In his introductory essay editor Edward López states the core idea advanced in the book: “[I]f we want to understand why the legal system sometimes fails to perform up to our ideals and expectations we must analyze the incentives available to actors in the legal arena and the institutions that set the ‘rules of the game.’” This focus raises the question of whether Public Choice analysis differs from the “economic analysis of law” advanced by Ronald Coase, Richard Posner, and others. López maintains that while “there is little fundamental difference between” the two on methodological grounds, there seems to be a difference “in the character of the reforms they recommend.” According to López, Public Choice emphasizes constraining political actors while the economic analysis of law emphasizes “arranging institutions to minimize transactions costs.”

Benjamin Barton’s chapter on the “lawyer-judge hypothesis”—which might be the marquee contribution to this volume—argues that “if there is a clear advantage or disadvantage to the legal profession in any given question of law, judges will choose the route that benefits the profession as a whole.” Barton offers a number of examples drawn from numerous areas of the law that support the hypothesis. Charles Keckler’s outline of recent changes in the cy pres doctrine that enable judges to award unclaimed funds from class actions to “law related entities such as law schools” fits squarely within this analysis.

The other nonquantitative contributions deal with more familiar topics. Nicholas Curott and Edward Stringham do a nice job retelling the story of Anglo-Saxon law as a spontaneous order that focused on victim compensation and how it was replaced by a centralizing Norman legal order after 1066. Ilya Somin takes dead aim at the use of eminent domain by local governments bent on “economic development,” and John Bratland argues that “just compensation” in cases of government takings fails as an ethical matter. Adam Summers recounts the case against government licensure of lawyers and argues for market-based alternatives.

Three chapters that use numerical data and summary statistics all include suggestions for reform. Roger Koppl offers a strong critique of the current use of forensic science in criminal justice administration. Government-run forensic laboratories make mistakes in testing crime scene evidence—television dramas to the contrary notwithstanding. Testing at multiple labs simultaneously would reduce the number of mistakes, but money for multiple testing is unlikely to be sought by the law enforcement bureaucrats who handle the laboratories’ budget requests—in part because the bureaucrats are likely more interested in maximizing the number of convictions than in the disinterested pursuit of truth. Koppl argues for triplicate testing of fingerprint evidence on the grounds of cost savings; his most conservative estimate is that $9 million in extra testing would save taxpayers $61 million in prison costs by “eliminating over 98 percent of the false felony convictions” caused by errors in fingerprint analysis.

Jeffrey Hammond explains class-action litigation as a vehicle for rent extraction, using the government lawsuits against the tobacco companies as a strong example.

The book’s three chapters that use regression analysis all find fault with the election of judges at the state level. Russell Sobel, Matt Ryan, and Joshua Hall suggest nonpartisan elections as an alternative. They also relate overly aggressive prosecutions to the election of public prosecutors. Adrianna Cordis finds that judicial elections contribute to government corruption, but does note a 2008 article by Alt and Lassen that finds the contrary to be true. Aleksandar Tomic and Jahn Hakes explain judicial sentencing of criminals as a function of whether the judges face political pressure. While all three papers will doubtless enter the long-running debate over state judicial selection, they are unlikely to provide a knockout punch to the supporters of judicial elections.

In all, this book is an excellent contribution to the Public Choice literature.

First, something that is right.

With one major exception (discussed below), the typical economist, when doing economics (and regardless of political bent), doggedly avoids ad hominem explanations. That is, economists don’t explain observed reality as resulting from specific human personalities or personality traits. Instead, economists (try to) identify the constraints and opportunities that confront decision-makers and then explain patterns of human activities as being predictable outcomes of the ways that individuals—any individuals—respond to identified constraints and opportunities.

This avoidance of ad hominem explanations is the source of one of the most important lessons that economists teach: greed explains nothing. Because greed—or, more accurately, “self-interestedness”—is largely unchanging across time, no observed changes in the economy can be explained by it.

Greed can’t explain rising fuel prices, for example, given that fuel sellers (and also fuel buyers) are just as greedy when prices are lower as they are when prices are higher. Likewise with booms and busts. Because people’s greed remains constant something else must explain booms and busts. And so too for any other economic phenomena you care to name—everything from the fact that Americans are richer than Armenians to the fact that, say, big-box retailers’ market shares are growing while those of mom-’n’-pop retailers are shrinking.

Of course the particular constraints and opportunities identified by economist Doe as being most relevant for explaining some phenomenon often differ from those identified by economist Jones for explaining the same phenomenon. Doe, for example, might identify an increase in the rate of growth of the money supply as the most crucial factor for explaining an observed boom and bust, while Jones identifies an easing in government regulation of banks as the crucial factor. But neither Doe nor Jones explains the boom and bust as caused by the likes of greed or ignorance.

Economists’ refusal to use always-popular (and often half-baked) romantic notions about human behavior to explain economic phenomena goes a long way toward making economics a genuine science, and it accounts for much of whatever good economists have managed to bestow on society.

What’s Wrong

Turning now to something that is wrong with economics, much of the harm that economists inflict on society is a direct result of the one area in which economists too often embrace such ad hominem explanations: analyzing government involvement in the economy.

Despite a long-established tradition in economics of studying the “public” sector using the same analytical tools that we use to study the private sector—and despite two founders of this Public Choice tradition being awarded Nobel Prizes (George Stigler in 1982 and James Buchanan in 1986)—far too many economists persist in sloppy, unanalytical ad hominem thinking about government.

For too many economists government is assumed to be able to escape many of the constraints that unavoidably bind and trip up people in the private sector. Asymmetric information, moral hazard, and adverse selection, as well as confirmation bias and the legions of other alleged “irrationalities” identified by behavioral economists, are just some of the “imperfections” economists find in markets and then too frequently simply assume can be dealt with effectively by government.

Overlook here the fact that many of the problems alleged to be unavoidable in the private sector are in fact handled quite well by human beings acting without government who exhibit far more ingenuity than the typical economist believes is possible in private-sector settings. (It’s notable that Elinor Ostrom, the first woman to win the Nobel Prize in economics, isn’t a professor of economics but instead of political science. She won the prize in 2009 for her work showing how creative people in private settings often overcome obstacles—such as free-rider problems—that most economists naively assume can be overcome only by government.)

Unanalytical Assumptions

Focus instead on economists’ bizarre stumble into an unanalytical assessment of government. That stumble goes like this: “Omigosh! There’s an imperfection in this private-sector market! My textbooks and the many refereed journal articles I’ve read and written make quite clear—with lots of difficult mathematics—that this market will therefore fail. My textbooks and journal articles also imply, and in many cases explicitly state, the conclusion that the government—and only the government—can solve the problem. Models prove this conclusion.”

Such stumbling is common. From today’s insistence that America needs more stimulus spending, through the support that many economists express for the new Consumer Financial Protection Bureau, to economists’ overwhelming belief that countries need central banks, too many economists unscientifically reach their conclusions about the alleged efficacy of government intervention without first asking how the information available to government officials, and how the incentives these officials face, will affect government decision-making.

In short, economists mysteriously conclude that desirable public-sector outcomes follow from the praiseworthy intentions that economists assume motivate most public officials.

Nowhere does this mystery run more deeply than in fiscal policy. Even if it were true that increased government spending can hasten an economy’s escape from a recession, the large number of economists who today endorse such spending is discouraging. Seldom do these economists inquire into the incentives facing government officials in charge of spending. The assumption is that these officials will spend the money in ways sure to promote the public interest. Also, seldom do these economists inquire into the information asymmetries and other constraints that might hamper even well-meaning officials’ efforts to carry out fiscal policy effectively.

Save for the relatively few economists steeped in Public Choice economics, the typical economist today remains a political naif—and a dangerous one at that. He is bloated with unjustified confidence in models which show that if government officials behave in the public interest and if these officials are immune to the same decision-making quirks and knowledge limitations that afflict decision-makers in private markets, then government can perform all manner of marvels. This economist then uses his authority to support interventions that are utterly unjustified by genuine scientific standards.

It’s shameful.

Although the phrase “nation-building” sounds much more constructive and well-intentioned than the destruction and death that have normally accompanied the use of American power, the reality is that attempts to build nations are likely to fail. What the nation-builders overlook is a distinction made by Ludwig von Mises almost 100 years ago: A nation is not necessarily the same as a “state.” In his underappreciated little book Nation, State, and Economy, Mises argued that “nations” are defined not by geography or by political institutions, but most fundamentally by language and other similar cultural institutions that provide a basis for “mutual understanding.”

Therefore the nation, Mises argued, cannot be understood as a static object that we can manipulate as we wish: “Nations and languages are not unchangeable categories but, rather, provisional results of a process in constant flux; they change from day to day, and so we see before us a wealth of intermediate forms whose classification requires some pondering.”

This evolutionary perspective on what constitutes a nation suggests that it may be very difficult for an external observer to even know whether a given mass of people constitutes a “nation,” much less be able to know what it would take to build a nation out of their current “intermediate form.” As we know from F. A. Hayek, people learn how to coordinate their behavior with one another via such evolutionary processes. In other words nations are spontaneous orders that emerge from the daily choices of people about the language they use and the other ways in which they participate in, or withdraw from, a variety of cultural forms. The people themselves constitute a “nation” by their individual choices.

States imposed on nations by princes, Mises contended, are doomed to fail because they normally attempt to eliminate all forms of community that lie between the prince and the people. Anything that doesn’t come from the State is to be dissolved. In other words imposed States dislike and destroy the delicate, complex, and evolved connections that comprise a true nation. This is why totalitarian regimes try to control language, religion, family, and all of the other intermediary institutions between individual and State: because those institutions help to define what it means to be a nation as distinct from a State. They provide a buffer between the evolving choices of individuals and the attempt to control those choices from the top down.

Like other attempts to control spontaneous orders, nation-building faces significant knowledge problems. It is no different in principle from attempting to plan an economy domestically. As Mises and Hayek pointed out decades ago, when planners attempt to allocate resources from the top down, they have no market signals to guide their behavior or to indicate what value people place on various outputs and inputs—that is, no prices with which to engage in economic calculation.

Nation-building is even harder than central planning at home. Once we understand that true nations are the unintended consequence of decentralized cultural processes involving millions of choices by millions of people, the absurdity of trying to build a nation as if it were a child’s toy or even a skyscraper becomes clear. Mucking around in processes that are too complex to understand in all of their relevant causal connections is almost certain to produce unintended and undesirable consequences. All the intermediary institutions that define a nation (such as language, customs, religion, and family) themselves have strong elements of spontaneous order to them because they grow out of the day-to-day practice of individuals with no overarching plan. These are ways in which individuals try to coordinate their behavior, slowly evolving institutions to assist them. Such processes of coordination work best when individuals and small groups are free to use their own particular knowledge to determine what will improve their lives. To build a nation, in Mises’s terms, would require one to be able to do a better job than the decentralized social processes described above.

Economist Chris Coyne, in his wonderful book After War, confirms that postwar reconstruction (the form recent nation-building has taken) suffers from the same sort of knowledge problem that faces those who would “build” an economy domestically. If Mises and Hayek were right about the impossibility of socialist planning because economies are simply too complex to be surveyed by one mind without the help of signals such as prices, then nation-building is equally impossible. Just as the intervention of economic planners inevitably produces results that run counter to their stated goals, leading them to intervene again to solve those problems, so will nation-building create pushback and new forms of culture and community that frustrate the designs of the builders. The quagmires of Iraq and Afghanistan are clear evidence for this argument.

Coyne articulates a number of propositions that explain the failure of attempts at “exporting democracy.” Three of those are of particular relevance to the argument here.

Why Democracy Can’t Be Exported

First, he argues that while economists and other social scientists have a pretty good idea of what constitutes a functional nation, they have much less knowledge about how to bring a “failed nation” to that point. How nations emerge is a process that is both complex and unique to each particular country. All that we can do is get out of the way and let people figure it out for themselves.

Coyne also distinguishes between the factors that nation-builders can control and those they cannot.

He argues that the uncontrollable factors are what we generally call “culture” or the “informal rules and institutions” that constitute societies. These factors constrain those that we can control. In other words there are things nation-builders can attempt to do, such as initiate democratic elections as the U.S. government did in Iraq, but the success of those formal changes depends greatly on whether they are consistent with the underlying culture. Just putting formal changes in place because you can control them does not mean they will produce the desired result.

Nirvana-Building

Finally, Coyne points out that many attempts at nation-building suffer from what economists have long called the “Nirvana fallacy.” That fallacy lies in comparing the imperfection of existing reality to the perfect world they can imagine in their theories or on their chalkboards, then condemning reality for failing to measure up. In the chalkboard descriptions of how nation-building should take place, planners are presumed to be guided by the public interest with all the information they need to generate the desired outcomes. I have already discussed the problem with the latter. The former, though, also omits the imperfections of politics. The knowledge problem is compounded by perverse incentives.

There is a pitfall in assuming that those charged with using the political process to build, or rebuild, a nation will ignore their self-interest and be motivated solely by the public interest. Nation-builders need to correctly identify the public interest. Although they may know what the endpoint is, knowing what path will generate that socially desirable outcome is the fundamental challenge. It is not possible for them to know if any given nation-building action is actually in the public interest. With that constraint we should not be surprised to see the self-interest of the nation-builders predominating. Coyne documents how political self-interest has ruled U.S. nation-building efforts in Iraq and Afghanistan, manifested in the cozy relationships American politicians and policymakers have with private-sector firms with whom they had preexisting associations. Nation-building is a fertile ground for the sorts of corporate-State partnerships that undermine genuinely free markets.

Liberalism and Anti-Imperialism

Coyne’s book and the broader arguments I have offered above are part of the long-standing classical-liberal tradition of anti-imperialism. Perhaps because of the accidental alliances created by the Cold War, many have forgotten that tradition. In fact, classical liberals have always believed that the best way to encourage national development is through trade in goods and services and ideas—not through political or military intervention, even in the name of helping others.

The arguments against nation-building are much the same as those against domestic intervention (which can be recast as “economy-building” or “morality-building”). Both spring from the mistaken belief that outsiders can do better than the arrangements that emerge spontaneously and evolve continuously as individuals engage with each other. Both suffer from insurmountable knowledge problems and the perverse incentives of the political process. A better choice is to encourage unhampered exchange—within and between nations. Failure to grasp the impossibility—and often brutal consequences—of nation-building can remove yet another bulwark against further domestic intervention. If we can build a nation to our liking overseas, after all, why can’t we do it at home?

Those two sentences helped focus the Progressive worldview. First, the United States needed an income tax to capture large chunks of revenue. Second, someone who had a large fortune, “by the mere fact of its size,” had to be treated differently from other wealth holders. Property rights became variable. One group would be treated one way, other groups would be treated another way. Third, the nation needed a “graduated income tax” to redistribute wealth from the haves to the have-nots. The new tax slogan would be “ability to pay.”

Author Delos Kinsman, writing while Roosevelt was president, said, “Individuals should contribute to the support of the government according to ability.” And “income is the most just measure of that ability.” Enlightened leaders like Teddy Roosevelt would redistribute wealth in the national interest.

Roosevelt’s thinking was a profound change from the views of the Founders. To them, government existed to protect property, not redistribute it. Americans had a right to pursue life, liberty, and property, not an entitlement to it. Thus the Founders never considered raising revenue through an income tax, least of all a graduated one. They wanted consumption taxes—levies on imports or on luxury goods. Why? Because, as Alexander Hamilton said in Federalist 21, “The amount to be contributed by each citizen will in a degree be at his own option, and can be regulated by an attention to his resources.”

Hamilton added, “If duties are too high, they lessen the consumption; the collection is eluded; and the product in the treasury is not so great. . . . This forms a complete barrier against any material oppression of the citizens by taxes of this class, and is itself a natural limitation of the power of imposing them.”

American law also reinforced the use of consumption taxes. “All duties, imposts and excises shall be uniform throughout the United States,” the Constitution reads. What could be more uniform than Congress’s first excise tax of seven cents a gallon on all whiskey produced in the United States?

Not Good Enough

Progressives, however, disliked consumption taxes as the major source for revenue. They were too small, too cumbersome to collect, and sometimes too regressive—wealth never properly redistributed itself through consumption taxes. Taxes on whiskey, tobacco, and imported olives from Spain shifted very little, if any, wealth from rich to poor. In 1913 the House Ways and Means Committee observed that federal revenue rested “solely on consumption. The amount each citizen contributes is governed, not by his ability to pay taxes, but by his consumption of the articles needed.” Swollen fortunes, as Roosevelt might say, went untaxed and became more swollen while some immigrants lived in poverty.

The Sixteenth Amendment was ratified in 1913, giving Congress the “power to lay and collect taxes on incomes from whatever source derived.” It did not rule out “ability to pay” as the basis for the levy. The amendment became law just as Woodrow Wilson was coming into the presidency. As a Progressive, Wilson wanted to start small, establish a precedent, and then increase rates over time. Under the new tax law, exemptions were so high that few Americans earned enough to pay any tax. Rates started at 1 percent and rose slowly to a high of 7 percent on all income over $500,000.

Progressives easily sold this tax plan to the voters. Fewer than one American family in 100 paid anything, but politicians could promise audiences that they might receive benefits from the revenue. And who would dare to suggest that billionaire John D. Rockefeller did not have the ability to pay 7 percent of his huge income to the government?

Ability to Pay

Yet that raises an interesting question. At what tax rate did Rockefeller, or other wealthy men, cease to have the ability to pay? If they could pay 7 percent, could they pay 15? Apparently so, because in 1916 Wilson and Congress raised the top rate to 15 percent. Unlike with a consumption tax, under the income tax politicians judge ability to pay and they choose the rates they think rich people can afford. If politicians choose rates too high they may lose the support of the rich, but they may gain support of those larger groups receiving subsidies from the tax revenue. If wealth really needs to be redistributed, should we trust people to do it with their own money or politicians with other people’s money?

Rockefeller, for example, was the best and cheapest oil refiner in the world. His charitable giving included the Erie Street Baptist Church, a cure for meningitis, and funding for Tuskegee Institute. That was how he redistributed his own wealth. Andrew Carnegie, the steel baron, built libraries, and banker Andrew Mellon built the National Gallery of Art in Washington, D.C. In the political realm, President Franklin Roosevelt supported high taxes and gave subsidies to silver miners, farmers, and the Tennessee Valley Authority to make cheap electric power.

Charitable givers and politicians both pursue their self-interest, but the politician’s self-interest includes winning votes. That means, if possible, channeling subsidies to voting groups to win reelection at the expense of taxpayers in general. Rockefeller’s gifts to Tuskegee did not cost anyone but him any money. FDR’s subsidy to silver miners, by contrast, cost millions of taxpayers small amounts of tax revenue. It helped FDR carry several western states each time he ran for president. His redistribution efforts were essential to his being reelected.

Thus U.S. politicians had incentives to steadily increase the income tax in the 1900s. The top rate went from 7 to 15 percent in Wilson’s first term. World War I took it over 60, then over 70 percent. It didn’t drop below 50 percent until 1924, and was about 25 percent the rest of the decade. The rate rose to 63 percent in 1932 under Herbert Hoover and then 79 percent in 1935. The World War II years pushed it over 80 percent, and in 1945, FDR’s last year in office, the top was 94 percent on all income over $200,000. Wealthy people apparently had a very high ability to pay, and politicians had a very high desire to fight wars and win elections.

Much of this well-written study, however, is devoted to describing the intellectual origins of the approach to political economy known today as “Public Choice”—the economics of politics. Nevertheless, its subject is the history of the analysis of nonmarket activity generally.

Modern economics offers two separate grounds for interventionism. One traces its origins to John Maynard Keynes, the other to Arthur Cecil Pigou. Both were students of Alfred Marshall; both were fellows of King’s College, Cambridge, in the 1930s; and both proposed theories of “market failure.” Pigou was probably the first to examine so-called “market failure” within a Marshallian, microeconomic framework, pointing out how self-interest can produce systematic inefficiencies. His intellectual descendants often use the framework he created to conduct “welfare analyses” of positive and negative externalities, as well as of the taxes, subsidies, and other measures that are supposed to fix them.

Steven G. Medema deals with the Pigouvian legacy in this fascinating intellectual history. But Pigou lies somewhere in the middle of the story Professor Medema tells.

The book presumes familiarity with economic theory and contemporary ideas in political economy, so I would not recommend this book for the general reader. But anyone who has taken an introductory course in microeconomics should be reasonably comfortable with the discussion. The book opens with a short overview of Adam Smith’s explanation of how self-interest promotes the general welfare via the “invisible hand,” contrasting that view with the more statist approaches of the earlier French Physiocrats and English Mercantilists. In the hands of Smith, self-interest “had finally found legitimacy.” But this is not the Smith of laissez-faire caricature. Medema offers an impressive list of interventions Smith advocated, from regulating public hygiene to taxes on liquor. For Medema, Smith’s great achievement, however, was to make laissez-faire capitalism the “default mode” of government policy.

The next two chapters trace the swing from widespread support for laissez faire among British intellectuals back to a more interventionist proclivity in the latter nineteenth century in the writings of Jeremy Bentham, J. R. McCulloch, J. E. Cairnes, and especially John Stuart Mill and Henry Sidgwick. However, despite important reservations, the default remained laissez-faire capitalism, more or less.

In chapter four we see how, beginning with the Italian La Scienza delle Finanze and the work of the Swedish economist Knut Wicksell, some economists by the mid-twentieth century were beginning to integrate political incentives into the area that we today call “public finance,” something British political economy (Keynes included) had neglected to do. This gave rise to a systematic examination of the causes and consequences of “government failure.”

Chapter five discusses the contributions of Ronald Coase, who opened inroads into the study of nonmarket phenomena. What later became known as the “Coase theorem” emerged from an explicit critique of the Pigouvian market-failure theory (though, as Medema argues, not of Pigou himself), and is the basis of the “economic analysis of law” tradition and modern theories of regulation.

Chapter six addresses the Public Choice school itself, moving in a most welcome and informative way from intellectual to institutional history. It chronicles the beginnings of Public Choice from the University of Virginia in the late 1950s, to the ideological tensions that may have scattered its most important scholars in the 1960s, to its reestablishment at Virginia Polytechnic Institute and the founding of the Center for the Study of Public Choice, as well as the journal Public Choice, in the late 1960s.

Finally, chapter seven could actually stand alone as an essay on how, largely in the masterful hands of Richard Posner, the law-and-economics tradition evolved into the “economic analysis of law.”

This book reads a bit like a “Whig interpretation of the history of political economy,” in that it gives the impression that the developments in political economy after Smith have led to Public Choice as not only the predominant but perhaps the sole market-based theory of government failure.

Thus there is only the briefest, nonsubstantive reference to F. A. Hayek and his influential book The Road to Serfdom and none at all to Ludwig von Mises, who wrote many tracts critiquing the doctrine of interventionism. While their take on government failure does appreciate the role of (perverse) incentives in the political process, its main focus is on how knowledge and calculation problems tend to thwart interventionism by systematically creating negative unintended consequences.

But these are really nits I’m picking here. I wholeheartedly recommend this informative book to anyone with a little background in microeconomics who is interested in a history of Chicago and Virginia political economy told in a clear, scholarly, and engaging way.

First, greed or, better, self interest, certainly does in a sense drive material progress and so on, but only if and to the extent that social institutions, the “rules of the game,” are truly consistent with the free market – that is, private property, free exchange, and the rule of law.

But not everything that looks like a free market is a free market.  If the economic system departs from the rules of the free market, self-interest tends not to promote the general welfare at all.  For instance, private property is violated every time special interests use government to seek a bailout or protection against competition.

Nevertheless, there is a certain “free-market” attitude, which I am told can even be found on Wall Street itself, that whatever self-interest produces must indeed be good.  Those with this attitude don’t take the trouble to sort out the basic requirements of the free market from the various regulations, protections, and transfers that are at odds with it.  You know, the sort of “free marketer” that Steven Colbert satirizes on his television show.  To such persons, the collapse of the financial market and the recession are evidence of failure of the “free market” and unbridled capitalism.

Two Kinds of Free Marketers

I think this attitude can be traced to two different mindsets that you could call free-market-friendly.  One of these sees self-interest itself as a virtue, and unfettered self-interest in particular as the highest good.  But what does “unfettered” mean?

While the subject is far too involved for me to delve deeply into here, I will say that I think it depends on whether the fetters reside within the agent, in the form of norms and conventions she has internalized, or outside the agent, in the formal rules and regulations that are enforced by external authorities.

Those who tend to use the phrase “unfettered self-interest” or “unbridled capitalism” seem to have in mind a situation in which there is no locus of restraint whatever, either within the agent or outside the agent.  Of course, the complete absence of restraint in this sense would result in the Hobbesian “war of everyone against everyone,” precisely the picture of modern finance that Oliver Stone paints in his movies.

In this rather naïve view the agent is free to pursue her self-interest wherever she finds it, even when it means acting opportunistically and dishonestly – so long as she observes or appears to observe the external rules and regulations.  Thus the hotshot Wall Street operator takes advantage of any opportunity she chances on, even if it violates the norms of honesty and conventions of fair play, since these don’t really exist in her internal moral world.  They believe that “greed is good” even when the rules of the game violate the rule of law, for example, by spreading the cost of risky investments among taxpayers (e.g., Fannie Mae) and concentrating the benefits on a few big players (e.g., Goldman Sachs).

(See Horwitz and Boettke’s “The House that Uncle Sam Built” for an excellent explanation of just how government policy did this leading up to the recent housing/financial crisis.)

Growing-Up

Now, a more mature view doesn’t claim that everything that shakes out of even an ideal free market, whatever that may mean to you, is good and without (even significant) imperfections.  It recognizes that in such a world aggression and fraud would still take place (though probably a lot less than in one dominated by standing national armies) and that nonaggressive behavior ranging from the annoying to the offensive to the deeply disturbing (no need for me to detail what these are for me or might be for you) would still be plentiful.

But the mature view recognizes that honesty, fair play, and trust are all important elements of the free market.  Without these, private property, free exchange, and the rule of law may still be observed under the watchful eye of external authorities, but they would not flourish, and neither would material prosperity and wealth-creation take place on the scale and consistency that we’ve seen since the rebirth of the liberal idea in modern times.

Moreover, this view recognizes that when profits and losses, the good and the bad, redound to those responsible for making the decisions that produce them, market participants tend to grow more responsible and make better decisions.  That is what the free market does: It makes us more responsible by making us more responsible.  As a result, just those kinds of internal restraints against opportunism that grease the wheels of the market process emerge over time: the norms of trust and the conventions of reciprocity and fair play.  This doesn’t mean, of course that “greed is good.”

Rather, the attitude is something like, to paraphrase Winston Churchill on democracy, “the free market is the worst possible system – except for all the others.”

***

The sequel just opened and I haven’t seen it yet.  Let’s see how much the filmmaker has grown up in the past 23 years.

The property-rights vacuum that encouraged Haitians to cut trees down  without replanting also motivated them to skimp on construction durability. When the “big one” came, buildings collapsed and tens of thousands died. Incentives mattered, big time.

A satellite photo of the Korean peninsula provides a similar border-economics lesson. Taken at night, the photo shows South Korea lit up like a Christmas tree. To the southeast, Japan is much the same and, to the north and west, China’s glowing, too. But North Korea has just one isolated dot of light. The message: In a vibrant region, North Korea is a failure, especially compared to its brethren just over the DMZ.

Economic statistics confirm the message. South Korea is the world’s 15th largest economy. North Korea is an economic coffin, at or near the bottom of all national economic rankings except misery. Things were not always this way, however. Some 60 years ago living standards were actually higher in the north.

What happened? The short answer is that the South Koreans accepted private property rights as an organizing principle for economic activity. The North Koreans shunned such rights, opting for the seeming sureness of top-down economic decision-making. Institutional choices trumped Koreans’ common cultural heritage and language to produce a disparity in living standards surely unimaginable to those who made the choices.

The Heritage Foundation publishes an Index of Economic Freedom, of which the security of private property is an important component. Of the 179 countries in the 2010 index, South Korea is 31st and North Korea is . . . you guessed it, 179th. Economic data for closed societies like North Korea are sketchy. Nevertheless, Heritage estimates South Koreans’ average income to be a double-digit multiple of that of their northern counterparts.

The contrast is sobering. But before we get too gushy about South Korean economic institutions, a note of caution is in order. South Korea has long pursued “crony capitalism,” where a number of chaebol—large industrial conglomerates, usually controlled by a single family—enjoy preferential status with the government. Samsung, Hyundai, and LG are three of the better-known chaebol. Among the special privileges of chaebol is access to government finance not open to others. The effect of such “privileges” is to limit entry of non-chaebol competitors. It also lets them deploy various tariffs and subsidies to keep imports—especially those from politically unpopular countries—artificially expensive.

Attempts at market closure are certainly not unique to South Korea, but it does make it difficult to label South Korea a wide-open, free-market economy. That South Korea has experienced prosperity in the presence of such impediments leads statist-types to assert that its government officials must have “picked the winners.” How myopic, risk-averse bureaucrats, largely immune from the consequences of their decisions, can have such insight goes unexplained.

Success Despite Cronyism

The more important point, however, is that the notion that market closure somehow promotes economic advancement is fatuous and at odds with all economic logic and evidence. The adage about correlation not implying causation certainly applies here. Market closure, with or without a miraculous ability to “pick winners,” stunts advance, reducing living standards below what they otherwise would be. South Koreans enjoy relatively high living standards despite their government’s crony capitalist practices, not because of the practices, though the families in charge of the chaebol and people pursuing lifetime employment as salarymen certainly get some extra benefits. Absent such practices, overall living standards would be even higher.

At the same time, the fact that the two Koreas are so far apart in economic institutions and economic outcomes is a useful reminder that living standards don’t just happen. The goods and services responsible for our survival and enjoyment of life must be produced. They don’t spontaneously appear like Old Testament manna or multiply like New Testament loaves and fishes.

The problem is that there’s not enough land, labor, and capital to produce everything people want. Consequently, every society must have processes that determine what gets produced and who produces it. The yardsticks for measuring the effectiveness of these processes are the extent to which people value what is produced and that this production occurs at minimum cost or sacrifice.

For example, raising beef cattle in downtown Boston for American Vegetarian Society conventions fails on both counts. Not only would the beef be of no value to its intended users, it would also be exceedingly costly in terms of other things that could have been produced on the Boston real estate. It would destroy wealth.
Raising cattle on, say, Montana ranches for National Football League training camps would be at the other end of the spectrum. Low opportunity cost and high consumption value translate into wealth creation.

Private property in a truly free market harnesses self-interested sellers and buyers to act as wealth creators not destroyers. First, such sellers will seek out the buyers who value their products most highly, since they will be willing to pay the most. Second, self-interested buyers will be drawn to lower-cost producers, since they will be most willing to sell at lower prices. The result is high consumption value at low cost—more wealth.

Smile Like You Mean It

Lest you think that this process begins and ends in self-interested behavior, note that self-interested sellers are also constrained to act as if they cared about buyers. To wit, they must offer buyers terms that benefit buyers. Otherwise, buyers don’t buy. Likewise, self-interested buyers must act as if they cared about sellers by offering terms that benefit sellers, or sellers don’t sell. Wealth accrues to people on both sides of the transaction.

My idealistic students tell me that acting as if you care about your counterparts in the marketplace isn’t good enough. It’s so shallow; we need to really care, say these students. Put differently, my students are telling me that economic actions should be grounded in benevolence and love. It’s a fair comment. What’s the answer?

Interestingly, Adam Smith noted in his 1776 masterpiece, The Wealth of Nations, that “In civilized society [man] stands at all times in need of the co-operation and assistance of great multitudes, while his whole life is scarce sufficient to gain the friendship of a few persons.” It’s not that benevolence and love are incapable of motivating our actions. It’s just that their operative range is limited by the extent we want to live in an economy with the high living standards that follow on a substantial division of labor and its accompanying anonymity.

So I tell my students that if they want to really care, join a commune. Not surprisingly, they take a rain check.

To think that top-down, czar-like government directives could even remotely approximate the market’s assignments of production tasks and consumption benefits is wrongheaded. There is no way so-called economic czars could ever command the millions upon millions upon millions of bits of information about buyer valuations and producer opportunity costs for countless numbers of goods and services. It simply cannot be done. And if a society tries? Lights out! Look again at that satellite photo.

Individual sellers and buyers in free markets have no need for information on such a cosmic scale. Readily observed prices provide each, individually, with the economic equivalent of green lights and red lights to guide their activities in wealth-creating directions. The lights flash green when selling prices rise relative to costs; they flash red when costs rise relative to selling prices.

Moreover, and this is key, each seller only needs to know the price of what he sells and his costs, just as each buyer only needs to know the price of what she buys relative to the value she places on the item. Do sellers have to know why prices are what they are, or why their costs are what they are? No. Do buyers have to know why prices are what they are, or why their consumption valuations are what they are? No.

Sellers and buyers responding individually to the green and red lights embodied in prices permit these millions of bits of information about potential sellers and buyers to get processed into market outcomes. Production assignments for a vast array of goods and services go to their lower-cost producers and the corresponding consumption benefits go to their higher-valued users. No one knows a lot, but lots of lights go on. Look at that photo again.

Both insights rely on the foundational idea that intentions and results are not the same thing. Thinking we ought to do something does not mean it will have the results that motivate the “ought.” With respect to profits we have to recognize that because someone does something to benefit himself, it does not mean the action doesn’t benefit others too. In both cases the core concept that is often overlooked is unintended consequences. Recognizing that intentions do not equal results and that we must consider the possibility of unintended consequences is what separates good social analysis from bad.

The issue of unintended consequences is interrelated with a more general aspect of human social existence: the pervasiveness of uncertainty. The future is not available to us in the present. We cannot know the course of nature, but neither can we know the course of human choices. We are always acting based on our best guesses about what others will do and how our actions will coordinate with theirs, which we can never know with certainty. This structural uncertainty of the human condition means that we can never know all the consequences of our choices, which implies that some of those consequences will be other than what we intend. Anyone who believes the consequences of his actions will be exactly as intended is blind to the fact that his choices must interact with those of others, creating outcomes that none of the choosers designed.

Unintended consequences come in two flavors: positive and negative. The concept of negative unintended consequences is acknowledged in some social analyses and in morality, but is certainly underdeveloped in the understanding of economic policy. Positive unintended consequences are rarely recognized in “serious” conversations about public policy, even though they are at the core of modern economics.

Consider the two-by-two matrix below.

We have moral language for three of the four possible combinations of intent and outcome. Vice and virtue are easy enough, as they are our common terms for discussing the morality or desirability of our actions when the outcomes match our intentions. But what about when they don’t? We have the category of “negligence” when we cause negative outcomes we did not intend, such as failing to set the brake on a car that rolls down a hill and damages property. But we do not have a word for the unintentional doing of good! That missing box is filled in by economics and good social science as they explain how, under the right institutional framework, the pursuit of self-interest leads to unintended benefits for society as a whole.

Naming the Unintentional Good

From Adam Smith in the eighteenth century to Carl Menger in the nineteenth to Ludwig von Mises and F. A. Hayek in the twentieth, the central mission of economics has been to understand how we can produce beneficial outcomes that were not intended. Smith captured this idea with the “invisible hand” that leads the butcher, baker, and brewer to provide us with our dinner not out of altruism but “self-love.” Smith understood how exchange guided by prices and profits would harmonize (to use a term associated with Frédéric Bastiat in the nineteenth century) the self-interest of producers with the self-interest of consumers. Even if we care not at all about the people we trade with, we will nonetheless be led to satisfy their wants in our attempt to satisfy our own. Looking only at the seller’s profits without tracing out the entire chain of beneficial though unintended consequences that his self-interest produces is to take an “unscientific” approach to understanding society.

Menger put the concept of unintended consequences (and the closely related idea of “spontaneous” or “unintended” order) at the center of his conception of the social sciences. In what is often termed “the Mengerian question,” he asked: “How can it be that institutions which serve the common welfare and are extremely significant for its development come into being without a common will directed toward establishing them?” Menger recognized that many social institutions are not the product of human design, but instead emerge as people seek their own self-interest. Menger’s own classic work on the evolution of money explains how it arose this way from barter.

Mises and Hayek deepened this argument another layer as both recognized, with somewhat different emphases, the role that knowledge plays in understanding the centrality of unintended consequences in social thought. Mises provided what we might call the “microfoundations” of Smith’s invisible hand by carefully explaining how we go from people’s subjective perceptions to market-level outcomes via prices, which facilitate our calculations about the effectiveness of the use of resources. Mises also explored how profit and loss provide further signals that serve as “aids to the mind” in guiding our behavior. Entrepreneurs are led to use resources wisely, profiting for themselves but also improving the well-being of others, thanks to the signals of the marketplace.

Hayek’s work on economics, knowledge, and the problems of socialism allowed us to see the opposite side of Mises’s analysis by exploring how socialist planners would be unable to replicate the workings of entrepreneurs. Hayek argued that without market signals government planners would be unable to marshal the dispersed knowledge available to entrepreneurs through prices and other market institutions. Because of their ignorance, planners would not only be unable to generate beneficial unintended consequences in their own pursuit of self-interest, they would in fact cause harmful ones by being unable to see how their mistakes would lead to further mistakes—not to mention accumulating State power. Both Mises and Hayek saw that regardless of the socialist planners’ good intentions, their inability to make use of the knowledge of the marketplace would lead to consequences very different from those intended—in fact, as history has clearly demonstrated, consequences devastating for millions.

Institutions Against Uncertainty

The Smith-Menger-Mises-Hayek line of thought can be tied back to our earlier discussion of uncertainty. This tradition argues that we use evolved social institutions, including the market, to get more accurate expectations of the behavior of others and push back against the uncertainty that threatens to derail our plans. At the simplest level we see this with prices: The prices of particular goods or services are “aids to the mind” regarding the preferences, knowledge, and expectations of others, enabling us to better anticipate the consequences of our choices and to thereby make better ones. Institutions that emerge as a result of unhampered social evolutionary processes all perform this uncertainty-reducing function.

Consider the institution of ownership. When someone says that he “owns” a particular good, we know that gives him a certain set of rights to it and imposes certain obligations, largely negative ones, on us. Knowing that the good is owned means we can form particular expectations about what the other person might and might not do with that object, and he in turn can have reliable expectations about what we will and will not do.

An irony of social institutions is that by limiting our choices they make us better able to execute our plans and anticipate their likely consequences. However, to perform that coordinative function in complex matters and help us overcome uncertainty, institutions need to emerge from people’s voluntary interactions, usually over a period long enough for them to embody the best ways of doing things. This is why markets are so good at generating positive unintended consequences and why institutions imposed by force from the top down tend to generate negative ones. Just as we are much more productive as a society when entrepreneurs and consumers have access to competitively determined prices, so in general does human action produce beneficial unintended consequences when social institutions generally are the result of unhampered evolutionary processes.

Even in less dramatic ways modern economics remains focused on unintended consequences, particularly in how economists like to make highly counterintuitive arguments. For example, a number of years ago there was a call for government to require very young children to sit in car seats rather than on their parents’ laps when flying on airplanes. This arose out of concern that in some circumstances lap children could be hurt or could hurt others. Critics, particularly economists, quickly responded that such a law would actually kill more children than it saved.

To see why, one has to explore the unintended consequences. Under the law parents would have had to buy tickets for children who formerly flew free in their laps. Faced with the additional charge, some families on the margin would switch from flying to driving. But the odds of being injured or killed in an automobile are much greater per mile than in a plane. Thankfully, that unintended consequence was anticipated before it was too late, saving many children in the process.

The idea of unintended consequences also helps us understand one process by which government has grown over the last century or two. Because even well-intentioned interventions produce consequences that political actors could not foresee and did not intend, every time government acts, it creates a new set of problems that in turn leads to calls for more government solutions.

A final observation: The neglect of unintended consequences and the focus on motives lead us to celebrate the lives and mourn the deaths of politicians, although they may have caused undesirable unintended consequences, while inventors and businesspeople who benefit humanity while pursuing their own ends go unnoticed. As my matrix on the previous page suggests, we simply don’t have a moral category for people who unintentionally benefit others in pursuit of their self-interest. And we also highly overvalue intentions as a measure of moral worth, leading to praise for those whose “hearts were in the right place” even as they have caused incalculable damage to prosperity and freedom.

A better understanding of the idea of unintended consequences will not only give us the tools we need to more accurately analyze social issues, it will also provide us with a different way of making moral judgments. After all, it is results that count, and we all know where the road paved with good intentions leads to.

Nassim Nicholas Taleb is famous for introducing us to black swans. Though these rare creatures have long been used among academic philosophers to explain the shortcomings of reasoning by induction (“Every swan I’ve ever seen has been white, therefore all swans are white.”), Taleb uses the black swan as a stark metaphor for the inevitability of highly improbable events. In other words, black swans are rare, but one will swim by eventually.

As far as Wall Street—particularly the people with a large stake in getting things right—is concerned, this financial crisis involved a confluence of events. Some of these black swans were set in motion by government, like flexible lending standards to extend home ownership, Fannie and Freddie, and a mortgage-friendly tax code. Others were set in motion by willfully ignorant bankers, big shot risk-modelers, and people believing they could live beyond their means. It all came together in a fantastic cascade of failure. The trouble is, no one—neither government nor market actors—can predict such a large-scale event. Black swans happen.

The other important thing to remember is that the economy is a chaotic system. Most of the time chaotic systems achieve a sweet spot between order and chaos, which is a good thing if an economy is to be robust. Chaotic systems, though, change constantly and involve dynamics that are highly sensitive to initial conditions.

An Ecosystem, Not a Machine

Sadly, we’re getting a whole lot of precisely the wrong kind of thinking in response to this crisis. Indeed most of the bad thinking arises from viewing the economy through the lens of a false metaphor: economy as machine. We’ve heard pundits accuse the government or banks of being “asleep at the switch.” But in a complex system, there is no switch. We’ve heard people ask how to “fix it,” “run it,” or “regulate it,” suggesting if just the right sort of genius controlled the rheostats, we’d get just the right sort of economy.

The economy is not like a machine at all. It is rather more like an ecosystem that no one can run, fix, or regulate. The hubristic sort of person who thinks he or anyone can run an economy is the victim of what Hayek called the “fatal conceit.” If given power, the planner will end up making the rest of us the victims of his false metaphor.

It is ironic that Alan Greenspan—once adored by the press but now pilloried by it—is being blamed not only for wielding a laissez-faire ideology that supposedly caused the crisis, but also for failing to predict a black swan. Greenspan was a single, powerful government bureaucrat in charge of gathering enough data to determine the “right” interest rate for a multitrillion-dollar economy. Given the size of that task, he did pretty well for many years. But he was one man. He was housed in a government building. He held an unelected office and made decisions in a bureaucracy that has a monopoly on money and influences the price of credit, at least in the short run. One can hardly call that free-market fundamentalism. Whether Greenspan offered artificially cheap credit or not, interest rates were only one factor among many. To have asked him to predict the best of all possible worlds and adjust interest rates accordingly would have been to ask him to be an oracle channeling the knowledge only God would have. Greenspan is not omniscient. Nor is Bernanke. No one is. But to “run” an economy would require not only omniscience, but omnipotence as well—a power that would bend the actions of millions to its singular will.

Whatever your ideological persuasion, the economy is a complex system that cannot be planned, designed, or have its black swans regulated away. Far from the caricatures sketched in the papers, this is precisely what serious free-market types have been saying for years. That’s why it’s a little more than silly to blame free-market ideology for the current mess, and a little more than mendacious to claim that government fingerprints won’t appear all over the crisis when the postmortem is done.

Hunting Black Swans with Shots in the Dark

The timeless nostra of the politician are to prime the pump (machine metaphor) and to regulate. It seems so simple. But that response is deceptively linear. If you could ask FDR, might he now concede his policies stretched the Depression out for a decade beyond what was necessary? He listened to J.M. Keynes and a coven of interventionists. If we agree that our mixed economy is a complex system, then we also have to agree that the benefits the partly free market confers are an emergent property of that system. If we attempt to regulate away the rare, unforeseen black swan event, the costs of our hubris will be terrible, for we will regulate away untold benefits, too.

In the real world the question may come down to whether we should accept a couple of years of painful market adjustments or decades of recession caused by the blunt instrument of politics. Devastating unintended consequences and unseen effects will follow government attempts to clean up a mess made in great measure by its own hand. Why? Because no one possesses a God’s-eye view of the economy. Government intervenes within the system as part of it, not from outside of it. Nor is the economy an instrument to be manipulated to positive effect—at least not over the long term. That is why Keynes got it so terribly wrong and why the economy must heal itself from within in a distributed, holistic way.

People want government, like God, to come down and fix the unfixable, or explain the inexplicable. That’s why they’re finding it easier to blame greed for our current financial crises. But greed is rather more like gravity: When you fall, you can blame either Newton or the banana peel on the ground.

The profit motive is a good thing when it operates in an environment where bad bets are punished with losses and good investments are rewarded. Only government can distort that healthy profit-and-loss system, giving people incentives to make bad decisions. And it’s in this environment that greed is no good to anyone. It turns out, however, that greed—or better, rational self-interest—can help our economy stabilize faster than government ever could. As the lubricant of our economic system, self-interest will cause a million market actors to recalibrate and to direct resources to projects that create value in our society. We the people will temper our irrational urges and mitigate our risks if government restores the rules that let profit and loss bring discipline. But if government continues to change the rules to bias the market in favor of irrational behavior, rent-seeking, and corporatism, the chaotic aspects of the system will continue to wobble out of equilibrium. Black swans will become commonplace.

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.