Law of Selective Gravity
By Leo Melamed
October 16, 2008
is no way to sugar coat it: Current economic conditions have
the earmarks not only of a severe U.S. recession but---dare
I say it---the potential of a global depression. That is
about as dire as it can get. However, for me, as tragic and
ominous as that prospect may be, it does not represent the
worst consequence of today's global economic conditions. I
fear in The Law of Selective Gravity---a cousin of one of Murphy's
Laws---which postulates "An
object will fall so far as to do the most damage."
the world knows, a couple of weeks ago, Treasury Secretary
Henry Paulson asked Congress to approve a $700 billion rescue
of the banking industry. Without this sudden, massive infusion
of federal cash, we were told, economic disaster loomed. Prompt
approval, on the other hand, would assure the solvency of the
financial sector, thaw frozen credit flows, and give investors
a badly needed dose of confidence. Faced with the prospect
of rising unemployment, a plunging stock market, and the inability
of corporate America to borrow, Congress approved a revised
package on Friday, Oct. 3. 2008. This gave investors the weekend
to contemplate the economic value of the federal action. Were
it able to inspire some confidence and halt for a moment or
two the bloodletting, one might be a bit more charitable in
assessing the panic-driven action by the captains of American
capitalism. On Monday, the stock market plunged into an abyss
and the turmoil spread to Europe, Asia and South America. The
plan which Secretary Paulson and Fed chairman Bernanke told
us we must approve to prevent a market crash did nothing of
the sort. The market crashed. Now the plan is for government
to rescue the banks with direct capital investment, whether
they want it or not. Did you every think that maybe the market
doesn't want any more of government plans?
don't miss the point. I am not lamenting the fact that the
desperate plan did not have an immediate medicinal effect---in
all reasonableness, the Trouble Asset Relief Program (TARP)
will take time to take effect. But what I am lamenting is the
fact the executive branch of an American administration was
so desperate that it proposed a rescue operation of gargantuan
proportion which gave it unlimited power, with minimal oversight,
little accountability, no recourse, and no judicial review.
I am lamenting the mind-set that would devise such a plan---surely
its blueprint had a Venezuelan origin. A plan that Steve Chapman
of the Chicago Tribune described as "giving the executive branch
powers that a Russian czar would envy."1
I am lamenting
the fact that hardly anyone paid the slightest attention to
a warning by a group of 122 economists, including at least
two Nobel laureates, who stated:
the plan is enacted, its effects will be with us for a generation.
For all their recent troubles, America's dynamic and innovative
private capital markets have brought the nation unparalleled
prosperity. Fundamentally weakening those markets in order
to calm short-run disruptions is desperately short-sighted.2
am lamenting that U.S. government officials were in such
a state of panic that they abandoned market solutions in
favor of third-world sorcery like blaming speculators and
banning short selling. I am lamenting the fact that all the
world's capitalists have turned to the government for salvation.
I am lamenting the fact that federally inspired rescue operations
were so quick to surrender the fundamental free market principle
that mistakes by the private sector must be borne by the
people who made them. As Thomas Donlan of Barron's remarked "The
U.S. and Europe are racing down the trail marked by such
economic leaders as Mexico, Argentina and Russia."3 Or as
Yale's Professor Jonathan Macey put it: "Officials at the
Federal Reserve, the Securities and Exchange Commission and
the Treasury Department are to blame for publicly losing
confidence in the very economic system they are supposed
all, what I am lamenting is the real cost of these
operations and not in terms of billions of dollars to American
taxpayers. I am lamenting the fact that The Law of Selective
Gravity will result in the unthinkable---a renunciation of
the free market. With that---America will lose its most precious
asset, the ability to innovate.
is not some fantasy of a hysterical pessimist with a propensity
for paranoid prophesies. The developing underlying blame---within
the walls of Capital Hill, Wall Street, and Main Street---is
that the economic disaster is the result of a laissez-faire
deregulatory mentality. Greed on Wall Street has become
the conventional theme of both presidential candidates. In
the public vernacular that is shorthand for the free market. "I
was a free market guy, but no more" is a common refrain heard
from ordinary folks on the streets of America. Its damning
echo is resonating throughout the pages of American newspapers,
radio talk shows, and TV programs.
it is a message roundly applauded by every enemy of freedom
on the planet.
is not to suggest that the financial system is not in trouble.
Or that some form of federal action was unwarranted. Nor is
this an attempt to absolve the private sector from blame. Surely
greed played a major role in what happened. Clearly financial
institutions, in their rush for greater immediate returns irrespective
of consequential long-term risks, were guilty of irresponsible
behavior or worse. As Randal Forsyth of Barron's suggested,
OTC structured investment vehicles became the financial equivalents
to steroids. Regulatory reform, as suggested by former SEC
chairman Arthur Levitt Jr., is necessary pertaining to lending
practices, licensing standards, oversight of mortgage brokers,
capital requirements for monoline insurers, and transparency
in the sale of OTC derivatives so that risks associated within
all forms of structured investment vehicles will be fully disclosed.5
Similarly, as Nobel laureate, Gary Becker recommended, there
is a need for increased capital requirements relative to assets
of banks in order to prevent the highly leveraged ratio of
assets to capital in financial institutions. 6
while endorsing regulatory reform, allow me also to draw
attention to one place where, in stark contrast to the turmoil
of recent events, the market system operated flawlessly.
I speak of futures markets, an indispensable component of
the global marketplace. While their growth in the last decade
was substantially less than in OTC derivatives, last year
the CME Clearing House cleared more than 2 billion futures
contracts, representing more than $1 quadrillion
in value. Which begs the question, how did exchange traded
futures perform during these unprecedented turbulent conditions?
The answer is clear: Flawlessly. No defaults, no
failures, no federal bailouts. The futures market model is
a poster child for the free market and innovation: price
transparency, liquidity, central counterparty clearing, twice-daily
mark to market, zero debt system, and regulatory oversight.
examples: On March 14th, 2008, the last day before Bear Stearns
was acquired by JP Morgan Chase, Bear held $761 billion
in notional value in open futures contracts for customer
and house accounts at the CME. All positions were paid for
and settled. Impressive, yes? Then how about this: On Friday,
September 12, 2008---the last weekday before Lehman Brothers
filed for bankruptcy---their total notional value of customer
and house positions at CME was $1.15 trillion. No defaults,
no failures, no federal bailouts. Unabated, futures market
continue to perform their essential functions: to create
a venue for price discovery, permit low cost hedging of risk,
and to innovate.
here is the rub: The free market model cannot function when
it is directed or, better still, misdirected by the heavy hand
of governmental edict. No matter how one views what happened,
no matter of what political persuasion, much if not most of
its causation has a governmental origin. First, because during
the past decade the world became awash with liquidity. Low
interest rates engineered by world central bankers caused
interest rates, especially in the U.S., to fall to the lowest
level in a generation. The consequential cheap money when combined
with loan syndication and securitization produced some highly
unintended consequence. A mortgage-lending boom ensued, and
bankers found ever more clever ways to repackage trillions
of dollars in loans. Professor Bob Shiller of Yale summed
it up this way: "The housing bubble is the core reason for
the collapsing house of cards we are seeing in financial markets
in the US and around the world."
leads us to the second and most egregious culprit of the
financial collapse: two government sponsored enterprises,
Fannie Mae and Freddie Mac. They were viewed in the marketplace,
correctly as it turns out, as government-backed buyers. These
two GSEs were on an affordable-housing mission, becoming the
largest buyers of subprime mortgages between 2004 and 2007
with a total exposure exceeding $1 trillion. It was a mission
supported and backed by elected congressional officials who
presented themselves as champions of affordable housing.7 It
fostered what Princeton's, Professor Burton Malkial described
as the so-called NINJA loans to borrowers---no income, no job
and no assets---and poisoned the global financial system. "The
Fannie-Freddie bailout," wrote
the Wall Street Journal, "is one of the great political
scandals of our age. Officials at the Federal Reserve warned
about it for years, only to be ignored by both parties on Capitol
other words, it was a rigged game. The dictates of the free
markets are always stymied by a monopoly, a cartel, or the
actions of government. It would be a tragic misdirect and
a perverted leap of logic if the conditions that caused the
global meltdown, the transgressions that occurred within
the private sector, or the regulatory reforms that are required
were blamed on the precepts that made this nation so great.
More than any other nation on this globe, Americans are free
to think, to experiment, to innovate. It is a legacy of the
free market. A story of two miracles: an economic miracle
and a political miracle. Its application by a people with
an immigrant ancestry, of a multicultural heritage, and
a multiracial composition, produced an unimaginable result.
It became a lightning rod for ideas. It created a crucible
for innovation. It combined to become the decisive driver
of progress in science, technology, and economic development.
pray that my fear is misplaced---but Murphy's Law demands
that I sound the alarm.
* * *
Chapman, Chicago Tribune, September 25, 2008.
Donlan, Barron's, October 13, 2008.
Macey Wall Street Journal, October 11, 2008.
Levitt, Jr., Wall Street Journal, March 21, 2008.
S. Becker, Wall Street Journal, October 7, 2008.
W. Calomiris and Peter J. Wallison, Wall Street Journal, September
Review & Outlook, September 8, 2008.
* * *
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