For example: “[T]hese reforms represent the strongest consumer financial protections in history.  And these protections will be enforced by a new consumer watchdog with just one job: looking out for people – not big banks, not lenders, not investment houses – looking out for people as they interact with the financial system.”

And: “[B]ecause of this law, the American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more tax-funded bailouts — period. If a large financial institution should ever fail, this reform gives us the ability to wind it down without endangering the broader economy.  And there will be new rules to make clear that no firm is somehow protected because it is ‘too big to fail,’ so we don’t have another AIG.”

Note that Obama did not promise to spare the taxpayers from having to foot the bill for the government’s mistakes. He and the members in Congress know better than to make that howler of a promise.  Nevertheless, the magnitude of the whoppers being told about this law is astounding.

The government cannot deliver on pledges to protect consumers in the financial markets and to shield taxpayers from bailouts. In the first instance — consumer protection — financial instruments are inherently complex and government attempts to shelter less-sophisticated investors and borrowers from all danger would either require control of products to the point of prohibiting things people want or inundating them with information until they ignore all of it because of the sheer volume. Alas, what the new law will provide consumers is a false sense security – and that’s worse than none at all.

As for the new watchdog agency, we have cause to wonder why the law of regulatory capture should suddenly stop operating or why the door between government and industry should suddenly stop revolving. (It’s still spinning in the energy industries.)

As for taxpayer bailouts, the new law leaves plenty of room for the FDIC to borrow money in order to keep favored creditors of failing big companies afloat. The wind-up fund that’s supposed to be financed by banks and other firms will of course be filled by their customers.

Most generally, the new law exhibits the standard governmental hubris. Who truly believes that an army of necessarily myopic bureaucrats can ever know enough to 1) anticipate a systemic crisis and 2) do something intelligent about it in a timely way? The more centralized the power the more vulnerable we average taxpayers are. Mistakes are system-wide. The virtue of a freed market is not that it’s unregulated (it’s not) but that its radically decentralized.

So anyone who thinks this 2,300-plus page monstrosity has a chance to prevent another large-scale financial failure has been watching too much network news. Two pieces of information are pretty much all you need to see through the hype. First, in all those pages you will not find the words “Fannie Mae” or “Freddie Mac” (or their official names), the two government-sponsored enterprises (that’s a term of art) that had so much to do with encouraging the hollow mortgages that underlay the flimsy securities and credit default swaps that made the financial system so fragile these last several years. (Search our archive for many articles about this.) When Fannie and Freddie couldn’t pay their bills a couple of years ago, the government took them over, proving that the widely assumed implicit government guarantee of their obligations was real after all. They are still in business buying up mortgages though they need regular infusions of the Treasury’s borrowed money. Before it’s over the bailout cost is expected to at least hit the $400 billion cap, though Obama has unilaterally promised unlimited financial aid.

The second important fact is that the chief movers of this law, Sen. Chris Dodd and Rep. Barney Frank, are the two biggest congressional champions of Fannie and Freddie. Whenever anyone expressed concern about the poor condition of the GSEs’ books, Dodd and Frank could always be counted on to fend off the threat of scrutiny. They would insist it was all part of an altruistic cheap-home-ownership program, but too much money was being made from government intervention to take that seriously. Dodd and Frank were aided by Fannie’s and Freddie’s well-connected lobbyists and campaign contributions. All told, they spent $200 million from 1998 to 2008. Fannie and Freddie are the ultimate Washington insiders. “They’ve stacked their payrolls with top Washington power brokers of all political stripes,” the Politico reported. Altruism, indeed.

It’s Dodd, by the way, who said of his bill, “No one will know until this is actually in place how it works.” And Frank is ready to submit new legislation to fix any mistakes in the law. We’re about to have a laboratory experiment of the law of unintended consequences.

Obama said: “For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy.” The implication is now we have up-to-date rules that will be vigorously enforced. But he can’t possibly know that. Why not? Because in writing the law, Congress did not write the rules. It merely handed that job off to unelected, unaccountable bureaucrats in a variety of agencies. In a word, Congress delegated its legislative authority, which has no authority to do. (Not that anyone cares.)

The Wall Street Journal reports,

In a recent note to clients, the law firm of Davis Polk & Wardwell needed more than 150 pages merely to summarize the bureaucratic ecosystem created by Dodd-Frank. …[T]he lawyers estimate that the law will require no fewer than 243 new formal rule-makings by 11 different federal agencies. [Emphasis added.]

The SEC alone, whose regulatory failures did so much to contribute to the panic, will write 95 new rules. The new Bureau of Consumer Financial Protection will write 24, and the new Financial Stability Oversight Council will issue 56. These won’t be one-page orders. The new rules will run into the hundreds if not thousands of pages in the Federal Register, laying out in detail what your neighborhood banker, hedge fund manager or derivatives trader can and cannot do.

In other words, your misrepresentatives have no idea what they just passed.

The Journal adds that “the biggest financial players aren’t being punished or reined in. The only certain result is that they are being summoned to a closer relationship with Washington in which the best lobbyists win, and smaller, younger firms almost always lose.”

The more the rules change the more they stay the same.

President Barack Obama signed into a law the most sweeping overhaul of U.S. financial market regulations in generations, marking the conclusion of year-plus effort to craft a legislative response to the 2008 financial crisis.

Speaking before he signed the legislation, Mr. Obama pitched it as a major step toward correcting the problems that contributed to that crisis and the severe recession that followed. “For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy,” Mr. Obama said.

That implies we have new rules and we know what they are, right? Wrong. The rules will be written in the coming months by, well, we don’t know yet.

There is no way in you-know-where that Obama really believes this new law will put an end to system gaming and systemic risk taking. As long as there are powerful bureaucracies there will be incentives to game the system, and as as long as government plays the role of safety net for a banking cartel — and it will continue to do so — it will encourage risk taking that wouldn’t occur in a freed market.

Dodd-Frank, with its 2,300 pages, will unleash the biggest wave of new federal financial rule-making in three generations…. In a recent note to clients, the law firm of Davis Polk & Wardwell needed more than 150 pages merely to summarize the bureaucratic ecosystem created by Dodd-Frank. …[T]he lawyers estimate that the law will require no fewer than 243 new formal rule-makings by 11 different federal agencies.

The SEC alone, whose regulatory failures did so much to contribute to the panic, will write 95 new rules. The new Bureau of Consumer Financial Protection will write 24, and the new Financial Stability Oversight Council will issue 56. These won’t be one-page orders. The new rules will run into the hundreds if not thousands of pages in the Federal Register, laying out in detail what your neighborhood banker, hedge fund manager or derivatives trader can and cannot do.

…[T]he biggest financial players aren’t being punished or reined in. The only certain result is that they are being summoned to a closer relationship with Washington in which the best lobbyists win, and smaller, younger firms almost always lose. New layers of regulation will deter lending at least in the near term, and they are sure to raise the cost of credit.

You don’t have to be an economist to see the truth in the Journal‘s remark: “The timing of Dodd-Frank could hardly be worse for the fragile recovery.” This is a classic example of what Robert Higgs calls “regime uncertainty.” Who would make a major financial move with all those rules still yet to be written?

PS: Rep. Barney Frank has promised to fix this bill’s mistakes in a follow-up bill. Relieved?

PPS: Sen. Chris Dodd has admitted that no one knows how the new law will work until it is in operation. Be afraid. Be very afraid.

That’s Sen. Chris Dodd commenting on the 2,319-page financial regulation bill that he helped construct and that is wending its way through Congress. Dodd’s words must be a relief to the 535 congressmen and President: no point in reading the gibberish-laden monstrosity if you can’t tell what it will mean in practice anyway.

Dodd added, “But we believe we’ve done something that has been needed for a long time.”

How can he know? I’m not comforted by his faith, are you?

Congress has long found it convenient to delegate its legislative power to regulatory agencies several steps removed from public accountability. A stickler might say this can’t be legally done under the Constitution, but that ship left the dock long ago.

You can see why Congress likes it that way. If our misrepresentatives actually had to take responsibility for the bills they pass, they might pass a lot fewer bills. What they have now is called “plausible deniability.”

There’s something eerily ritualistic about the current occupant of the White House berating Wall Street for its irresponsibility and proposing new regulations, while his targets send a swarm of lobbyists to Washington to keep the regulatory overhaul from getting out of hand. (History says they’ll be on good terms with the regulators in any case.)

I’m reminded of journalist and historian Walter Karp’s book Indispensable Enemies. These apparent adversaries need each other.

This may sound outrageous. In what sense could it be said that the advocates of new financial regulation and the big financiers are on the same side? In this sense: Neither side would wish the other to disappear. Each is integral to the existing political economy (call it what you will), and neither would want it to change in any significant way. They are “indispensable ‘enemies.’”

Roderick Long has it right when he says,

We might compare the alliance between government and big business to the alliance between church and state in the Middle Ages. Of course it’s in the interest of both parties to maintain the alliance — but all the same, each side would like to be the dominant partner, so it’s no surprise that the history of such alliances will often look like a history of conflict and antipathy, as each side struggles to get the upper hand. But this struggle must be read against a common background framework of cooperation to maintain the system of control.

We have a system that’s a mix of government and “private” control. (It’s not truly private because the control entails force-backed guarantees, barriers to entry, and the like.) But it’s an unstable mix. Sometimes those who want more formal government control get the upper hand, while at other times those who want more “private” control elect their people to office. So the mix can change. What doesn’t change is that some mix of the two will exist, as opposed to an unalloyed political economy based on freedom and free exchange. The battles are at the margin.

As Long writes elsewhere, the people who run the system con the public by portraying the marginal disputes as fundamental struggles. What’s really an internecine argument over where to move the line is represented as a monumental battle between Unfettered Capitalism and Enlightened Progressivism, or some such pair of misleading terms. Long writes,

Corporate liberalism functions via a façade of opposition between a purportedly progressive statocracy and a purportedly pro-market plutocracy. The con operates by co-opting potential opponents of the establishment; those who recognise that something’s amiss with the statocratic wing are lured into supporting the plutocratic wing, and vice versa. Whenever the voters grow weary of the plutocracy, they’re offered the alleged alternative of an FDR or JFK; whenever they grow weary of the statocracy, they’re offered the alleged alternative of a Reagan or Thatcher. Perhaps the balance of power shifts slightly toward one side or the other; but the system remains essentially unchanged.

Moderate Radical

This is why the alleged radical Barack Obama can be elected president and we still find economic policy in the hands of establishment “corporate liberals” Larry Summers, Tim Geithner,  Paul Volcker, Christina Romer, Ben Bernanke, and Robert Rubin. You could see it coming, though: Obama got more Goldman Sachs-connected money than John McCain in 2008.

There’s been some controversy lately over whether it is appropriate to call the Obama administration a “regime.” It’s appropriate in my view so long as you’re also willing to talk about the Bush and Reagan regimes. But what we really should be talking about is “the permanent regime,” the underlying system that endures despite changes in White House occupants.

If you have doubts about any of this, imagine some top Wall Street operator calling for elimination of the Federal Reserve System and the banking cartel it administers. Imagine him endorsing repeal of all federal and state banking regulations and their replacement with free banking and market-based money. Imagine him testifying on behalf of an end to all implicit guarantees, bailout promises, and the “too big to fail” doctrine. If you can’t imagine it you have begun to grasp the nature of the actual political economy in which we live.

The latest financial crisis cannot have had roots in the free market because no free market has existed in finance, banking, or housing for a very long time. Its roots rather are in the government-business management of money and banking, and the political agenda imposed on a willing mortgage industry (among other things). So prevention of another crisis can hardly be found in new regulation by unaccountable bureaucrats who will necessarily lack the knowledge required to modulate risk systemwide without stifling innovation and progress.

Wall Street acted according to the incentives generated by the corporatist political system. That’s why it’s so absurd for Chris Dodd, Barney Frank, and Andrew Cuomo (among others) to stand in judgment of Wall Street. They were principals in creating the incentives that made recklessness appear rational and even compatible with the political agenda being pursued. Yet they continue to occupy perches of power.

Wall Street’s blame lies not in behaving according to the incentives created by Washington – what should we have expected? — but in actively supporting a cartelized financial system that feathers its nest at the people’s expense while sheltering it from the disciplining gales of free and open competition. A coherent, sophisticated, and liberty-oriented populist response would consist of a repudiation of Washington and Wall Street.

Posner describes well-known events—the failure of investment banks Bear Stearns and Lehman Brothers, the series of bailouts by the Treasury and the Federal Reserve, the stimulus package passed by Congress—then tries to explicate the causes of the crisis. His account, unfortunately, merely hews to current conventional wisdom.

Here’s a capsule version: Deregulation of banks combined with cheap and easy credit to cause interlinked debt and real estate bubbles. “Free market ideology” left banks and other financial firms free to take huge risky bets on mortgages, which they did. In 2007–08 the twin bubbles collapsed, resulting in a steep downturn in economic activity. The government had to shore up the system with extraordinary measures. The long-term solution is more government action to restrain and supervise financial institutions, although Posner would wait until the dust settles before reregulating.

It’s true that some household borrowing was channeled to risky instruments like adjustable-rate mortgages and much of the lending by banks was turned into complex securities backed by debt. When property prices declined and foreclosures spread, the values of these securities also declined, decimating bank balance sheets. But all that is a consequence not a cause of the trouble.

At the heart of the story is the ready availability of credit that fueled excessive borrowing and lending. Posner describes how the Fed flooded the economy with money in the early 2000s in response to the collapse of the previous bubble in stocks. However, he claims that even without the Fed’s loose monetary policy, an alleged global capital surplus brought in enough money from abroad to keep interest rates low.

That claim is dubious. Yes, Asians saved a lot, but other people, notably Americans, saved relatively little. In the world as a whole there was no surge in saving to drive down interest rates. It was the Fed’s easy money that pushed markets into a credit binge.

Posner’s line is that “Laissez-faire capitalism failed us, but government allowed the preconditions of depression to develop and wreak havoc with the economy.” He discusses the Federal Reserve’s culpability for the crisis, granting that it “would be a powerful argument against re-regulation,” but places more blame on that hobgoblin, “free market ideology.” The “free market” canard requires one to ignore that the United States hasn’t had anything close to a free financial market in a century.

Major mistakes by experts pose a challenge for Posner’s way of looking at behavior. For example, he describes Fed Chairman Ben Bernanke’s neglect of the warning signs of an impending crash as “extremely puzzling.” As a proponent of neoclassical economics, Posner assumes that people act rationally in the sense of making the best choices in view of all available information. And the Fed must be even more rational than the rest of us.

Another academic tribe, behavioral economists, attributes the crisis to human quirks like herding or imitation. Posner rejects those explanations on the ground that such behavior is not really irrational. On regulatory issues, however, he does not differ from behavioral economists who assume that government experts are trustworthy because they’re better informed than the general population.

Long before the currently fashionable behavioral school emerged, F. A. Hayek criticized the neoclassical rationality premise but came to a different conclusion from today’s proregulation behavioral economists. He found that government agents possess less wisdom than the market, which pools the knowledge of many individuals. The “fatal conceit” (as Hayek put it) that government knows better has resulted in economic disasters ranging from the Soviet Union to the Federal Reserve’s destabilizing policies.

Now the Fed is to become an even more powerful regulator of vaguely defined “systemic risk.” Posner grasps that “The successive Federal Reserve chairmanships of Greenspan and Bernanke must be reckoned prime causes of the financial crisis,” but even so agrees with President Obama that more government intervention is needed.

As a reform, Posner advocates the consolidation of agencies like the Securities and Exchange Commission into one top regulator along the lines of Britain’s Financial Services Authority. He appears oblivious to the fact that this authority with its overarching powers did not save Britain from financial crisis.

This highlights the book’s great flaw: Posner clings to the myth of benign government rationalism.

Following the financial problems of the last two years, short selling has come under fire, with new or revived regulations proposed to curb the practice. It is unpatriotic, destructive, and destabilizing, say the critics. Such complaints are nothing new. President Hoover blamed short sellers for the continuing market declines of 1931 and 1932, threatening regulation or even outright prohibition. “Individuals who use the facilities of the [stock] Exchange for such purposes are not contributing to the recovery of the United States,” he grumbled.

Defenders say short sellers add liquidity to markets. When short sellers are present, buyers encounter a more liquid market because they face a larger pool of sellers than they would otherwise. More sellers—more liquidity—means more predictable prices and smoother price changes. Shorts can put a damper on runaway enthusiasm, and when they are right, they can hasten the demise of failed businesses.

The mechanics of short selling are simple. You borrow stock and sell it, hoping its market price will decline so you can repay your loan with stock that you buy cheaply. In the meantime, you are said to be “short” that stock, the opposite of the situation of someone who owns the shares and is “long.” For widely traded stocks, brokers can easily find shares to borrow, either from their own inventory or from customers who have agreed to make their shares available. For thinly traded stocks it may be difficult or impossible to find shares to borrow. The short seller must pay the lender the amount of any dividends that the stock pays while he is short. And most brokers require cash on deposit to cover the obligation to buy the stock later on.

Most short sellers simply think a stock is overpriced and hope to profit from a decline. But sometimes short sales are used as part of a hedging program. If you want to “hedge your bets” you can short a stock to offset possible losses in a related stock that you own. For example, if you aren’t sure where the oil industry as a whole is going but you think Chevron is overpriced relative to Exxon Mobil, you can buy XOM and sell CVX short. Or you may have shares of your employer’s stock coming to you as part of your year-end bonus but you fear a price drop before then. You can sell short and then cover your position with the shares you receive. (Hedge funds, incidentally, were originally organized to engage in hedging, but have since expanded into all sorts of exotic trading strategies.)

Since there is no limit on how high a stock price can go, short sellers who are not hedging expose themselves to unlimited potential loss. Amateur investors should be very careful about selling short and should use stop orders to exit their position if the market goes against them.

Failure is an essential feature of free markets. Companies that suffer losses must be allowed to fail so that scarce capital can be redeployed into lines of business that better serve consumers. Short sellers, when they are right, hasten the necessary decline of the stock of a faltering company. In extreme cases, short sales can predict liquidation or bankruptcy. In other cases the stock of a generally sound company may have been driven to unsustainable heights by bandwagon psychology, and short sellers can help deflate those spikes and hasten a return to more realistic levels.

But the message that the short seller brings is not always popular. We don’t like to hear bad news. We may think there’s something unseemly about speculators profiting from other people’s troubles. Executives of companies whose stock is being shorted can be particularly vocal about blaming speculators for beating up their company shares when in fact their own management blunders are at fault. Almost since the beginning of organized stock trading, short sellers have been suspected of distorting markets, destroying good companies, and reaping unjust profits.

Abusive Short Sales?

Can speculators start a run on a stock using massive short selling? Dumping large blocks of stock could cause a price drop that would frighten many holders into selling out, driving the stock still lower—a waterfall decline. Then at just the right moment, the shorts could cover their positions (buy shares to repay their stock loans), taking a big profit. Their profit would come at the expense of other shareholders, with no fundamental developments accompanying the price swings.

Such maneuvers are possible in theory but quite difficult to pull off successfully. You have to find shares to borrow, and lots of them, if you’re going to have a noticeable impact on the share price. Then you have to get the timing just right. If you don’t and the share price rebounds before you can get out, you’re left holding the bag, with unlimited potential losses as the stock rises. If you are conspiring with others, there is always the danger that one of your group will break ranks and grab profits ahead of the others. Manipulation, therefore, is much easier said than done.

“Naked short selling” has come under scrutiny recently and has been the subject of an increasing number of lawsuits. One plaintiff’s lawyer calls the practice “the largest commercial fraud in U.S. history, involving hundreds of billions of dollars.” In a naked short sale, the seller has not borrowed the shares that he is obligated to deliver, but seems to be making them up out of thin air. Clearly this is fraudulent behavior. Clearly someone has been cheated.

Not necessarily. Sellers, short or not, are given three business days to deliver the shares they have sold. Short sellers are required to have borrowed the shares or have good reason to expect to find them by the settlement date. If that day arrives and the stock has not been delivered, a “failure to deliver” event is recorded. To see what happens next, we need to understand a little of how stocks are held and traded these days.

Stock trading has evolved into a highly efficient business. Customers can enter orders online and see the results in just seconds. Commission rates are low, often under $10, and problems are extremely rare. This happy situation has been made possible in part by the elimination of paper stock certificates. When you buy stock in today’s market, you actually acquire an entitlement to shares that are kept in the possession of an organization called the Depository Trust Co. (DTC). When you sell your stock (or, strictly speaking, when you sell your entitlement), another organization, the National Securities Clearing Corp. (NSCC), issues an order to the DTC to record the new entitlement. The physical securities are not touched. Most brokers are members of the NSCC and conduct virtually all their trading by electronic transmission of orders to transfer entitlements.

Failures to deliver are rare, and the DTC and the NSCC have procedures in place to handle them when they do occur. First, the seller does not receive funds until the shares are delivered. Likewise, the buyer does not relinquish funds until the shares are delivered. If the settlement date passes and the seller has not delivered, the buyer can send a “buy-in” order to the NSCC. The seller gets two more days to deliver the shares, and after that if there has still been no delivery, the NSCC will purchase the shares and charge the account of the member who failed to deliver.

In this situation the only difference is who acts as the effective lender of the security. While this is certainly not the normal course of events, it is hard to see how the economic effect on the market as a whole is any different from the effect of a short sale completed in the normal way.

Thus naked short selling does not appear to be a major problem, nor does it have the dire consequences one might expect.

Regulation of Short Selling

The Securities and Exchange Commission (SEC) regulates stock trading in the United States. Regulation of short sales began in 1938, and the current “Regulation SHO” was adopted in 2005. Short sales are explicitly permitted except, according to an SEC commentary, when “effected to manipulate the price of a stock.” The commentary does not state how the intent of a seller is to be determined. Presumably, an expression of satisfaction when the stock falls is not enough. Nor, one hopes, is knowledge that any sale will put at least marginal downward pressure on the price. But this is just the sort of fuzzy, non-objective law that opens the door to abusive prosecution.

The SEC commentary on regulation specifically addresses failures to deliver and naked short selling. Interestingly, it declares that naked short selling is not always a bad thing, but rather, in certain circumstances, it “contributes to market liquidity.” It cites as an example a market maker (a specialist or a broker/dealer) whose job is to offer to buy and sell a particular stock continuously even when there are no other buyers or sellers. To meet a sudden surge in buying, a market maker may sell short without having first found shares to borrow. The public benefits from a smoother market, and there is almost no risk that the market maker will be unable to net out his position in a reasonable time.

The SEC has been fielding a growing volume of complaints alleging possible market manipulation via short sales—about five thousand between January 1, 2007, and June 30, 2008. Of these, just 123 were forwarded for investigation. None were pursued. The SEC staff has downplayed the importance of naked short-selling abuses.

This has not deterred politicians from gunning for short sellers. Leading the charge is a group of six senators led by Edward Kaufman (D-Del.). So, notwithstanding its relatively benign view of short selling, even some forms of naked short selling, the SEC has decided to propose rule changes to curb short selling. Reinstatement of the “uptick rule” is one proposal, and there might also be “circuit breaker” provisions to further inhibit waterfall declines. The SEC’s recent proposal to reinstate the rule was met with mainly negative reactions from people in the securities business, and at this writing no decision has been made.

From 1938 to 2007 an uptick rule was in effect. At any given moment, a stock has “ticked up” if its last price was higher than the previous price. When a stock was declining, short sales were forbidden until an uptick occurred. This was supposed to help curb runaway declines.

A major change in trading took place a few years ago when the time-honored practice of quoting prices in dollars and eighths of a dollar (sometimes sixteenths) was abandoned in favor of decimal quotes. The change was welcomed by just about everyone, especially those who had to do arithmetic with prices. The economic importance of the change was that stocks now move in one-penny increments rather than eighths (12.5 cents). An uptick rule in the one-penny environment has far less effect than under the old fractional regime simply because there are smaller and more frequent price changes, so that the tick changes direction more frequently. But reinstating the rule would let politicians take credit for pressuring the SEC into “doing something” about the nasty short sellers. And they will probably cause little damage to the markets in the process.

Circuit-breaker rules were put into effect after the crash of 1987. In case of a severe selloff, trading on the New York Stock Exchange, as measured by the Dow Jones Industrial Average, can be interrupted or halted, depending on the time of day and the magnitude of the decline. The proposed new rule would extend this idea to individual stocks, interrupting or halting short sales of stocks that have experienced rapid declines. This rule may or may not make much difference depending on how the parameters are selected. It could give an unfair advantage to sellers of a stock who already own it. With competing short sellers temporarily locked out of the market ordinary sellers, still allowed to sell, could enjoy a price advantage. It might also be difficult for market makers to distinguish ordinary sell orders from short sales.

In the long run stock prices are determined by fundamentals. In the short run all sorts of influences drive stock prices: exuberance, despair, rumors. Those who choose to engage in short-term trading should understand this and be prepared for volatility. Restraints on honest short selling can only hinder the recognition of failing companies and stymie the efforts of hedgers to reduce their risk.

“The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing ‘imperfect’ institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.”

A common form of the fallacy is rejection of the imperfect free (or freer) market in favor of (presumably) omniscient, omnipotent, and omnibenevolent government regulation. A “flawed” but achievable arrangement is set against an (alleged) ideal, though it is left unestablished whether the ideal can in fact exist. The problem here should be obvious. If the ideal is not available, then the comparison is worthless. If the rejected option were compared to other achievable—also imperfect—alternatives, it might well be judged superior.

A recent example of the Nirvana Fallacy comes from Sen. Charles Schumer of New York. Asked how the Obama administration will prevent another financial crisis, Schumer said:

“You’re gonna find a different system of regulation. . . . So like when Bear Stearns began to run into trouble, they’re gonna call the heads of Bear Stearns in and say, ‘All right fellas, you’re getting rid of those two hedge funds; you’re gonna raise more capital—even if it means you have lower profitability. . . . [Y]ou do it or we’re gonna take sanctions against you.’ . . . You need a tough, strong regulator, unified—no holes in the system— . . . who . . . sees the problem ahead of time, so they have complete transparency, they know exactly what’s going on. . . .” (emphasis added)

We see at once that Schumer assumes what he must demonstrate: namely, that the regulator can overcome the Hayekian “knowledge problem,” the limits posed by the fact that the most critical economic information is not readily obtainable statistical data but rather is diffused and often unarticulated knowledge, including know-how.

Look at what I’ve highlighted in his statement, and ask yourself what Schumer apparently has not asked himself: How will the regulators “know exactly what’s going on”? Spotting Bear Stearns’s specific hedge-fund problems “ahead of time” would have required insights and hunches that only entrepreneurs with money at risk could be expected to have—and even those might not have been enough. Fortune-telling is not a widely distributed skill. It’s not a matter of toughness or access to Bear’s books but, at the very least, of entrepreneurship (not to mention luck), which is profit driven. Bureaucratic regulators bring no such talent to their jobs. More likely, they’d be enforcing formal (possibly outdated and irrelevant) rules, looking for a repeat of the last problem, while missing the next one entirely. As Nassim Nicholas Taleb might say, it’s the next black swan, not the last one, that bites you.

Schumer’s fallacy is actually worse than the standard Nirvana Fallacy. He doesn’t compare his unrealizable regulatory vision to the free market but rather to our corporatist economy replete with government bailouts, moral hazard, easy credit, and all the other ways of disabling market forces.

The closest we can get to what Schumer says he wants is through the discipline—that is, the regulation—imposed by the unfettered market. That includes bankruptcy’s Sword of Damocles and the freedom of traders to sell short—that is, to profit by betting that a company’s stock is overvalued and communicating that information to the market early. Predictably, the government is planning to restrict short selling. Bad regulation drives out good.

* * *

Advocates of big government claim they learned lots of lessons from the New Deal. But here’s something they missed: The post-1929 economy began to rebound before FDR’s programs could have taken effect and even before he took office. Jim Powell explains.

Government spending is said to be indispensable to recovery from a recession thanks to the magic of the “multiplier.” Is there really more bang from the government-directed buck? James Ahiakpor debunks the myth.

But surely the government is good at creating productive jobs when it spends money, no? Larissa Price, applying Bastiat’s lesson, throws cold water on that hope.

By now you may have bought some of those funny-looking spirally light bulbs after hearing they use less energy and save you money—only to find that they can’t hold a candle to the old incandescent bulbs. Thanks to Congress and former President George W. Bush, though, soon you won’t have a choice. Michael Heberling has the unfortunate details.

Last spring’s G-20 economic meeting called for a crusade against tax havens, places where people can protect their wealth from greedy politicians. Daniel Mitchell comes to their defense.

Can there be freedom when the state sees itself as Robin Hood? Carlos Rodríguez Braun shoots an arrow into the heart of that belief.

Land has been at the center of conflict from time immemorial. Even so-called capitalist countries have been blemished by land monopolies, government-sponsored speculation, and feudal-style interventions, such as property taxes. Joseph Stromberg conducts a tour of the great land question.

Our columnists again serve up an intellectual feast. Lawrence Reed writes about perseverance in the face of adversity. Thomas Szasz further documents psychiatric slavery. Burton Folsom takes a critical look at an economic interpretation of the Constitution. John Stossel examines the “fatal conceit” of interventionists. Walter Williams defends school choice. And Robert Murphy, encountering a free-market advocate’s case for government monitoring of derivatives, responds, “It Just Ain’t So!”

Our reviewers render verdicts on books about World War II, libertarianism, early globalization, and the Constitution.