Henry Paulson, the SecTreas, has proposed a new set of regulations for the financial markets. As expected, the response is all over the map, from “its just re-arranging the desks at the Treasury Department” to “an unwarranted interference with the free market.” Nothing new in all of that. Of course, the “interference” argument is somewhat strained, since the meltdown is occurring precisely in those parts of the market that were lightly regulated or not regulated at all. And even in areas where the Fed had oversight authority (and therefore, responsibility), they did not exercise it. And further, while it is true (or should be true) that anyone has the right to arrange whatever exchanges they agree to, it is also true that if any set of exchanges have the power to bring down the whole market—indeed, the whole economy—then the rest of the economy has the right to review those transactions; if something we do can so deeply affect everybody, then everybody has the right to review what we do.
This clearly establishes, I believe, a right to regulate, as well as a principle directing us when and where to regulate. No small group of traders should have it within their power to bring down the market, and any market where that can happen cannot be called a “free” market in any meaningful sense of that term. The right to regulate, or rather, the duty to do so, has to be further guided by intelligible principles that anyone can examine to see whether particular regulations make any sense. In our last post (Aristotle and the Subprime Mess) we reached back to Aristotle to recover the distinction between natural and unnatural exchanges, a principle that guides us to where regulation is most needed and where least. To put it briefly, natural exchange needs little in the way of regulation, while unnatural exchange needs a great deal of it. Now is a good moment to apply these principles directly to the regulation of financial markets.
Before we can do this, however, we need to make a further distinction, one that is normally lost today, and that is the distinction between investing and speculating. Today, we tend to call anybody who buys a share of stock, for example, an investor. However, normally this is not true. Investing is the deadly serious job of getting money into the hands of businesses so that they may expand their production, providing both goods and services to the public and jobs to the workers. The investor takes a risk and hopes to reap a reward, a reward that is earned by the risk he takes and the products he helps provide. No economy can ever hope to grow and proper without investment; aside from the rewards to the investor, there is a great utility provided to the public, a contribution to the common good. Investment is normally either a “win-win” or “lose-lose” proposition. That is, if the enterprise succeeds, then both the entrepreneur and the investor prosper; and if it fails, then both share the loss.
There is, however, another kind of bet in the financial markets, and this is a bet that provides no funds to business; it does not directly expand the output of goods and services. This is a pure bet on the future of some firm, and a bet that provides nothing to the firm. The stock market is normally a bet of this kind. That is, when we buy a share of stock, we normally buy a “used” share, one that was issued long ago and for which the company was paid. What we are doing is making a bet on the future of the company, with buyer and seller betting in opposite directions; the buyer things the price will rise above its current value, while the seller thinks it won't, or thinks that there are better values for his money. This is always a “win-lose” or “lose-win” situation. That is, one sides gains or losses are measured precisely by the other sides losses or gains; there is no net gain to society. Ninety-five percent of trades in the stock market are of this type, and only 5% are really investments, usually in the form of initial offerings, a “new” share of stock rather than a “used” one.
It should be pointed out that there is an indirect gain to the public in such speculation, in that speculative markets provide liquidity (the ability to quickly and reliably convert non-cash assets into cash) and therefore make people more willing to invest in the market. Therefore this speculation does have some social utility, even if it doesn't directly add to new production. However, there are other speculative markets which provide very little social utility, and which are pure zero-sum games, with one party's gain being exactly equivalent to the other party's losses. These are the derivatives, which are normally (or abnormally) just bets speculators place on the direction of a given market or security. Now, even these derivatives can have some utility, as when a bond-holder buys an insurance policy or hedge against the bond defaulting; he lowers both his risk and his reward. However, you can buy the insurance policy without owning the bond; it is pure speculation without any social benefit: no new goods are produced, no risk is insured, and the whole thing is zero-sum. Further, such sums devoted to speculation compete with sums for investing; the more devoting to bets, the less is devoted to production. Therefore, there is a net loss to the economy.
Normally we would not care about such silly bets, anymore than we would give much thought to the local crap game. If some man were foolish enough to gamble away his paycheck, we assume that his conduct will be “regulated” by his wife's anger and his children's misery. However, unlike the local crap game, which is a threat only to the solvency of a few families, the derivatives crap game can become a threat to the solvency of an entire economy. This is because they tend to be highly leveraged.
During the 1920's, people were highly leveraged in the stock market; they could buy stocks on 10% margins. That is, they put a thousand dollars down and could buy $10,000 worth of stocks. This is an excellent way to make a lot of money when the market is going up; it accelerates the gains on your $1,000. However, when the market is going down, it accelerates the losses. And when that happens, the brokers issue “margin calls”; that is, they ask you to pay down your debt. At that point, you must sell your assets. But since everybody is selling, prices plummet, with bankruptcies all around. The government no longer allows such 10-1 buying; I believe 50% margins are now required in the stock market.
However, in the derivatives market, there is no limit on the margins. Hedge funds (major speculators on these pure bets) were typically leveraged 15-1, 25-1, or even 75-1. With a little money down, they could generate enormous gains. But again, they can also generate enormous losses, and when the bets are as large as they are, they can lock up the entire credit system, drying up funds for investment. People who had not the slightest connection with these schemes find that they have lost their jobs, or taken pay cuts, because their employers can't get operating funds. They find that their homes have decreased in value, because defaults are forcing an oversupply of homes on the market, while drying up credit for potential buyers. Now, the people who caused this problem tend to get bailed out by the federal government; the people who had no connection with it tend to suffer the consequences.
Note how well this distinction between investing and speculating matches Aristotle's distinction between natural and unnatural exchange. Insofar as investment is connected with production, the exchange is natural and requires very little regulation. If I give a million dollars to an entrepreneur to build a factory, the government has little need to scrutinize the transaction. If it wins, we all win, and if it loses, the major loss is only to ourselves. But of course, most of us do not directly give our money to an entrepreneur; perhaps we give it to the bank, and let them choose the entrepreneurs. Here we are at one remove from production, and a bit more regulation is required. Since there is danger that a bank failure can affect all the depositors, we naturally want the bank to be required to follow certain rules and keep a certain amount of reserves against losses. But such regulation need not be onerous. But as investment becomes pure speculation, and as it becomes large enough to threaten an entire economy, more and more regulation is required to protect the innocent parties, that is, all of us.
However, we have done exactly the opposite in regulation: we heavily regulate natural transactions, and lightly regulate—or fail completely to regulate—unnatural exchanges. We place onerous requirements on regular banks, and ignore completely the investment banks and the hedge funds. But when these banks and funds fail, they are in a position—a blackmail position—to demand a bailout from the federal government. As Ha-joon Chang has observed, it constitutes Keynesianism for the rich, and Monetarism for the rest.
The regulators do not normally read Aristotle; Paulson and his colleagues would, no doubt, consider such an exercise to be a pointless waste of time in a modern economy. Hence, they can derive no principle upon which to base their regulations, and get it wrong nearly every time. The regulators are normally trained in the sterile economics of the Chicago or Austrian schools, and economic “science” which has demonstrated, over and over again, that it has no power to describe, much less understand, any actual economy.