How Capitalism Will Save Us (39 page)

I
n his book
The Road to Serfdom
, Nobel Prize-winning economist Friedrich Hayek said that the purpose of law in a democratic capitalist economy should be to codify the rules of the road. It should make certain that people travel in an orderly fashion. Rules and regulations should let people set their own path. They should not tell people precisely where and when they should travel—they should not micromanage markets. Hayek believed democratic capitalism was best facilitated by common law that applied to everyone, not by arbitrary laws designed to favor or penalize particular groups, enacted to carry out political agendas.
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Milton Friedman thought that the role of government should be to protect people from abuse and coercion by others. “Unless there is such protection we are not really free to choose,” he wrote. “The armed robber’s ‘Your money or your life’ offers me a choice, but no one would describe it as a free choice or the subsequent exchange as voluntary.”
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The problem these days is that too many regulations reach beyond the basic functions of guidance and protection advocated by Hayek and Friedman. They often impose artificial constraints on behavior that distort the normal operation of markets. They end up hurting the people they’re supposed to help, at great cost to the economy and society.

Many fear that the free market would degenerate into anarchy without regulation. The truth, though, is that free markets are to a great degree self-regulating.

This may be hard for some to believe, given the financial meltdown of 2008, with its nonstop headlines of wrongdoers and wrongdoings. But overall, in the Real World economy of democratic capitalism, the Bernard Madoffs of the world are the exception. Free-market economist and blogger William Anderson provides a good explanation of why this is so. The free market regulates itself precisely because it is voluntary and, as Adam Smith wrote, governed by self-interest. You can’t force someone to do business with you. Thus, it’s in your self-interest to act in a responsible way that will help attract and keep customers. After all, what individual or business will thrive by offering shoddy products and poor service?

Anderson reminds us that for about a century after the founding of the republic, businesses in the United States functioned largely without regulation. Settlers established the colonies in part to escape the suffocating rules of the Old World, where the minute workings of the economy could be dictated by government. Anderson gives the example of Louis XIV’s finance minister, Jean-Baptiste Colbert, who “regulated the French economy down to the required thickness of threads for textiles.”
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However, by the late 1800s, old-world regulatory habits began to reassert themselves in this country. Why? People feared that corporations had grown too powerful to be controlled by the usual marketplace checks and balances. In addition, a growing number of people believed that the certainties of science could be brought to bear on politics and economics. Free markets seemed so messy and chaotic. Why couldn’t they be efficiently, scientifically managed?

The Progressive Era, which began in the late nineteenth century and ended with World War I, ushered in a new era of regulation. Politicians like Republican Theodore Roosevelt and Democrat Woodrow Wilson believed that Washington should be involved in managing a modern society.

The first major federal agency, the Interstate Commerce Commission, was established in 1887 to regulate the railroads. The market, driven by customer demand and competition, had formerly set rates and rail routes. Now government bureaucrats took over those functions in the name of safeguarding the public good. Routes and rates were now determined by a handful of regulators responding to political forces.

The ostensible purpose of the commission was to protect railroad customers, mainly farmers, from monopolistic practices and unfairly high rates. However, the commission ended up reinforcing the interests of the biggest industry powers—effectively creating a cartel—and destroying what had been an open, competitive market. As Milton Friedman recounts in
Free to Choose
, “Farsighted railroad men recognized that … they could use the federal government to enforce their price-fixing and market-sharing agreements and to protect themselves from state and local governments.”
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Unfortunately, this is all too often a Real World consequence of well-intentioned regulations. They’re sold by politicians as solutions to help the consumer or “the little guy.” But they end up protecting the biggest industry players and special interests.

What free-market critics fail to appreciate is that markets are merely people expressing—or responding to—one another’s needs and desires, based on the current realities of either supply or demand. Free-market transactions seek to achieve the greatest mutual benefit possible under the circumstances. In this way, as Adam Smith observed, the “invisible hand” of the free market ultimately acts in the best interest of the greatest number of people.

This behavior is not always what “the experts” think it should be. That’s often because the people who make up a market are responding to imbalances in price and supply created by existing regulations. The most recent example, of course, is the 2008 collapse of the housing and financial markets. As we explained earlier, contrary to the heated claims of House Speaker Nancy Pelosi, Congressman Barney Frank, and others, these events were anything but the results of “unfettered” markets.
They were the result of markets thrown out of whack by layers of government mismanagement.

Overly stringent rules and regulations don’t just distort market behavior, they can strangle an economy. Every year, the Heritage Foundation and the
Wall Street Journal
release their Index of Economic Freedom. Nations that rank lowest on the list, with the least economic freedom, are usually the poorest.

For example, number 131 out of 179 on the 2009 list is Indonesia, with a per-capita income of just $3,454 and 9.6 percent unemployment. The report explains that despite recent reforms that have helped boost growth, many obstacles to economic activity persist in that country.

The report also noted: “Despite some progress, foreign investment remains restricted, and judicial enforcement is both erratic and nontransparent. Because of pervasive corruption, impartial adjudication of cases is not guaranteed.”

Indonesia’s corruption is typical of government-dominated nations. That is the irony of an overregulated economy: it ultimately undermines a lawful society. People strive to circumvent rules they perceive as unfair. We observed in
chapter 1
that this is the case in Russia, where private businesses skirt an overly meddlesome bureaucratic system by paying bribes in order to operate.

A democratic capitalist economy shouldn’t be entirely unregulated. But in today’s heated debates, too little attention is focused on the potential impact of a proposed regulation in the Real World. Any well-intentioned rule has benefits, at least for some. The question is whether those benefits are worth their cost. We discuss later in this chapter the largely ignored unintended consequences of the initial CAFE standards enacted in the mid-1970s. These regulations did produce more fuel-efficient cars, but with a major cost—higher accident fatalities.

Another example: the ban on the pesticide DDT. Environmental and health concerns led to prohibition of the insect killer in the 1960s and ’70s. Alternative methods for fighting malaria, such as netting, were
supposed to serve as replacements, but they have been comparatively ineffective. Malaria epidemics have since killed over a million people a year, with fifty million deaths over twenty-five years. Were the benefits of banning DDT really worth so many lost lives?

Several years ago, South Africa started allowing judicious use of DDT. The spraying of small amounts was permitted inside people’s residences. There were no negative health effects. Quite the contrary: the incidence of malaria declined by 90 percent.

According to the Competitive Enterprise Institute, the cost to the U.S. economy of complying with the nation’s countless regulations came to almost $1.2 trillion—almost equal to the amount that the federal government collects in personal income taxes.

In 2008, Congress passed and the president signed into law 285 bills. Federal agencies finalized over 3,800 new rules and regulations.
That’s just in a single year
. Everyone wants rules to protect their welfare, health, and safety. The question is—how many?

T
he meltdown was anything but the result of too little regulation. It was the outcome of a “perfect storm” of regulatory mismanagement—that is, existing rules poorly designed or applied.

A key regulatory failure was the Federal Reserve’s low-interest-rate, “easy money” policy that fed Wall Street’s appetite for selling—and buying—fee-generating packages of subprime mortgages.

We noted in our introduction that government economic and regulatory decisions are ultimately driven by the agendas of politicians and not the needs of people in a market. Why didn’t the Treasury Department—behind the scenes—tell the Fed to strengthen the enfeebled greenback? Because the Bush administration liked a weak dollar, believing that it would improve our trade balance by artificially making our exports cheaper. Not since Jimmy Carter had the United States had such a weak-dollar
administration. Without the Fed flooding the banking system with too much money, the housing bubble could never have reached the size it did.

There’s another part of this story: the failure of bond-rating agencies such as Moody’s, Standard & Poor’s, and Fitch. They, too, were caught up in the irrational exuberance of the housing boom and gave mortgage-backed securities triple-A ratings. This was hardly surprising. Though private entities, rating agencies are essentially a government-sanctioned cartel. The SEC still must approve which firms will be “nationally recognized.” Even today, rating agencies’ powers are protected by federal and state law. Pension funds, banks, and insurers, in many cases, must still have certain amounts of securities that are rated investment-grade by these government-sanctioned agencies. Another peculiarity of rating agencies is that the issuers of securities that are being rated—not the buyers—pay for the ratings. This presents a strong potential conflict of interest. Many observers strongly believe that to get business, rating agencies have been tempted to soften criticisms of securities since the issuer is their client. This is the opposite of how stock analysts are compensated—no one would take seriously an analyst’s stock recommendation that was paid for by the company being analyzed.

Thus the ultimate alchemy: junk mortgages, bundled together, became prime-grade, triple-A-rated mortgage-backed securities. They were bought up by financial institutions, spreading the risk everywhere. The Fed and other bank regulators stood by as the bubble ballooned.

Another culprit: the Securities and Exchange Commission. If the SEC had not repealed the uptick rule in July of 2007, much of the unprecedented volatility would have been avoided. As we’ve explained, the rule created a critical road bump by requiring that an investor could short a stock only after it had gone up in price.

Hedge funds, however, wanted the rule repealed. In response, the SEC conducted a study of market activity in recent years to determine if the rule was needed. Unfortunately, that period happened to be one of the calmest ever for stocks. So in 2007 the SEC repealed the seven-decade-old rule. Market volatility soared. A key measure of volatility, the VIX index, quadrupled.