“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?

Thus far the typical libertarian response to the growing clamor has been to challenge the science behind it. Now it really is the scientific consensus that global warming occurred during the twentieth century. What is not so obvious is that (1) humans caused this warming and (2) this warming is necessarily bad.

Although it is interesting to explore the question of whether science has been perverted in the cause of environmentalism, there is a danger for libertarians in pinning their entire case on this strategy. After all, every serious student of science knows that when it comes to empirical claims, we never achieve certainty. For example, even if today one thinks that there are insurmountable problems facing the theory of manmade global warming, one still must accept the possibility that new evidence or theoretical advances could indicate that the environmentalists are perfectly right. Another possibility is that there is some other, similar disaster lurking unsuspected.

For these reasons, I believe it is crucial to accept provisionally, for the sake of argument, the scientific claims behind the case for manmade global warming. In the present article I will demonstrate that it still would not follow that the taxes and other regulations typically proposed by greens are the best way to address the problem. Just as the free market is still the optimal economic arrangement, regardless of how many citizens are angels or devils, so too does the free market outperform government intervention, regardless of the fragility of Earth’s ecosystems.

When trying to determine if the free market is to blame for possibly dangerous carbon emissions, a logical starting point is to list the numerous ways that government policies encourage the very activities that Al Gore and his friends want us to curtail.

The U.S. government has subsidized many activities that burn carbon: it has seized land through eminent domain to build highways, funded rural electrification projects, and fought wars to ensure Americans’ access to oil. After World War II it played a key role in the mass exodus of the middle class from urban centers to the suburbs, chiefly through encouraging mortgage lending.

Every American schoolchild has heard of the bold transcontinental railroad (finished with great ceremony at Promontory Summit, Utah) promoted by the federal government. Historian Burt Folsom explains that due to the construction contracts, the incentive was to lay as much track as possible between points A and B—hardly an approach to economize on carbon emissions from the wood- and coal-burning locomotives. For a more recent example, consider John F. Kennedy’s visionary moon shot. I’m no engineer, but I’ve seen the takeoffs of the Apollo spacecraft and think it’s quite likely that the free market’s use of those resources would have involved far lower CO2 emissions. While myriad government policies have thus encouraged carbon emissions, at the same time the government has restricted activities that would have reduced them. For example, there would probably be far more reliance on nuclear power were it not for the overblown regulations of this energy source. For a different example, imagine the reduction in emissions if the government would merely allow market-clearing pricing for the nation’s major roads, thereby eliminating traffic jams! The pollution from vehicles in major urban areas could be drastically cut overnight if the government set tolls to whatever the market could bear—or better yet, sold bridges and highways to private owners.

Of course, there is no way to determine just what the energy landscape in America would look like if these interventions had not occurred. Yet it is entirely possible that on net, with a freer market economy, in the past we would have burned less fossil fuel and today we would be more energy efficient.

Even if it were true that reliance on the free-enterprise system makes it difficult to curtail activities that contribute to global warming, still the undeniable advantages of unfettered markets would allow humans to deal with climate change more easily. For example, the financial industry, by creating new securities and derivative markets, could crystallize the “dispersed knowledge” that many different experts held in order to coordinate and mobilize mankind’s total response to global warming. For instance, weather futures can serve to spread the risk of bad weather beyond the local area affected. Perhaps there could arise a market betting on the areas most likely to be permanently flooded. That may seem ghoulish, but by betting on their own area, inhabitants could offset the cost of relocating should the flooding occur. Creative entrepreneurs, left free to innovate, will generate a wealth of alternative energy sources. (State intervention, of course, tends to stifle innovations that threaten the continued dominance of currently powerful special interests, such as oil companies—for example, the state of North Carolina recently fined Bob Teixeira for running his car on soybean oil.)

Private insurers have a strong incentive to assess the potential effects of global warming without bias in order to price their policies optimally—if they overestimate the risk, they will lose business to lower-priced rivals; if they are too sanguine about the dangers, they will lose money once the claims start rolling in. Individuals finding their homes or businesses threatened by rising sea levels will find it easier to relocate to the extent that unfettered markets have made them wealthier. Industrial manufacturers, as long as they are held liable for the negative environmental effects of their production processes—a traditional common-law liability from which state policies intended to “promote industry” have often sought to shield manufacturers—will strive to develop technologies that minimize the environmental impact of their activities without sacrificing efficiency. Government interventions and “five-year plans,” even when they are sincere attempts to protect the environment rather than disguised schemes to benefit some powerful lobby, lack the profit incentive and are protected from the competitive pressures that drive private actors to seek an optimal cost-benefit tradeoff.

If the situation truly becomes dire, it will be free-market capitalism that allows humans to develop techniques for sucking massive amounts of carbon out of the atmosphere, and to colonize the oceans and outer space. Beyond these futuristic possibilities, the obvious responses to global warming—such as more houses with AC, sturdier sea walls, and better equipment to evacuate flooded regions—are again only feasible when the free market is unleashed.

It is the poorest people and nations that stand to suffer the most if the worst-case scenario for global warming is realized, and the only reliable way to alleviate their poverty, and thus help protect them from those effects, is the free market.

Can the Market Meet the Threat Head-On?

In the first section I summarized some of the ways governments inadvertently contribute to the very activities that allegedly cause dangerous global warming; in the second I sketched some of the ways that free markets allow humans to better adapt to climate change. However, I haven’t really tackled the problem directly. Am I conceding that with a worldwide problem the market—which is just dandy for one-on-one interactions—can’t match the concerted “will of the people” working through their elected representatives for a common solution?

Of course not. Even when economic transactions generate so-called negative externalities (activities that shower harms on third parties), I still contend that the free market is the best institution for identifying and reducing the problems.

One way negative externalities can be addressed without turning to state coercion is public censure of individuals or groups widely perceived to be flouting core moral principles or trampling the common good, even if their actions are not technically illegal. Large, private companies and prominent, wealthy individuals are generally quite sensitive to public pressure campaigns.

To cite just one recent, significant example, Temple Grandin, a notable advocate for the humane treatment of livestock, asserts that McDonald’s is the world leader in improving slaughterhouse conditions. While many executives at the fast-food giant genuinely may be concerned with the welfare of cattle, pigs, and chickens, undoubtedly a strong element of self-interest is also at work here, as the company realizes that corporate image affects consumers’ buying decisions.

But that self-interest does not negate the laudable outcome of the pressure McDonald’s has applied to its suppliers to meet the stringent standards it has set for animal-handling facilities. Similarly, to the degree that the broad public regards manmade global warming as a serious problem, companies will strive to be seen as “good corporate citizens” that are addressing the matter. And this isn’t ivory-tower speculation on my part—I can see the “green friendly” ads already.

Critics of libertarianism sometimes denigrate it as a political program of “market fundamentalism” that, if put into practice, would reduce all human values to the price they can fetch as mere commodities. But that is a caricature of the social arrangements advocated by any sensible libertarian. The great figures of classical-liberal and libertarian thought have always recognized the vital contributions that nonmarket institutions, such as churches, families, charities, social clubs, communities of scholars and their students, art foundations, conservation groups, neighborhood associations, and youth athletic leagues, make to the healthy functioning of a free society. What libertarians offer as an alternative to statism is not a social order that judges every human interaction solely on a miserly calculation of profit or loss, but a society in which every desirable form of voluntary association is allowed to flourish, free from coercive interference by the state.

Customary Law

Besides the samples listed above, most libertarians recognize private or customary law as another important, nonmarket source of social order. A historical case in point is the Anglo-American common-law tradition in which legal norms evolved spontaneously from the customs of the people to whom it applied, rather than through legislation and state planning deliberately aimed at achieving some “public good.” The many centuries during which the common law sustained civic order in the face of inevitable divergences between individual citizens’ own interests demonstrate that a successful legal order does not inevitably require state sponsorship. The common law has shown itself to be fully capable of dealing with a number of issues that, while not exhibiting the worldwide scope of global warming, are still similar to our present concern in arising from the cumulative effects of many individual actions, each of which, regarded in isolation, appears to be unproblematic and not subject to legal sanction. For instance, the salmon-fishing streams of Scotland are a valuable natural resource, and the communities along them have developed quite successful institutions for ensuring the value of the streams is maintained, including private policing and legal penalties for overfishing and for polluting the water.

The many cases in which voluntary solutions to problems of collective choice have worked pose an empirical embarrassment for those who argue that “public goods” must be provided by the government. Most advocates of compulsory solutions to pollution abatement, for example, would assert that voluntary efforts will be vitiated by “free riding.” If individuals are not forced to contribute their fair share toward addressing these problems, this argument runs, each person rationally will hold back and hope others will pay for the proposed solution, since any free riders would gain the benefits (such as clean air) anyway. Since almost no one likes to be “the sucker,” it follows that the amount of resources devoted to the provision of the public good will fall woefully shy of the total that would be available if each person gave the amount he’d be willing to give if only he could count on everyone else pitching in equally. The sole solution that can be imagined is for the members of a society to create a “social contract” by which they are forced to pay for pollution abatement.

However, Anthony de Jasay notes in his book The State that this argument is severely flawed. If people cannot solve public-goods problems through voluntary cooperation, how can they rely on politicians’ promises to do so? There is no external authority to enforce those promises. There is only public opinion, the same thing that would enforce voluntary solutions. Moreover, government is itself a “public good” in the sense that free riders benefit from the efforts of those who try to get the government to produce public goods such as clean air.

Is Temperature a Public Good?

Another consideration is that the earth’s temperature isn’t such a public good after all. That is, certain people really do have more at stake, particularly if the warming is moderate. For example, if Manhattan became submerged because of rising sea levels, that calamity would not affect every human being equally. The residents of Manhattan and the owners of its skyscrapers would be hurt far more than people living in inland China. Because all the various potential dangers of global warming affect particular people more intensively than others, it is these groups that (in a free market) would have the incentive to reduce CO2 concentrations. For example, if rising sea levels would cause $10 trillion in damage to a comparatively small group of wealthy individuals, that’s a huge “pie” that the wealthy can offer others to motivate them to reduce emissions.

Despite my optimism about the potential to deal with environmental problems through voluntary means, I don’t wish to be misunderstood: If the official global-warming story is true, it presents a serious problem that humanity will find difficult to solve through voluntary means. But this isn’t a strike against voluntarism—of course a difficult problem will be difficult to solve! By the very same token, the government doesn’t do a terrible job at collecting stray dogs, because that’s a very simple task. When it comes to harder assignments, such as stopping terrorism or reducing teen pregnancy, the government’s record is quite a bit worse.

The very features of the official global-warming scenario that hamper purely private solutions would apply equally to government efforts. For example, even if the U.S. government passed draconian measures at home, that alone wouldn’t be enough if China and Indiadon’t follow suit. And just as private companies in a free market may have an incentive to pollute if they can get away with it, so the state, under the influence of special-interest groups and run by leaders always tempted to ignore the public good in favor of increasing their own power and wealth, can have incentives to allow more pollution than is optimal. (It should be clear the “best” amount of pollution is not zero, because even using fire to cook generates some pollutants, and I doubt that anyone but the most misanthropic, fanatical nature worshippers want to reverse all of the last 40,000 years of human progress.)

As in all debates over public versus private choice, it’s inappropriate to measure a realistic free-market response to global warming against an idealized government program. We must try to envision what real people would do if their property rights were respected and compare that scenario with the probable outcome of actual politicians in today’s world being given a blank check in the name of saving the earth.

Government programs don’t ameliorate world poverty or sickness, and no libertarian would deny that these are serious problems. So even if manmade global warming is a real threat, why should we expect governments to get it right on this issue?

Related posts:

1. Global Warming Revisited
2. Higher CO2, More Global Warming, and Less Extinction?
3. Global Warming and the Layman

Law and economics, or the economic analysis of law, is a relatively new discipline. It was launched in the late 1950s and early 1960s and has grown in importance and in the number of its practitioners ever since. It uses key principles of economics—such as self-interest, rationality, efficiency, and externalities—to predict the intended and unintended effects of different legal rules and to explain why we have the particular legal rules we do and why some legal rules might be considered better than others. Aaron Director and Ronald Coase, to whom the book is dedicated, and Judge Richard Posner, to whom the author refers in several chapters, have been major contributors to the field.

David Friedman is an economist and a professor of law at the University of Santa Clara School of Law. This book is one of his best efforts. His style makes it great fun to read, and it is filled with intriguing insights. Because of its comprehensive scope, it could easily be used as a text in an introductory course in law and economics. For example, it includes a chapter on antitrust law that I wish Joel Klein and Judge Thomas Penfield Jackson had read before they proceeded to punish Microsoft for being too effective a competitor.

Friedman’s early chapters explain basic economic concepts vital to understanding law. A transition chapter explains the structure of the American legal system, and the later chapters apply economics to the analysis of such things as criminal law, tort law, contract law, and marriage, sex, and babies. One especially interesting chapter is devoted to a law-and-economics analysis of three alternative legal systems—saga-period Iceland, eighteenth-century England, and Shasta County, California.

Law’s Order is more than an introductory text, however. For example, in Chapter 5 Friedman goes far beyond the usual exposition of the Coase Theorem. He illuminates the differences between property rights and liability rights and how the choice of efficient rules depends on such things as the free-rider problem among joint buyers and holdouts among joint sellers. A reader is well advised to read this chapter carefully, with pencil and paper at hand since it is basic to much that comes later.

Friedman introduces each new concept with an actual or hypothetical example that puts the reader in the center of the issue. Frequently, he comes to what seems a reasonable conclusion and in the very next paragraph he explains why it is wrong. In one case, the issue of whether, on efficiency grounds, we need criminal law at all, he goes through seven rounds of arguments changing his answer each time. He offers this “as evidence of how risky it is to go from the existence of an argument for the efficiency of some particular rule to the conclusion that the rule is in fact efficient.” It is also an effective expository device because it engages the reader. I tried to anticipate the arguments in each round before I read them. I was often wrong, but I learned something useful every time.

Judge Posner is famous for his conjecture that the common law, which develops over time through judicial precedents and decisions, consists of legal rules that are, for the most part, economically efficient. Friedman gives many examples—for example, the negligence doctrine in torts—consistent with Posner’s conjecture, but he also gives a few—such as product liability rules—that aren’t. Posner’s great contribution, according to Friedman, has been to direct attention to the question of economic efficiency in the law. “We do not know whether the law is efficient. We do know that the question ‘What is the efficient legal rule?’ converts the study of law from a body of disparate doctrines into a single unified problem.”

The book is filled with elegant, instructive arguments. Consider just one. Burglary, Friedman argues, should be a tort rather than a crime, and denting a fender should be a crime rather than a tort. The basis of those startling assertions is the incentive for potential victims to undertake efficient preventative measures. In tort law, successful plaintiffs are made whole through compensatory damages. In criminal law, victims do not receive compensation. If the penalty is a fine, it is the state that receives the money, not the victim. If the penalty is imprisonment, the victim suffers an additional loss in taxes to pay for the incarceration. Therefore, potential victims of crimes are more likely to undertake efficient prevention measures than are potential victims of torts. Preventative measures are more effective for dented fenders than burglaries. Under the general rule that incentives should be placed where they do the most good, denting a fender should be a crime, and burglary a tort.

Finally, the book has no footnotes and very few references. Friedman and his publisher have set up a Web site for his readers to obtain the missing information online. Friedman chose this option to make the book more user-friendly for the intelligent layman who will read it for general information and entertainment rather than as an academic resource. Icons in the margins of the hard copy point to corresponding online icons. I think this bit of entrepreneurship will pay off and thus become widely imitated.

Charles Baird, a professor of economics and the director of the Smith Center for Private Enterprise Studies at California State University at Haywood, is a quarterly columnist for Ideas on Liberty.

Related posts:

1. Book Review: Hidden Order: The Economics of Everyday Life by David Friedman
2. Book Review: The Libertarian Reader: Classic and Contemporary Writings From Lao-Tzu to Milton Friedman edited by David Boaz
3. Book Review ~ The Lexus and the Olive Tree: Understanding Globalization by Thomas L. Friedman