“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.

Recall last month’s advice not to complain out loud about the mistakes that you think speculators are making. If your criticism is correct, you can make a fortune by not sharing your information and entering the market yourself. You will increase the value realized from our scarce resources. If you are wrong, however, you can lose lots of money. Again, speculation is risky.

Many people disapprove of speculative markets because of the risk associated with them. They believe these markets are little more than gambling havens on par with Las Vegas and Atlantic City casinos. The critics fear that allowing speculative markets to proliferate, as they have in recent years (allowing people to speculate on such things as foreign currencies and the rate of inflation, as well as on resources such as petroleum and agricultural products), creates harmful levels of risk in society. Wrong! There is a fundamental difference between the risks in Las Vegas casinos and the risks in speculative markets.

Craps versus Crops

A crucial difference between the risk of playing craps and the risk of speculating on the price of wheat is that the game of craps creates a risk that otherwise would not have existed. Creating risk for the enjoyment of people who like to take chances is the purpose of gambling games. Of course, some people also enjoy the risks of “betting” on the future price of wheat in speculative markets. But speculative markets do not create risks. The risks associated with speculative markets are inherent in the act of growing crops and are necessarily borne by someone. If speculative markets were outlawed, farmers would have to take the risk of “betting” that the cost of planting a crop today is less than the unknown “payoff” from selling it at harvest. Only those who hate gambling more than they love eating should criticize the risks associated with speculative markets. Actually speculative markets lower the cost of unavoidable risks.

Consider the farmer who invests most of his wealth in planting wheat each spring. Taking a risk on the future price of wheat is extremely costly for him. He could win, of course, if the price of wheat is higher than expected. But the price might plummet, in which case he could lose everything. Even enthusiastic gamblers are reluctant to put their life savings on one roll of the dice. Thus our farmer would like to eliminate the risk of declining wheat prices so he can concentrate on growing wheat, which is risky enough. And that is exactly what he can do in the speculative (futures) market for wheat. In the spring he can arrange to sell his harvest for the fall price that currently prevails in the futures market for the type of wheat he is growing. The farmer eliminates the risk he faces from declining prices by locking in his sales price.

This doesn’t eliminate the risk of price declines. The farmer has simply passed that risk on to those who agreed to pay the specified future price. If the price of wheat increases above that price, the buyers of the futures win; but if it falls below that price, they lose. This is not just a game of “hot potato” in which the cost of holding the risk is the same no matter who holds it. Those who accept the price risk have a lower cost associated with that risk than the farmer does; maybe they are less averse to risk. Also, the farmer passes the risk to many people, each of whom takes just the amount he wants. Finally, those accepting the risk can diversify, agreeing to buy many different products. Because of speculative markets, the “hot potato” of risk ends up in the hands of those with the thickest gloves.

In some cases, speculative markets allow risk to be eliminated almost entirely. In fact, the term “speculative market” can be a misnomer, since parties on both sides of the market often use them to avoid speculating. Those who agree to pay a wheat farmer a specified future price for his harvest may do so to avoid speculating in wheat prices themselves. Consider bakers whose profits are reduced if the price of their primary ingredient, wheat, increases in the future. The risk bakers want to avoid (wheat prices going up) is exactly opposite to the one wheat farmers want to avoid (wheat prices going down). So farmers and bakers can eliminate the risk they fear most by using “speculative” markets to agree now to a specified price in the future. The risk of fluctuating wheat prices isn’t eliminated—the farmer risks losing the gain from rising prices and the baker risks losing the gain from declining prices. But the degree of risk has been greatly reduced for both.

Derivatives Don’t Cause Risk

Agreements to buy and sell agricultural products at specified future prices are made with futures contracts. These contracts are traded on markets, and their prices fluctuate over time with changes in the expected prices of the products. So the value of each of these futures contracts is derived from the value of something else. Any contract whose value is derived from something else is called a derivative. Derivatives have proliferated in recent years, allowing people to speculate on the future prices of a wide range of things (including interest rates). Unfortunately derivatives are widely blamed for the risks that have resulted in a few large losses suffered by businesses and governments that speculated in them. This criticism reverses cause and effect. Increased risk caused the derivative, not the other way around. The increase in the numbers and types of derivatives was the predictable response to the increased risks caused by such things as the uncertain value of the dollar due to the inflation of the 1970s and ’80s, the volatility of prices of resources such as oil, and the move to floating exchange rates for foreign currencies. These risks were not caused by derivatives. Derivatives emerged as a way of reducing risks in the same way farmers and bakers reduce the cost of fluctuating wheat prices with futures contracts.

Blaming risks on derivatives is as silly as blaming diseases on doctors.