turn to their “financial engineers” to bundle pools of mortgages into a new entity, broadly classified as a collateralized debt obligation (CDO). Outside investors could then buy bonds issued by the CDO. The flow of monthly mortgage payments into the CDO funded the flow of coupon payments to the bondholders. In the event of defaults, there were pre-determined rules for which CDO bondholders took the hit first. Naturally, the riskier classes (or “tranches”) of CDO bonds offered higher rates of return at the outset.

The growth in popularity of CDOs allowed institutional investors to participate in the booming housing market. Someone managing a pension fund didn’t have to do research on employment and default rates in Sacramento to gain exposure to real estate; all he had to do was buy bonds issued by the relevant CDOs. The high ratings granted by Moody’s and other agencies satisfied contractual and regulatory requirements, and reassured these outside investors that such investments were safe. Sure, any individual borrower could default, but the Ph.D.s at the investment banks had quantified the risks so everybody (apparently) knew exactly what he was buying into.

Of course, the party ended once housing prices peaked, and things turned ugly when prices began falling sharply. Most obvious, homebuilders were caught flat-footed, with more inventory in the pipeline that now had no buyers. But the fall in prices also   devastated those borrowers who had been banking (literally) on the opposite expectation; with negative equity and no buyer, they were stuck with mortgage payments (especially those with resetting ARMs) they couldn’t afford.

As is well known, the housing bust wreaked havoc in the credit markets as well. CDOs involving real estate were suddenly dangerous. The mathematical models that had previously been used to value them were obviously deficient, yet market prices weren’t available because nobody wanted to purchase the securities. Thus beginning in August 2007 and continuing to this day, banks have been reluctant to lend to each other because they couldn’t really trust the solvency of their counter-parties. (A bank asking for a short-term loan might have $1 billion in mortgage-backed securities on its books to pledge as collateral, but how much were those assets really worth?)

Because of banks’ reticence to lend not only to regular people but also to each other, the housing bust led to a much broader credit crunch. The process was a vicious circle. Spooked by the debacle, banks became much more stringent in their standards when evaluating new mortgage applications. This has only intensified the fall in house prices, as willing buyers can’t obtain financing.

How Government Caused the Trouble

Now that we have a better grasp of exactly what happened, the next issue is, “Why?” The typical answer is greed, on the part of investment banks, real-estate brokers, and speculators. But unless someone can explain why financiers and speculators were greedier in the mid-’00s than at other times, this explanation isn’t too helpful.

The free-market economist has learned from many different examples that when individuals and firms systematically make boneheaded decisions that lose them gobs of money, there is usually a government policy driving the madness. And in the housing bust, the pattern holds.

First and most obvious, the Federal Reserve had an easy-money policy to try to rescue the economy from the dot-com crash. In 2001 alone, the federal funds target rate was slashed from 6.50 percent down to 1.75 percent; the target eventually reached an incredibly low 1 percent by June 2003, where the Fed held it for an entire year. Then from June 2004 through June 2006, the target was steadily hiked back up to 5.25 percent. Although the correlation isn’t perfect, when the federal funds rate is cut, other interest rates—including mortgage rates—generally fall with it. Given the close connection between mortgage rates and home prices, even mainstream analysts have blamed the Fed for its role in the housing crisis.

Another obvious government distortion resulted from the actions of the Federal Housing Administration (FHA), which provides insurance for mortgage holders in the event of a default by borrowers. To see the connection between the FHA’s activities and the housing boom, we need only quote from the main page of its website: “Unlike conventional loans that adhere to strict underwriting guidelines, FHA-insured loans require very little cash investment to close a loan. There is more flexibility in calculating household income and payment ratios.”

Implicit Government Guarantees

Freddie Mac and Fannie Mae, major participants in the secondary market for mortgages, also share a portion of the blame. They buy mortgages from originators (banks, thrifts, credit unions, and so on), package them into bundled securities, and then sell the new assets to outside investors. As so-called government-sponsored enterprises, they do not directly receive tax dollars or explicit government assistance. However, many investors believe there is an implicit federal guarantee behind these agencies, and their regulatory requirements are also looser than for their purely private-sector counterparts.

Because of these advantages, when mortgage originators know a loan will be eligible for purchase by Freddie Mac and Fannie Mae, they can charge home buyers lower rates than would otherwise be profitable. Indeed, part of the official mission of these companies is to make the dream of homeownership attainable for millions of low- and moderate-income families. When trying to understand why so many obviously unqualified people were able to obtain financing during the housing boom, we shouldn’t ignore the role of large intermediaries explicitly designed to “soften” the strict requirements of the pure market.

Pressure to loosen underwriting standards was placed on private lenders as well in the name of avoiding discriminatory “redlining.” Stan Liebowitz, an economics professor at the University of Texas at Dallas, has been a critic of such political correctness for over a decade. In a February 5 New York Post op-ed (http://tinyurl.com/2ahdkd), he explains how beginning in the 1980s, activist groups such as ACORN (Association of Community Organizations for Reform Now) agitated against lending practices that yielded fewer approvals for minority and other low-income applicants.

In 1992 the Boston Fed produced an academic study that purportedly verified this bias in lending and distributed a manual for lenders that said the use of “arbitrary or outdated” criteria could be evidence of discrimination. Some of these criteria included income verification and the credit history of the mortgage applicant.

In 1995 the fuzzy-sounding 1970s Community Reinvestment Act (CRA) was strengthened. Henceforth, all banks and thrifts that enjoyed deposit insurance had an affirmative duty to lend throughout the regions in which they accepted deposits, notably including poor neighborhoods. If they received bad marks on this score, they could be subject to direct or indirect sanction, such as having merger plans held up by the Department of Justice. Studies by both the Federal Reserve and Harvard’s Joint Center for Housing Studies found that the CRA achieved its goal—namely, higher rates of homeownership in poorer communities.

Although some defenders of the CRA have pointed out that half the subprime loans were made by institutions outside the law’s purview (http://tinyurl.com/3sjcfj), surely government and activist efforts to shame lenders into loosening standards must play some role in our story. To quote Liebowitz: 

Ironically, an enthusiastic Fannie Mae Foundation report singled out one paragon of nondiscriminatory lending, which worked with community activists and followed “the most flexible underwriting criteria permitted.” That lender’s $1 billion commitment to low-income loans in 1992 had grown to $80 billion by 1999 and $600 billion by early 2003.

Who was that virtuous lender? Why—Countrywide, the nation’s largest mortgage lender, recently in the headlines as it hurtled toward bankruptcy.

In an earlier newspaper story extolling the virtues of relaxed underwriting standards, Countrywide’s chief executive bragged that, to approve minority applications that would otherwise be rejected “lenders have had to stretch the rules a bit.” He’s not bragging now.

Finally, there is the matter of the ratings agencies. Had they done their job properly, and given more accurate estimates of the riskiness of the rather exotic CDOs with which many investors were unfamiliar, then the housing boom would not have gained so much momentum. As usual, critics of capitalism attribute their mistakes to simple greed or even corruption.

Yet we have to ask: Don’t agencies such as Moody’s and Standard and Poor’s have an incentive for honest and accurate reports? Aren’t they suffering now for their wildly overoptimistic ratings, the way Countrywide and other lenders have either gone bust or are on the verge of doing so?

The answer is no. State and federal regulations of entities such as banks, insurance companies, and broker-dealers often rely on the creditworthiness of the bonds on the books of these organizations. Naturally the government then has to specify which ratings agencies are legitimate for this purpose; a banker can’t simply get a letter from his brother-in-law declaring his bonds to be “investment grade.” Although space does not permit a full treatment here, suffice it to say that the major ratings agencies are largely shielded from open competition (http://tinyurl.com/5akgq3). Consequently they will not be ruined by the housing bust, and it is no wonder then that they were so reckless with their profitable (at the time) evaluations.

Now that we understand the problem with the housing and credit markets, and how misguided government policies caused or at least greatly exacerbated the mess in the first place, we can quickly evaluate the likely effectiveness of some of the recent and suggested moves to fix things:

Cutting the federal funds rate. From September 2007 through April 2008, the Fed cut its target rate from 5.25 to 2 percent. Not surprisingly, things are still awful in the housing market, and the credit markets are still unsettled. As we’ve seen above, it was arguably Fed rate cuts that caused the housing boom in the first place. At this point, everyone is spooked; newly created dollars won’t flow into housing, but rather some other sector, such as commodities.

Bailouts of firms judged “too big to fail.” The Federal Reserve Bank of New York notoriously assisted with JPMorgan’s rescue of Bear Stearns in March on the grounds that its collapse would have led to widespread panic and further failures. As many critics have argued, such rescue attempts lead to a “moral hazard” that will only further encourage risky practices in the future. For a market to work, we need to rely on the profit-and-loss mechanism. Bear Stearns was heavily invested in mortgage-backed securities (MBS) and should have been left to suffer its fate on the open market. The only way to reward firms that wisely eschew hot items during a boom is to allow their competitors to go bust.

Accepting mortgage-backed securities as collateral for short-term loans. On March 11, the Federal Reserve announced the Term Securities Lending Facility, authorized to lend up to $200 billion of the Fed’s holdings of Treasury securities to primary dealers in 28-day loans. The Fed agreed to accept MBS as collateral for these loans. The move promoted “liquidity” because it is much easier to raise cash in the market with bonds issued by the federal government (Treasuries), rather than securities tied to mortgages at risk of massive defaults.

There are several problems with this arrangement and others like it. First, it obviously puts taxpayers on the line if the primary dealers default and the Fed is stuck with (grossly overvalued) MBS. Second, it intensifies the moral hazard discussed above; it benefits those who hold a large amount of MBS—precisely the investors with poor foresight. Finally, it perversely encourages holders of MBS to keep them off the market, since the Fed will accept them at an unrealistic book value.

To repeat, the problem in the credit markets isn’t simply the massive losses from bad loans. It’s also the uncertainty caused by the large holdings of derivative assets tied to mortgages. Only when institutions bite the bullet and begin selling these assets, presumably at large losses, can realistic market prices be established. Only then will banks be able to assess each other’s creditworthiness, and only then will they begin lending freely to one another. Government efforts to prop up the MBS market perversely stall this shakeout.

Rewriting contracts in favor of the homebuyer. Senator Hillary Clinton has been the most aggressive in this area. In December she called for a 90-day moratorium on certain types of foreclosures, and a five-year moratorium on ARM resets. Although these measures would help some existing homeowners in the short run, they would make it harder for newcomers to obtain financing to purchase a house. After all, the reason a bank is willing to lend out such large sums to a young couple is that the loan is secured; the bank can take possession of the house if the couple defaults. As far as ARM resets, it obviously doesn’t help the beleaguered holders of MBS to be told that the government has codified their fears of nonperformance.

A federal “loan substitution” program. In a March 7 op-ed in the Wall Street Journal (http://tinyurl.com/2zo6nm), economist Martin Feldstein proposed that the federal government pay off 20 percent of the mortgages of homeowners who opt into the program. They would repay the government over 15 years at the rate earned by two-year Treasurys (1.6 percent when Feldstein was writing). The point of the plan would be to encourage homeowners—especially those with negative equity—to continue making their monthly mortgage payments, rather than walk away.

Feldstein said the plan would be financed “by issuing new two-year debt until the loans are fully repaid, thus eliminating any net cost to the government.” It is rather shocking that Feldstein, chairman of the Council of Economic Advisers under President Reagan, didn’t consider that some of the participants in the plan might default on their debt to the government. As usual, the taxpayer would ultimately foot the bill for this massive handout to the mortgage industry.

Enhanced regulation. Almost every “serious” commentator on the housing crisis, including the allegedly laissez-faire Treasury Secretary Henry Paulson, has called for enhanced government oversight of the financial sector. It is ironic that in February the constraints on Freddie Mac and Fannie Mae were considerably loosened to allow them greater leeway in buying mortgages—and this just as the companies were reporting losses in the billions of dollars in the fourth quarter alone of 2007.

Where Do We Go from Here?

There are two distinct approaches the government can take to discourage institutions from engaging in reckless financial transactions. One is to let them do whatever they want (subject to prohibitions on outright fraud and theft) and let them go bankrupt if they screw up. The other is to hold their hands every step of the way, bailing them out of trouble but also second-guessing every decision they make.

In light of the complex and quickly moving financial system, as well as the politicians’ own dismal record on matters of honest bookkeeping, I think the first approach is far more sensible.

Unfortunately, even some nominal friends of markets have argued the housing crisis is too serious to ignore. If the government sits back waiting for prices to hit bottom, we are told, there will be unacceptable ripple effects throughout the rest of the economy. Yet as we have seen, most of the proposed interventions would make the housing crisis worse; any alleged ripples would turn into tidal wives. Beyond that observation, we should also remember that prices really do serve a function in a market economy. The politicians have already caused real damage, and people need market prices to know how to make the best of a bad situation. Propping up home prices at unrealistic levels will simply waste tax dollars and hamper the correction.

Our current housing and credit crises are quite serious—perhaps the worst since the Great Depression. As usual, the free market is not to blame; numerous government policies caused or exacerbated the situation. The host of “solutions” being implemented or  recommended will only make matters worse.

Related posts:

1. Nationalization of the Mortgage Market
2. Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse
3. Bailing Out Statism

The article begins with the anecdote about Stephen Crawford, then the co-president of Morgan Stanley. A few months after accepting this promotion, Crawford quit during a “management shake-up” and “strolled off with a severance package that included two years’ salary and bonus,” which amounted to $32 million. To make sure his readers are sufficiently outraged, Crowley points out that “Crawford pulled in $54,000 per hour!”

Before delving into the conceptual issues, let’s be clear on where that number comes from. It is obviously due to Crawford’s quitting much sooner than anyone (probably including himself) predicted when the contract was originally negotiated. (Had the shakeup occurred six weeks earlier, Crawford would’ve earned over $100,000 per hour, according to this method.) This is certainly a misleading approach, especially when contrasting it with the mean annual earnings of workers (as Crowley does). If one wants to show how much more CEOs get paid—and of course they do get paid far, far more than the average worker—then a fairer comparison would have been mean annual earnings of workers versus mean annual earnings of CEOs. (Later, Crowley follows this more reasonable route and reports that in 2003 “CEOs were paid over 300 times what the average production worker made.”) To pick an example like Crawford rigs the comparison; one could certainly find cases of average Joes who quit or were laid off after only working a very short time, and hence whose “hourly earnings” would appear vastly inflated.

For example, I myself was once sent home after only working about ten minutes as a receptionist in a law firm; I had been sent there by my temp agency, and it turned out I was unfamiliar with the phone system at the firm. Nonetheless, I still got paid for at least one hour (possibly more, I can’t remember) of work. Using Crowley’s approach, he could argue that the case of Robert Murphy shows that some Irish workers are paid six times more per hour than the median temp worker.

Even on its own terms, the calculation is suspect. Crowley isn’t explicit about where the $54,000 per hour figure comes from, but we do know that the total package was $32 million and that Crawford quit “[a]bout 100 days” after starting in the new spot. Well, $32 million divided by 100 is $320,000 per day, which works out to $40,000 per hour if we assume eight hours of work per day. Thus to get the higher figure of $54,000, Crowley must be assuming that, in addition to working only eight hours per day, Crawford only worked five days per week. Now I don’t know too much about being co-president of Morgan Stanley, but even so, I’m quite sure that this job requires more than 40 hours of work per week.

Of course, these minor quibbles about the figure overlook the biggest objection: So what if CEOs earn more money than most other workers? In a free market (and below we deal with the complication that in today’s world there is no truly free market), the price of labor corresponds to its marginal product. That is, competition ensures that workers are paid according to how much additional revenue they bring in to their employer. The fact that some types of labor command thousands of times more market value is no more surprising or outrageous than the fact that some goods in the marketplace (such as a house) have a price hundreds of thousands of times higher than the prices of other goods (such as a pack of gum).

Oddly enough, it is the critics of capitalism who implicitly claim that market value should correspond to ethical worth. No competent economist would argue that Stephen Crawford was a good person because he earned so much money, just as no economist would argue that a television set is ethically superior to a copy of the Holy Bible because of its higher price. No, the only thing economic science can say is that Stephen Crawford’s services were in higher demand than the services of (say) the janitors at Morgan Stanley. So long as the labor contracts are voluntary, there really isn’t an issue of fairness (subject to the complication noted above).

Later in the article, Crowley raises concerns that may trouble even a genuine supporter of the free market. Of course it makes perfect sense that successful corporate executives earn millions of dollars. But what of the strange cases of “corporate leaders actually failing their way to riches”? Crowley gives us some allegedly outrageous examples of this trend:

Viacom CEO Sumner Redstone took home about $28 million in 2004, including a bonus of $16.5 million, even as his company’s stock dropped 11 percent during the fiscal year. Applied Materials CEO Mike Splinter got a tidy $5 million bonus in 2004, despite a stock slide of more than 22 percent. That same year Rick Wagoner, CEO of General Motors, saw GM stock plunge 25 percent, yet he still pocketed a $2.5 million bonus—only slightly less than his award in 2003, when GM stock actually rose. So much for accountability.

As noted, this phenomenon is initially quite puzzling. Why would firms reward incompetent executives? Don’t they want to make money? Yet before dismissing power brokers in the business community as self-destructive and/or incredibly stupid, perhaps we should give them the benefit of the doubt and search for a rational explanation.

The most important point that scoffers like Crowley overlook is that the business world is uncertain. When a company brings in a new executive, it is not at all obvious what steps he or she should take to turn the company around and boost profits. (If it were obvious, the company wouldn’t waste millions of dollars hiring the executive.) Now regardless of the executive’s competence, it is entirely possible that the plan will fail—and the executive knows this as well as anyone else. Because of this, it would be very risky for such an executive to sign a contract in which, say, he or she earned $20 million if the company were profitable, but $50,000 if the company tanks. Rather than sign that contract, the executive (who must be quite skilled to be offered such a job in the first place) could consult or take a less glamorous position and earn, say, $5 million for sure.

This principle—that an executive gets paid handsomely even if the company does poorly—doesn’t seem outrageous when the numbers are lower. For example, when GM stock plunged 25 percent, did Crowley expect the assembly-line workers to give back a quarter of their wages for that year? If not, why not? After all, if the public stops buying GM vehicles, the services of the assembly-line workers aren’t as valuable. The simple answer, of course, is that the assembly-line worker doesn’t want his contract contingent on the overall profitability of the company; he wants to be paid—and to get his pension and other benefits should he retire or quit—whether or not the company’s stock does well. If it’s acceptable for the assembly-line workers, why not for the CEO too?

Greater Influence

Naturally, there is one obvious difference in this respect between assembly-line workers (or janitors and receptionists) and CEOs: Far more so than these other employees, the CEO can greatly influence the profitability of the company. Rather than giving the CEO a well-specified set of instructions to mechanically implement, the people hiring him allow far more discretion. After all, the CEO is brought in to run the company.

Yet this difference shows up quite clearly in the market: CEOs and other executives do get paid according to how well the company does. In addition to a base salary, these executives are often paid in stock options. A stock option (specifically a call) gives its owner the right to purchase shares of stock at a specific price, called the strike price. Therefore, if the actual market price of the stock is lower than the strike price, the option is worthless. But if, through their behavior, executives can boost the company’s stock price above the strike price, the options are valuable in proportion to the difference between the strike and actual prices.

Given his outrage over executives being paid regardless of profitability, one would expect Crowley to be a huge advocate of paying CEOs in nothing but stock options, which perfectly tailor earnings to the success of the company. Yet Crowley complains about the fairness of this too, even with highly successful companies. He cites the case of Yahoo! CEO Terry Semel, who took advantage of $230 million in stock options in 2004:

The average Joe might be more outraged if he understood the sorts of payouts and benefits that corporate brass are getting. Stock grants still provide a windfall for many chief executives, despite new regulations that force companies to account for options as expenses. Yahoo! CEO Terry Semel exercised $230 million in options last year. His company has had strong earnings of late so it’s fair to say that Semel earned his $600,000 salary, plus a hefty award for boosting the stock price. But $230 million? Come on.

Now what exactly is Crowley’s definition of fairness? If Semel is paid a large chunk of options, and under his leadership Yahoo! stock rises tremendously, why shouldn’t he be rewarded in proportion to this gain? At this point we can see past Crowley’s other alleged arguments; his basic objection is obvi ously that $230 million is more than anyone should earn, period.

Arbitrary Limit

There are three problems with this popular view. First, the upper limit that “decency” allows is arbitrary; no doubt many people would also deny the fairness of Semel’s $600,000 base salary. (“We’ve got starving children in the streets and some guy who heads a company of spammers gets 600 grand a year?!”)

Second, we must accept that in the modern economy, with billions of potential consumers worldwide, certain individuals have extraordinary earning power on the open market. If someone like Semel (or, a stronger case, Bill Gates) can add hundreds of millions of dollars of value to an organization (as judged by the spending habits of consumers), then to not pay him accordingly just means that someone else gets the money. Whatever happened to the principle of labor being paid the full value of its product? If Semel only got, say, $1 million, then Yahoo! shareholders (a group hardly in need of charity) would be $229 million richer. Would this outcome be fairer than what actually happened?

Third, we must consider the problem of incentives. If certain market exchanges are prevented because people such as Crowley find them unconscionable, then the individuals involved may stop working as much or as hard. For example, if Semel knew that outsiders would confiscate his stock options if the stock price rose too much, then he wouldn’t have put in the long hours and sleepless nights that he undoubtedly did during the year in question.

This is a point liable to misinterpretation, and it’s probably easier to switch contexts to professional sports. Economics tells us that placing a limit of, say, $1 million on salaries would reduce the incentives for star athletes. Now the critic might scoff and say, “Come on! Whether they make $1 million or $30 million, people will still go into the NBA. That type of cap isn’t going to affect anybody’s career choice.” Yet this objection overlooks the marginal nature of economic decisions. Yes, a first-round draft choice will still go pro (rather than become an accountant) even with a $1 million cap. But he’ll probably retire much earlier. (In the extreme, consider the heavyweight champion of the world—once he earns his title, he won’t defend it nearly as often if people like Crowley get to dismiss multimillion-dollar payments as unfairly high.)

This reasoning applies even more so to leadership positions in large companies. Especially when considered in the aggregate, if “outrageous” compensation packages are forbidden, the quality of corporate leadership will suffer. These people aren’t qualified for just CEO spots, and they’re well aware of the social stigma against big business. If the compensation packages are as high as they are, it’s because that’s what firms need to offer to attract and retain these highly skilled individuals. Of course, this phenomenon isn’t peculiar to corporate-leadership positions; if we declared tomorrow that brain surgeons could only make 50 percent of their current salaries, the frequency and quality of brain surgery would plummet.

Entrenched Management?

Of course, any reader who has actually worked in (or owns stock in) a large corporation may reject the above description as naïve. In the real world, such a reader might object, most shareholders in practice exercise no control over management. Suppose, for example, that 85 percent of the shareholders (consisting of thousands of people who each owned far less than 1 percent of the stock) thought the CEO made far too much money. Even so, would it really be worth it for them to organize and demand that the corporate board do something? After all, the increased dividends made possible by such cost-cutting wouldn’t translate into very much per shareholder. In this environment, management becomes entrenched and a lavish corporate culture takes over, with kept board members approving the jet-setting lifestyle of the CEO and his cronies.

As some of the recent scandals suggest, there definitely seems to be at least a grain of truth in such claims. Yet it nonetheless remains a puzzle to the free-market economist. For even if individual shareholders wouldn’t find it worthwhile to organize and put an end to profligate abuses by management, such waste would nonetheless show up in the stock price of the firm. If, for example, management collectively frittered away $10 million per year in unjustifiable expenses, the total shares of the corporation would be valued around $200 million less than they otherwise would be, assuming an efficient stock market and an interest rate of 5 percent. (This is because $200 million is the present discounted value of a perpetual stream of $10 million annual dividends.) Such a corporation would then be a prime target for the much reviled corporate raider. The raider would institute a “hostile takeover,” in which he bought up a controlling share in the corporation (by offering far more than the current price per share to the stockholders) and then used his power to fire or straighten out the inefficient managers. After cleaning house the corporation’s dividends and/or stock price would rise accordingly, netting the raider a profit.

Thus we see that in the free market, even the realistic problems with “democratic” mechanisms can always be overcome in the final analysis by a “strongman,” i.e. the corporate raider. (It should go without saying that these political metaphors are just that; in a free market all transactions are voluntary exchanges of property.) Consequently, if CEOs and other members of upper management make incredibly high earnings year after year, it must be that the shareholders find their services worth the expense. In some cases it may take the outside analyst some effort to discover how, but we shouldn’t doubt that the shareholders are careful with their money.

Unfortunately, I cannot close the analysis on this optimistic note. For the above relies on the assumption of a free market in corporate takeovers, and that is decidedly lacking. In the present legal and cultural environment, so-called corporate raiders are even more despised than golden-parachuting CEOs. Regulations severely restrict so-called hostile takeovers, and hence hamper the ability of shareholders to restrain their managers. For example, the federal Williams Act (1968) compels a would-be raider to declare his intentions after acquiring 5 percent of a corporation’s shares. Declaring one’s intention to take over a company would likely push up the stock price, making the takeover plan unfeasible.

The market’s other checks on inefficient management are stifled as well. After all, even before the financial innovations allowing the issue of “junk bonds” and hostile takeovers, there was always a sure-fire way to keep corporate officers in line: any firm that wasted too much money on fancy offices and executive perks would be vulnerable to its competitors. Again, this initially poses a puzzle for critics such as Crowley; if outrageous compensation for CEOs is so endemic in American corporate culture, why don’t new firms enter these industries and drive the old ones out of business?

But as with hostile takeovers, so too with new entrants to industry: Government regulation muffles this threat and thus allows entrenched businesses a margin of profligacy that they otherwise would not enjoy. Many people (especially young students) new to the ideas of laissez faire believe that big business opposes government meddling, but this is naïve and contradicted by the history of actual legislation. Ironically, the profitability of big business can actually be enhanced when the government regulates an industry, because the big firms can more easily handle the fixed costs of filling out paperwork, providing a “safe” working environment, proving that they are making every effort to comply with affirmative action goals, and so on. In this environment, would-be competitors face additional hurdles if they want to challenge the large incumbents, and thus the latter may indeed get away with lavish expenditures that would be short-lived in a truly free market.

Related posts:

1. Bill to Mandate Paid Sick Days Introduced in House
2. The Piper Will Be Paid
3. The Redistribution of Blame