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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

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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Jeff Scott is financial analysis at Wells Fargo and an adjunct scholar of the Mises Institute.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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