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The Failure of State-Designed Markets

Mises Daily: Thursday, August 28, 2003 by

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A growing recognition of the superiority of markets over planning has created an unviable hybrid: the planned market, one created not by property owners but rather by the state and for the state. Planned markets bear a close enough resemblance to the real thing to fool even astute observers who are otherwise friends of genuine market forces. And yet the designed "market" is responsible for a whole range of recent economic failures, such as electricity shortages and blackouts, and will cause more if the idea is taken to areas like predicting terrorism.

Let us begin by examining real markets. Their appearance is as spontaneous as it is unpredictable. Back in the summer of 1998, for example, I was working as an over-the-counter broker dealing with forward electricity contracts in New York. Our office was located on the 10th floor of 1 World Trade. One summer day when the market was slow due to a credit meltdown in the Cinergy market, two brokers started making some bets. They were betting on the temperature displayed on a digital clock across Liberty Street. In similarity to an option contract where the price is derived from an underlying commodity or index, they bet on the clock temperature rising above or below a particular "strike" at a particular time.

One could bet that the clock "temp" would be above the 102 Fahrenheit strike by 10:15 expiration or below 99 by 11:30. Since the sun was shinning directly on the clock causing volatile swings in the temp by the minute, and we were bored out of our minds, interest began to grow in this market for clock temp bets. It eventually sounded like just another busy day on the trading floor. It got so complicated at one point that some were trying to make spread trades between different temp strikes. Out of thin air, a market was created the speculative market for clock temp bets. Kind of sounds crazy, but it was fun. Of course, when the sun stopped shining on the clock, interest waned and the market was over.

The above represents an excellent example of a market economy. Just as in the more formal case of the Buttonwood Agreement, individuals freely contracted to make mutual gains from exchange. Granted that the payouts in the clock temp market are zero-sum in a monetary sense, and it only lasted for three hours. Consumers in the market were able to trade some of their money for the boredom of that slow summer day. And when the consumers were done, the market for clock temps bets ceased to exist.

This is much like a futures contract, an exchange traded forward agreement, that starts off hot with growing open interest, but then interest wanes with the contract's eventual delisting. Such a case happened when the New York Mercantile Exchange (NYMEX) introduced electricity futures contracts. The forward market for wholesale electric power of various hubs across the US developed when the FERC (Federal Energy Regulatory Commission) "deregulated" the market. It was the equivalent of a deregulated wholesale milk market with a corresponding regulated retail market, in other words, totally insane.

Anyway, NYMEX saw an opportunity to market electricity futures to members of the exchange, natural hedgers (power marketers and utilities), and speculators. Open interest started to grow steadily in the beginning but began to drop off when, in the summer of 1998, massive price spikes hit the Midwest market for Cinergy. This was primarily due to a power plant tripping in Chicago combined with record heat causing Midwest wholesale power players to scramble for supply, bidding up the market.

Prices became so volatile for a market previously trading between $30 and $70 a megawatt hour, that it was now trading between $200 and $500 a megawatt hour. At times it took a hundred bucks just to cross a bid-ask spread. Locals on the floor like volatility, but when it means they are already down a hundred dollars a megawatt hour (which translates in the millions) after hitting a bid, they begin to lose interest fast. Power producers also didn't like the small size of the futures contract, 2 megawatt hours as opposed to the more conventional 25 to 50 megawatt hours in the over-the-counter market. Producers and locals exercised their subjective preferences in avoidance of the NYMEX power contracts, with the eventual delisting of the contracts from the exchange after the California "power crisis."

In neither case of NYMEX power or of clock temperatures, did the government design or create a market. This is an important point. The market process exists independent of actions by the state serving to satisfy the subjective preferences of consumers. As Mises explains in Human Action:[i]

The market economy is the social system of the division of labor under private ownership of the means of production. Everybody acts on his own behalf; but everybody's actions aim at the satisfaction of other people's needs as well as at the satisfaction of his own. Everybody in acting serves his fellow citizens. Everybody, on the other hand, is served by his fellow citizens. Everybody is both a means and an end in himself, an ultimate end for himself and a means to other people in their endeavors to attain their own ends.

This process exists logically antecedent to the empirical examples shown. In praxeological study, the data does not prove the theory correct. Rather, a logically correct theory explains the data. In the case of NYMEX power futures, individual traders exercised their own judgement by independently moving away from the futures to the over-the-counter forward market.      

The Government's "Market"

Which leads us to the case of the government's "market."  The two prior cases consisted of naturally occurring markets, one totally unregulated by the state (clock temperature bets) and the other which the state has allowed to operate with restriction (wholesale electric power). The state does not limit itself to restricting markets; often it attempts to create markets for its own intents and purposes.

The most well known example of state market creation is the primary market for government debt. A government issues debt to expand its rule and power with the expectation of taxing its subjects to pay back principle and interest. The state's means of revenue are a use of force and coercion, a concept antithetical to the market. "The market directs the individual's activities into those channels in which he best serves the wants of his fellow men. There is in the operation of the market no compulsion and coercion," explains Mises [ii]. Why is there no market coercion?  Coercion is absent because consumers would naturally avoid threatening vendors. Knowing this, state organizations have to use a hammer to keep consumers under their tutelage.

In the case of government debt, taxation and monetary debasement are the hammers. Naturally this leads us to ask, can the state create a market economy?  Not if we accept a logical definition of the market process. Of course, state propaganda distorts economic reasoning to justify its existence, "squaring the circle" if you will. The statists can redefine "market" to mean whatever they want it to mean, even if it defies all logical reasoning, primarily because the state can force others to accept it.

The U.S. Treasury auction on government debt is portrayed as a market, but in reality, it serves to help only one consumer, the government itself. Even more so than voting, the primary Treasury market is the ultimate auction on stolen goods. This makes it quite amusing to hear financial practitioners call interest rates on the Treasury yield curve, "risk free."  It doesn't seem logical to consider an investment in an entity that uses coercion, theft, and force to remain solvent, as one that is risk free. But such illogical propositions help the state in its solvency. Granted, individuals do not have to buy primary Treasury securities, but many do so, seduced by the "guaranteed" rate of return at the expense of themselves and their fellow taxpayers.   

It is interesting to note that rising from state market products, like the U.S. Treasury debt and Federal Reserve notes, the secondary and derivative markets developed reflecting market principles. Treasury bond futures on the Chicago Board of Trade rose from those who were looking for a way to hedge interest-rate risk in their portfolios. Currency swaps markets naturally occurred when governments tried to impose foreign exchange controls on their currencies. However, regardless of secondary market characteristics, there is no justification for the primary market aberrations created by the state's use of force.  

Moving beyond money and credit, governmental organizations continue to design other markets, which often claim to meet the needs of some nameless consumer. These consumers are usually collective entities like the public at large, or a nonhuman element like the environment. The EPA, in its perpetual quest to save the environment from owners of private property, imposed sulfur dioxide emissions regulations on companies with coal burning plants. In the regulatory process they came up with a "free-market" solution of tradable emission allowances. The EPA would distribute a certain amount of allowances a year for companies with coal emitting plants.

This is another example of a coercive attempt to change behavior, but not a real market. Of course, this led to the push for power generation companies to move away from building coal plants toward natural gas fired generation. After all, in the minds of government regulators and even power companies, natural gas was a pretty cheap substitute for coal and in some cases, more efficient. What was not seen as a possible consequence of this regulation, was that the market price for natural gas could increase as demand from gas fired power producers increased during the traditional summer storage months for natural gas, and that they have.   

Which brings us back to money. The EPA's particular regulatory framework is not the only reason natural gas prices have been riding high. Another governmental "market" contributing to distortions in the natural gas market, as well as just about every other market process in the economy, has been the Federal Reserve's Open Market Operations. A reasonable case could be made that distortions in the structure of production resulting from the Fed's operations have caused drastic fluctuations in the supply and price of natural gas. As both Mises and Hayek have argued, all prices do not necessarily rise or become distorted at the same time as a result of inflationary policy:

The crucial point is that so long as the flow of money expenditure continues to grow and prices of commodities and services are driven up, the different prices must rise, not at the same time but in succession, and that in consequence, so long as this process continues, the prices which rise first must all the time move ahead of the others. This distortion of the whole price structure will disappear only sometime after the process of inflation has stopped. This is a fundamental point which the master of all of us, Ludwig von Mises, has never tired from emphasizing for the past sixty years. It seems nevertheless necessary to dwell upon it at some length since, as I recently discovered with some shock, it is not appreciated and even explicitly denied by one of the most distinguished living economists.[iii]

Hayek's appreciation of time and inflation is still ignored by a majority of economists and market participants. Looking solely at the CPI and PPI indicators, one would never see the inflation of money and credit created by the Fed's Open Market Operations. In the opinion of this market observer, a deeper analysis will show the true nature of inflation as described by Hayek. As unprecedented amounts of money were created, exhibited by the M3 indicator, banks began investing the newly created money and credit heavily into technology companies. And with the depression of the Fed Funds rate, the corresponding broker call rate was lowered for margin interest, giving incentive for the masses to bid up technology companies in the heavily tech weighted Nasdaq Composite index.  

During the tech boom, the newly created money allocated existing capital toward tech ventures away from other ventures in the economy. Boring, stodgy natural gas companies were one major economic player ignored in the tech boom. The Nasdaq reached its height in the spring of 2000; not long after the Fed's Y2K emergency creation of massive amounts of money and credit.

As Silicon Valley and the rest of California boomed on these tech ventures, demand for power and natural gas grew to an eventual boiling point, perpetuating what became the California Power Crisis. Eventually, investors grew weary of tech companies; realizing profitability in such ventures was unsustainable. With gas moving to the stratosphere and tech collapsing almost a year after the Nasdaq's high, banks with constantly increasing money and credit, courtesy of the Federal Reserve, began pouring money into electric power and natural gas companies, like the infamous Enron, and out of technology ventures.

Money and credit was going toward new exploration and production with the increase in gas rigs as well as electricity power plants. Eventually many of these ventures went bust as well with natural gas prices plummeting on record storage levels and spark spreads (electric power producer's margin) diminishing. This bust recorded some of the largest bankruptcies in US history, including Enron. Of course, mainstream analysis will fail to see the Fed's role in this process because many hold a neutral view of money and credit. Further study will illustrate the non-neutrality of money, combined with the component of time, have volatile effects on the seemingly uncorrelated markets like natural gas and power.    

Of course, culpability politically lies with the now bankrupt Enron and the "free market," not with Federal Reserve policy or with any other statist market creations all are forced to comply with.

Power Market Design

Since the failure of the reregulation of the electric power market in California, the Federal Energy Regulatory Commission has proposed "harmonizing" US wholesale power markets. Their justification for potential standardization of the wholesale power market is based on the same tired argument that markets just don't work. According to a FERC white paper on the Wholesale Power Market Platform [iv] issued this year:

…short-term wholesale markets with transparent prices and market structures that will reliably produce just and reasonable prices are not likely to develop without strong Commission action. Wholesale electricity markets do not automatically structure themselves with fair behavior rules, provide a level playing field for market participants, effectively monitor themselves, check the influence of market power, mitigate prices that are unlawful, or fix themselves when broken.

We have heard this type of argument before. It goes something like this. Government "deregulates" market. Market fails under "deregulation." Government must place stronger restrictions on a process to correct its failures and shortcomings. Of course what is lost in this whole argument is that the government's original regulations caused the initial problems. Also, it is never mentioned that after "deregulation," the government is still regulating the market.

In the case of electric power, there is still massive Federal regulation of the transmission system and massive state regulation of retail markets despite the deregulation of wholesale. To the one-dimensional economic thinker, a "deregulated" wholesale market can exist or be expected to exist independently and effectively from the transmission (electricity transportation) and retail markets. Therefore, according to FERC, since "deregulated," "unhampered" markets for wholesale power are failing, FERC needs to step in and make it function "properly." 

However, the astute multidimensional economic thinker knows better, understanding that all markets are interrelated. Deregulated wholesale power markets are not free markets when transmission and retail markets are restrained by government power. It is not the free market that has failed, rather it is the restrictions on the market participant's ability to deal with scarce resources. Since this ability is restricted, people are unable to creatively deal with shortages and surpluses in an effective manner. Economic calculation becomes impossible due to the centralized control of the market's resources, and in this case the controlled resources are transmission and retail supply. Taking the analysis to the next dimension, socialized money and credit compound the impossibility of effective economic management, distorting the medium of exchange and unit of account used in transacting in the power market.         

To fix the perceived market problems, FERC proposes to impose a Wholesale Market Platform consisting of components like "fair cost allocations for transmission," "market power mitigation," and "transparency in congestion management."  FERC is under the impression that its market design is superior to failed models like California because it is more effective in curbing unwanted market behaviors while at the same time effectively serving the consumer. But how can FERC, with the use of compulsion and coercion, serve the consumer?  It cannot, and its market design will fail because its plan could never be a market. Consumers will have no choice in abstaining from it. If power companies find that the FERC's wholesale market isn't exactly what they want out of a market, they will have no choice but to accept it. Unlike the case of NYMEX Futures versus over-the-counter forwards, there will be no alternative.

The only way to get innovation and change is to beg FERC or payoff some politicians. While they wait and beg, transmission lines will decay, blackouts will ensue, and the consumers will be asked to conserve. In other words demand will not be met, because supply will have to beg the government to serve demand. Such a "middle road" is always doomed to failure, because the middle road is not the market.

Terror Futures

Looking at US Treasuries, Federal Reserve Notes, EPA emission credits, or power market designs, it should be no surprise that DARPA (Defense Advanced Research Projects Agency) under the Information Awareness Office has tried to mold such a monstrosity as the market for terror futures. In essence, the market would be purely speculative unlike most futures markets which have large hedging interests. Profits in the market would also be restrained to $100 a trade thus keeping would-be terrorists from having massive windfall profits on an event's occurrence. [v] 

Proponents of the initiative argue that it would be an effective way to gather intelligence and combat terrorism. According to Hal Varian in the New York Times, markets can be great "predictors" of future events. [vi]  He cites evidence of online betting markets, like tradesports.com, which is similar to the DARPA proposition and the earlier example of clock temperature bets. Pat Buchanan argues that a bettors' market might have predicted some of the greatest strategic disasters in the last century. [vii]  In a Wired news article, Noah Shachtman quotes proponent David Pennock, who has done extensive surveys on the reliability of such markets:

"'The very fact of the terrorist doing that (investing money in an attack) would reveal his hand,' he said. Prices would rise as the terrorist invested his cash, and that would tip leaders off to the potential for strike. 'The market would know something is going to happen that people never would have known otherwise," Pennock added." [viii]  

It is important to note that futures markets are not necessarily good predictors of future events, rather they are the best estimate of a future market price now. It is a market's effectiveness in dealing with events as they arise due to their roots in property rights that make them desirable. With this ability to freely exercise private property rights comes the potentially rewarding prospect of increased profitability.

Where all of these proponents fail in their analysis is that markets are effective means of information dissemination because they are decentralized institutions rooted in property rights. Even with their own examples of sports betting or the Hollywood stock exchange, they fail to see the fundamental difference between freely functioning markets and a creation of the state.

The state's idea of terror futures is so bad, that only the use of force could sustain it. The prospect of earning a whopping hundred dollars on a futures trade is not very lucrative. It is highly doubtful that traders would expend large amounts of capital towards better systems and information gathering to reap a hundred bucks. Since there are few restrictions on profitability in a normal futures markets, futures players are willing to expend their private capital toward all sorts of detailed information in the hopes of future profit maximization. For instance a monthly subscription to a Bloomberg or Reuters news service can run in the thousands. Some companies have paid meteorologists six figure salaries to help with their weather risk management.

With the potential profitability on a terror futures trade of a hundred bucks, the prospect of any relevant intelligence arising in such a market is highly unlikely, since information is an expensive commodity, particularly on military intelligence and political instability. For an annual subscription to an Economist Intelligence Unit's (a major sponsor of the DARPA market) country report it would cost $470 a country.

If one went long the potential overthrow of the Jordanian monarchy, and decided to use an EIU annual subscription to track it, one would hope the monarchy was overthrown at least five times before meeting information costs.   Just to get a good two to one risk reward on such a trade, the poor Hashemite king would have to be overthrown at least ten times. I guess one could hire some disgruntled policy analysts from DARPA for $20 bucks a month, but even that would put a big dent into profit margins. What DARPA, EIU, and the state fail to see, is that you can't have the benefits of robust market information, while limiting the profitability of a trade.   

The one positive aspect of the terror futures market proposal is the implicit admission by DARPA that the state's current means of intelligence gathering is as ineffective as every other means it uses in protection of its tutelage. To further justify the state's roll in intelligence gathering and protection, DARPA developed a scheme under the auspices of "market" economics. Unfortunately, such a measure will fail to meet the demands of consumers because it is not market economics. Fortunately, this means the state's ineptitude is becoming more obvious.     

Conclusion

While things like terrorism futures are overtly grotesque, economic thinkers need to be disciplined in understanding the fundamental differences between the market and the state. In more subtle examples like EPA emission credits, US Treasuries, or Federal Reserve Open Market Operations, economists need to realize the roots of these creations and how they affect the market economy. It cannot be stressed enough that the state cannot create its antithesis, the market. Markets are rooted in private property; states are rooted in theft. Don't be fooled by squared circles.  

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Casey Khan [ send him mail ] works as a risk analyst in the energy industry in Phoenix, AZ, where he lives with his wife.



[i] Mises, Ludwig von, Human Action. Chapter 15, Section 1, fully interactive addition.

[ii] Ibid. Chapter 15, Section 1.

[iii] Hayek, F.A. "Can We Still Avoid Inflation?" The Austrian Theory of the Trade Cycle.

            Edited by Richard Ebeling. The Mises Institute, 1996.

[iv] Federal Energy Regulatory Commission, White Paper, Wholesale Power Market Platform .

            Issued April 28, 2003.

[v] Varian, Hal R. " A Good Idea With Bad Press ." New York Times. July 31, 2003.

[vi] Ibid.

[vii] Pat Buchanan. " A City of big ideas and tiny minds ."  Townhall.com, August 6, 2003.

[viii] Shachtman, Noah. " The Case for Terrorism Futures ."  Wired, July 30, 2003.