ArcticPatriot brought up a good point about how Enron and Worldcom could not have been the fault of a free market simply because they didn't exist in a free market. This is true, however by the definition of "free" as in "unhindered" there is no such thing as a truly free market.
Back deep into the history of humanity the oldest written records are those of agricultural contracts. You can't have contracts without trusting someone at their word. If you trust someone at their word and they break their word, what do you do? Well if you are anything like the ancient Hebrews you plead your case in front of a judge and get a judgement. Ever wonder why large parts of the the Old Testament read like obscure case law? Because it largely is just that.
A market cannot exist without two people. And whenever two people try to do anything financial a lawyer will eventually show up. Enough lawyers and judges and eventually you have an established contract law system. Eventually markets are necessarily "bounded" by law, specifically contract law. In essence the original Judges were the Regulators, and both providers and consumers were the marketplace watchdog agencies. Human nature hasn't changed since humanity began, and we still have judges, consumers, providers and watchdogs...
Now in a market we have "short term" and "long term" strategies. A short term gain can kill your long term prospects, and a long term plan can cause a short term loss. Some strategies are short term gain and long term gain (such as selling seeds then switching to selling fertilizer then switching to selling weed killer). Or selling software, hardware, and upgrades through service packages.
Morality in the marketplace is simply being a man of your word, that you fulfill your contracts. A short term gain can be had by being immoral, either through intentionally not fulfilling a contract (taking the money and running essentially) or trying to deliver a substandard product and hope you win your case in front of the judge.
The point is that both moral and immoral behavior are viable strategies for the short term. For the continuing long term only moral behavior is rewarded by the market, but immoral is a definite choice for the short term.
That Enron and Worldcom were able to act in an immoral manner for their own short term gain is a failure of the market to identify and punish immoral behavior. We know that it wasn't a failure of the bounds of the market (after all, the legal boundaries were effective in sending executives to jail) but a failure of players in the market to choose moral behavior.
And that is what the Free Market cannot do, it cannot impart a morality into humanity. Alan Greenspan said "What collectivists refuse to recognize is that it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product." But that is very different from actually being an honest dealer with a quality product. And as Greenspan concluded, the financial markets can not effectively regulate themselves because the short term gains brought on by immoral behaviors are too tempting to pass up.
If we take a look at the housing crisis and things like "liar's loans" or "No Income, No Asset" loans we see the financial sector following a case of "everybody else is doing it, and if I don't I will be left behind." And so big banks like Bear Sterns went under, while small town banks that kept high loan standards and didn't try to pass off the debt did well. The whole model was flawed, but everyone was doing it because it was so profitable in the short term.
This is why the free market fails, because a mortgage outfit in Podunk sold a "NINA loan" to a Wall Street Firm who then mish mashed and hashed a bunch of different loans into a "Mortgage Backed Security" and got a triple A credit rating on it to sell to retirement fund managers. Everybody made money in the short term, from the mortgage outfit all the way through to the retirement fund manager.
Now, do I want a centrally planned Marxist economy? Hell no. But I don't want a complete lack of regulation either. A simple law preventing the buying and selling of debt on a secondary market would have prevented the Housing Bubble in the first place. Because if the mortgage outfit had to hold on to that "NINA" loan there is no way they would sign the contract. Unfortunately our "free" market allowed people to pass risk and fraud down the line to eventually collapse the whole system.
About Me
- AM
- Raised by conservative Christian parents, enlisted in the Army at 18, used the GI Bill to finish college, and I'm back in the Army. Along the way I've encountered a huge cast of characters, some I got into trouble with, some that passed on skills that have helped me on my life journey.
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5 comments:
Well said, and a lot of good points were made.
You said this:
"This is why the free market fails, because a mortgage outfit in Podunk sold a "NINA loan" to a Wall Street Firm who then mish mashed and hashed a bunch of different loans into a "Mortgage Backed Security" and got a triple A credit rating on it to sell to retirement fund managers. Everybody made money in the short term, from the mortgage outfit all the way through to the retirement fund manager."
I do not argue with this, not one bit. This short term thinking led to long-term disaster. I would point you back further a step though. What caused the situation above, in my opinion, can be traced back to a political failure and its unintended consequences. A new market of riskier than normal mortgages was born via Congress' "American Dream" act (I think that's the name). This was where congress essentially decided that it could legislate the "right" of people who could not afford homes to have them anyway.
Yes, human greed took over and created the situation we are still in now, no doubt. But the beaker within which this noxious mess grew was provided by the political intervention (failure) in the markets.
I agree with your points about moral behavior being necessary for the survival of the market. It also encourages .gov to leave things alone.
I also recognize a need for the role of government to protect private/business property rights through contract law, etc.
In the end though, I think none of my desires for a more free market mean anything. The direction we're heading is exactly the opposite.
You've been putting out some good stuff, lately. Keep on keepin on...
AP
Would it not be better if accountability was enforced, rather than ski the regulation slope?
By way of analogy, I'd rather we punish a murderer than someone with an unlicensed SBR.
AP, I really wish that Congress would leave well enough alone, because I completely agree that the root of the cause was political pressure to give unqualified individuals loans.
And I really wish every blog post was a winner, but mostly they come at random.
emond, there are two types of crimes, those with a victim and those that are regulatory.
You can point to the murderer's victim, so that is a clear case of a felony. You can't clearly point to the "victim" of someone owning an unregistered SBR. Therefore this is a "regulatory" crime.
Unfortunately those that make the law and those that enforce the law don't think the way I do, and choose willy nilly to make some regulatory crimes felonies and some misdemeanors...
In something like market fraud, you can put a face to the victims. Enron's victims had thousands of faces. Obviously a felony right?
So I agree that there are some things regulated way out of proportion. But on the flip side I am not against all regulation, because some of it is useful for protecting consumers.
AM, isn't it a straw man argument to say we need some regulation? I mean, who is seriously saying there should be no regulation at all? Only complete anarchists, AFAIK. I certainly believe in meaningful regulation, the problem is that the regulators have to be watched like a hawk because there's so much incentive for them to cheat. In general, the bare minimum regulation is better.
The Fed.gov will dribble out more money, like a toddler in leaking Pampers, than you or I will see in our lives. It's why that town attracts the crowds they do. None of this is news.
The housing mess goes back to the execrable Jimmy Carter and the Community Reinvestment Act. Stir liberally (hah!) with groups like ACORN protesting in banks - or at the homes of the bankers - if ACORN didn't think the bank gave enough loans to people who couldn't afford one. And congress made Freddie and Fannie back the toxic loans.
When I got my first one, mortgages were boring things. Banks had rules that said you needed to prove income and have demonstrated good credit handling. This made the loans very secure and very likely to be paid off. When Glass-Steagall was lifted, allowing banks and investment houses to be the same place, it was natural to sell the rights to collect parts of the very secure chance of the mortgages being paid back on time. By itself, that wouldn't have caused the crash.
The crash, like any big disaster nowadays, required the convergence of government and business. Neither is big enough to cause that much damage themselves. In this case, the lenders diluted the toxic loans urged by the Fed.gov by chopping them up and mixing them with mortgages to ma and pa Kettle who were virtually certain to pay their loan back. They made the loan soup into a product to sell to all sorts of investors and lied about the risks.
"The solution to pollution is dilution" only works so far. If you put a little dog poop in the soup bowl, you change the whole thing from soup to poop. By putting those NINA loans into funds they didn't minimize the risk, they made everyone's soup into poop. The problem was no one knew what was in the soup.
I would argue that morality in the marketplace consists of something more than what you say, (be a man of your word). Be honest about everything. Enron, Worldcomm and the Goldman-Sachs were dishonest about what they were packaging and selling. They made the things so complex that people buying them didn't understand them. They should have said those bonds contained a certain percentage of poop.
If they had been 100% honest about what they were selling, my guess is that intelligent financial guys would not have bought as much as they did.
Graybeard, this was not so much of a straw man argument for regulation but a critique of when Ayn Rand's Objectivism is put into practice. But what you say about politics brings up the very bounds of the marketplace. By changing the rules they essentially changed the game.
Enron followed the deregulation of the energy market, the housing bubble followed the inevitable deregulation of the financial services sector. Not complete deregulation but a definite loosening of the rules as policy wonks swore up and down that free market forces would be enough to ensure moral behavior.
As you wrote, mortgages used to be boring things until deregulation changed the game so to speak. The legal boundaries around the financial marketplace were altered by politicians but in the end it is the behavior of the companies themselves that brought about the crashes.
Groups like ACORN may have been part of the problem, but they were not the root cause. The root cause was a market that was not able to identify immoral behavior and put a stop to it, and if the market can't do it then the obvious answer is that regulators must do it.
Nobody thinks that Communism will work because we know that it is in human nature to take as much as you can for as little effort as possible. But the exact same critique applies to free markets as well.
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