“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.

Cases of ridiculous occupational licensing regulations are a dime a dozen. One that I came across recently is illustrative. Due to the fact that the diet of horses today contains much less abrasive material than in the past, their teeth need to be filed down periodically. Without that service, called “floating,” it becomes painful for a horse to chew or hold a bit.

A veteran horse teeth “floater” in Minnesota has run into trouble with the State Board of Veterinarians, which informed him that he was doing work that fell within the legal purview of veterinarians and because he was not a licensed vet, he would have to stop. No customer of his had complained about his work, so what was the problem? The problem was that he charged only half as much as vets did for the same work. That was intolerable. The licensed vets of Minnesota saw an easy way to eliminate competition from this outsider by enforcing the law.

Is there any justification for occupational licensing statutes? The many professional organizations that promote such laws invariably claim that there are laudable public purposes behind them—primarily that they are needed to protect the public against incompetent practitioners. “All we care about is guaranteeing that those in the field have at least achieved the basic level of competence so consumers won’t be cheated,” they claim.

Should we accept that claim? Morris Kleiner, an economist who teaches at the University of Minnesota and is a visiting scholar in the economics department of the Minneapolis Federal Reserve Bank, takes a careful look at the issue in Licensing Occupations and comes to the conclusion that occupational licensing statutes do little or nothing to protect consumers, but do tend to raise the price of services. Kleiner writes, “[F]rom the evidence I was able to gather, there is no overall quality benefit (measured in a number of different ways) of licensing to consumers. Consequently, the cost of regulation to society is higher prices or longer waits for a service. An additional societal cost is the reallocation of income from consumers to practitioners of the licensed occupation as well as lost output.”

So once again we find that coercive interference with market processes creates benefits for a few that are outweighed by costs to the many.

Kleiner’s analysis involves comparing states that license certain occupations with others that don’t. For example, while most states require that practical and vocational nurses be licensed, several do not. If licensing actually raises practitioner quality, Kleiner reasons, then insurance rates for those nurses in nonlicensing states should be higher than in states with licensing to reflect their supposedly higher likelihood of making mistakes. Too bad for licensing advocates—Kleiner finds that insurance rates are no higher in states that don’t require licensure.

Kleiner also makes excellent analytical use of data from the neighboring states of Minnesota and Wisconsin. Wisconsin requires licensing for many occupations that Minnesota doesn’t. Many of the licensed occupations in Wisconsin are only subject to certification in Minnesota. From the data on complaints filed by consumers, Kleiner concludes, “At a minimum, licensed occupations showed no greater ability to reduce constituents’ complaints to licensing boards about the service provided compared to complaints filed in a regime where the same occupations were certified. . . .”

That is an important finding. Free-market advocates have long maintained that private certification—which allows practitioners to demonstrate competency by passing an examination, but does not prohibit noncertified individuals from offering their services (as long as they don’t falsely claim to be certified)—is preferable to licensing because it allows consumers to choose. If they think a certified practitioner best suits their needs, that option is available; if they don’t want to pay more for a certified professional or believe that a noncertified practitioner can do the work competently, they can make that choice. Certification is consistent with liberty whereas licensing statutes are authoritarian attacks on liberty.

Kleiner makes it clear that the impetus behind occupational licensing is overwhelmingly the desire by professionals to control entry into their field, not a dispassionate analysis by public officials that citizens would be best served if they were forced to choose between doing business with a licensed, state-approved practitioner and either getting no service at all or attempting a do-it-yourself job. Licensing Occupations pounds another nail into the coffin of the belief that labor-market regulations are wise policy choices.

Oh yes—the Minnesota “floating” case. It is currently before a state court, and the Institute for Justice attorney who represented the defendant says that the Veterinary Board is pulling out all the stops to show that the licensing statute is necessary and reasonable. I wish  someone would send the judge a copy of Professor Kleiner’s book.