The Law of Selective Gravity
By Leo Melamed
Financial Innovation Conference
Vanderbilt University
October 16, 2008
Nashville, TN

There 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."

As 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?

But 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:

If 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

I 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 to protect."4

Above 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.

This 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.

And it is a message roundly applauded by every enemy of freedom on the planet.

This 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

But 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.

Two 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.

But 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."

This 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 Hill."8

In 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.

I pray that my fear is misplaced---but Murphy's Law demands that I sound the alarm.

* * *

1Steve Chapman, Chicago Tribune, September 25, 2008.

2Ibid

3Thomas Donlan, Barron's, October 13, 2008.

4Jonathan Macey Wall Street Journal, October 11, 2008.

5Arthur Levitt, Jr., Wall Street Journal, March 21, 2008.

6Gary S. Becker, Wall Street Journal, October 7, 2008.

7Charles W. Calomiris and Peter J. Wallison, Wall Street Journal, September 23, 2008.

8WSJ, Review & Outlook, September 8, 2008.

* * *

Return to top of page | Return to Index | Home Page