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Reregulate?

October 20, 1998

The failure of a major hedge fund, in concert with the lingering shrinkage of Asian markets and the further slide of Russians into corruption and chaos, is ripe for the symbolic pickings. The anti-capitalist crowd, the people who never respected the market, has found their whipping boy.

After spending the last two decades downtrodden by the popular ideal of global capitalism, they now find themselves on an island of confidence in a sea of doubt about markets. The message, which hasn't changed since the first resistance to the Industrial Revolution, is, once again, that capitalism isn't delivering on it promises. Because this and that market is down, the market as such is a failure.

William Greider, the voice of damnation, writes in The Nation that, "The global system will either be reformed in fundamental ways or we will watch passively as the destabilizing dynamics of unregulated markets continue to deliver random destruction around the world, compounding the loss and misery for innocent bystanders."

The New York Times buys this: "It is obviously true that market failures were a prime cause of the world's problem," the paper writes. At root of such failure is "market excess." Investors, it seems, do not accurately gauge risk, since they "poured money into emerging markets with little concern for risk." Further, "With private capital running scared, the role of public money is all the more important."

The sense of deja vu is chilling. Recall that they confidently predicted in 1990 at the height of anti- Michael Milken hysteria and the bottom of the junk bond market that there really didn't need to be such a market for low grade bonds in the first place. After all, they assured us, the market was illusory, based on phony accounting and plainly deluded or self-blinded investors. Regulators were wise to let friendless Drexel be cannibalized by jealous competitors and moral antagonists.

President Clinton has moved this issue to the top of a top-heavy international agenda. The President announced his new policies to contain the crisis in confidence. Government finance minister festivals are, as the Wall Street Journal observes, platitude factories. Clinton, eager to fit in, joined the parade of antidotes. Fresh in his mind is the idea of "early intervention", that we as a people should get to these problems earlier, before they get out of hand. We need more disclosure, better supervision, and weeding out of improper investments.

The only difference between the old financial regulation and the new one is that the first is domestic and the second is international. In other words, just do more of the same, yet on an international scale. The government, in concert with international or cross- border agencies should get more information, watch its protectorates more closely and perhaps ban or make impossible the use of high-powered investment strategies. Tighten the web of public-private partnership. In this regulatory utopia, there is no such thing as a redundant safety system. The poverty of this program staggers the imagination.

In the emerging bureaurocratese of world financial regulation, there is a problem of "transparency." There is not enough of it, because outsiders don't know what the insiders are really doing. Markets work best, it is alleged, when everyone has access to information. In downturns, where innocent mistakes are made, disclosure of minutiae will feed the need for transparency and ward off the beast of fear.

If John Meriwether, principal strategist of the investment partnership Long-Term Capital Manangement, had made known his obscure modeling technique and strategies, regulators believe they could have adequately safeguarded the sources of his funding. Those funding sources hold billions of dollars in federally insured savings accounts.

Without sufficient disclosures, one failure could lead to others, causing the "contagion" effect. One investment fund, Brand X, sneezes and another fund, Brand Y, catches the flu. With regulators controlling the conduit through which investor information flows, the investing public is thought to not have enough information to know that Brand Y is in fact different than Brand X. Only with transparency can regulators build walls to stop the public from reacting in fear to possibility of loss. Individuals reacting with special information, not available or transparent to others, will act earlier than others. They get out early and undermine overall confidence.

One way to alleviate the contagion of failure and fear is to provide "liquidity." Normally we think of a security with liquidity as a kind of product provided by the exchanges and other markets. Market liquidity not such a product. It is simply a pool of funds generated by governments (typically taxpayer revenues, borrowings, freshly printed money, or new forms of fiduciary media) made available to policy executives. When confidence sinks and markets in individual securities cannot be made at some politically tolerable level, the government pumps in new funds. Contagion is stopped, and the problems of transparency no longer matter. The market moves up, because restored confidence leads to renewed buying. Hence, the popularity of "buying on the dip."

"Early intervention" measures are means of fortifying this policy. New and ambitious disclosure requirements will fight the "transparency" problem. Better supervision will tend to isolate a financial institution that has the virus before it can be announced it to the general investing public and start the rapid spread of fear. New restrictions on asset choice will assure that the sure new money doesn't chase the old "bad" investments but instead is channeled toward new, "appropriate" investments.

Note how much this sounds like a welfare state in credit rather than a free market. What if the government said to a private citizen, we want to know everything you are doing, in excruciating detail, because there may be some information that you provide that is associated with your success or failure and we want to know about it.

Plus, your actions affect so many people that we have the right to monitor your behavior. In fact, we are supporting your income by taking money from all those other people whom you effect by your actions. In order for us to do the best job we can, we need to see your grocery lists before you use food stamps, we need to pre-diagnose your medical condition before you see our doctors and we have to check your movie tickets before you go into the theater.

To take this one step further, how would the Times editorialists react if the government first artificially raised the number of welfare recipients by lowering the qualifications and increasing the payment frequency? And then they sent an army of social workers to make sure that the recipients spent the money on clothes, education and food rather than lottery tickets and alcohol? It would be looked at as a massive and counterproductive invasion. They would recognize that welfare expansion encourages the pathologies that the welfare payment "cure" was designed to alleviate. But when they apply the same prescription to financial markets, they don't bat an eye.

The quest for transparency and injection of liquidity work at cross purposes. Transparency, first and foremost, is a fool's paradise. If any metaphor were appropriate to the real marketplace, it would be cloudiness. The closer you are to a company, a product or a trade, the more you will know about it. The further, the more ignorant you are. Trade occurs when one party places a lower value on the thing they give up in exchange for the thing they get. If they thing they want to get rid of is ignorance and fear, then they can have knowledge or reversibility, but rarely both. The same applies to the buying and selling of shares and loans in companies by financial institutions. It is false that stock X seller and buyer "know" the same thing in the same respect in an exchange. And it is acutely false that the information that nourishes the complex motives for securities trading can ever be made more "transparent." Human cognition undercuts this model of economic action. Outsiders can never know what insiders know and the laws demanding ever more disclosure of information will never resolve this basic condition. Information, and the knowledge that comes from it, is not without cost. It is scarce, it is a product, and you negotiate for more or less of it in trade.

Liquidity is also a product. More liquidity for a particular security reduces the value of information about that security to the average investor. Broad market liquidity, provided to support broad market values, is indiscriminate capital. Transparency, such as it is, is made irrelevant when liquidity is high. Why? Because you can reverse your decision quickly and not worry about the risk of loss. If liquidity supports the values in the market, why would new and better information be necessary?

But when liquidity drops out, everyone is made ignorant all at once. Thus, stampede to the exits. What do shrewd investors they demand then? More information to make sure that they can protect themselves from further damage. Normally, we would think of that as rational behavior. Under the convoluted logic of epidemiological economics, people who know more and who try to avoid the flu are acting irrationally. The desire to be the first to avoid a contagion is thought by regulators to be an irrational response. Early intervention is founded on false beliefs. One is that disclosure will equalize the trading position of all people in the market. Another is that good supervision is the best way to monitor the fluctuating values of investment portfolios, rather than the techniques, choices, and entrepreneurial insights of the investment firms principals. Another is that disclosure and supervision can uncover hidden "bad" investment practices before they are revealed and jeopardize the market as a whole. The truth is market players are more sophisticated than the market watchers. If a John Meriwether wants to push the envelope, there are ways to do it in which no regulatory regime can anticipate.

The role of oversight, of layers of auditors and reviewers is a matter of judgement and firm prerogatives. There is no silver bullet to control risk takers during a full moon. There are merits to voluntary disclosures and alternately, to keeping business property confidential. In the case of Long Term Capital Management, the price of being secretive to creditors and others, of not having an open book (or maintaining a proprietary technique as losses mount) was that suspicions worked against them. Connections, perhaps, overcame suspicions.

Normally, however, unwarranted secrecy will impose a cost during a failure, either in preventing a quick forbearance decision or in promoting the minimization of value destruction. In free markets, those who live by the sword of secrecy will die by that sword. But its hard to imagine a less free financial system than the one we are in now, mired in the complex strategies of very sophisticated investors. . These innovators and strategists, right or wrong, crude or complex, cannot survive when threatened by pressures now looming.

Maybe the far left is correct this time. Maybe the swan song of state-financed capitalism is being sung right now. Global early intervention is really the last straw, isn't it? What better means of picking of winners and losers in the integrated global economy. Who can blame the left for wanting to assert the rights of labor and the environment in the new world economy? They are after all, constituencies with a right to a place at the political table.

World regulators have been extending the public- private partnership so long that no one can even imagine the separation of government and economy, much less the separation of government and capital markets. By promoting confidence over value creation, they perpetrate a gross fraud on the American public, not unlike the welfare scam perpetrated on the poor. It is a system ill-suited for the private management of the world's long term capital. Rather, it is the system best suited for long-term capital destruction.


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