In Praise of Complex Financial Markets

The ongoing presidential race has occasioned an impassioned, if not exactly enlightened, consideration of the causes of the 2008 financial crisis, nearly all of it based on misinformation, fallacy, and unfocused populist outrage. While much of that outrage is quite justified, the arguments and charges through which it usually expresses itself reflect a deep misunderstanding of the moral hazards at the heart of the financial crisis.

“Many of these moral hazards,” writes economist Kevin Dowd, “involve increased risk-taking: If I can take risks that you have to bear, then I may as well take them; but if I have to bear the consequences of my own risky actions, I will act more responsibly.” In the search for simple answers and the manufacture of pithy headlines, this kind of risk-shifting moral hazard was often wrongly attributed to the operations of an untrammeled free market.

Progressives and the media establishment were only too eager to foster this misbelief, aware of the opportunity afforded by the crisis. The growth of government following crises, be they wars or economic depressions, is well documented in American history (see, for example, Robert Higgs’s excellent Crisis and Leviathan). Confronted with an emergency, the urge to pass a law, to enact some bold new reform, however shortsighted, seems to be irresistible. Further expanding the role of government, though, will only increase risk, interfering with one of the free market’s most important functions — the separation of the wheat from the chaff.

In a free market economy, the only way to manage risk is through peaceful and voluntary decisions about your own property: One either abstains from a particular investment altogether or attempts to bargain his risk away through some kind of contractual arrangement. Mortgagee derivatives are simply one such contractual arrangement, and there is nothing particularly dangerous or sinister about these securities — at least not in a free market.

In fact, these agreements have many salutary effects for economic health. As economist Thomas F. Siems of the Dallas Fed observed almost 20 years ago, “[U]nder a market-oriented philosophy, derivatives allow for the free trading of individual risk components, thereby improving market efficiency.” These manifold outlets, competing for dollars just like commodities or consumer goods, distribute risk much more widely than does a highly regulated — and therefore inflexible — financial market environment.

In a free, competitive derivatives market, diversity and complexity are therefore sources of strength and stability, with investors’ competing bets (and the prices attached to those bets) tending constantly to equipoise. Market prices are vessels for information, summary statements of an investment’s riskiness relative to others. Regulations disrupt both the flow of that information and the kinds of voluntary exchanges that actually keep consumers safe. Further, they act as indirect subsidies to certain kinds of financial products and institutions: if it is unlawful to buy and sell a certain interest or to engage in certain aspects of the banking business, then other products and institutions are favored as a matter of course, regardless of their relative merits or the demands of consumers.

This is one of the many less obvious ways in which government, often quite without intent, picks winner and losers. The existence of true market power, in contrast, must always rest on the satisfaction of expressed consumer wants through the provision of quality goods and services. Absent the introduction of government’s coercive authority, a quality unique to it, market actors have no way of growing in size or influence without serving consumers (that is, serving us, the people).

Despite their lofty rhetoric, governments — particularly those based in remote national capitals — need not serve the people, sustained by a unique right to steal (pardon me, tax) and clothed with the power to demand obedience. Whereas firms in a free market must always adjust to shifting consumer needs and preferences, constantly recalibrating in response to the latest information, government bodies have very little incentive to attend to the wishes of the citizenry, to appropriately manage risk, or to use resources efficiently.

Market actors are, of course, not perfect; they are decidedly human, capable of mistake and failure. But competition and the inability to simply and arbitrarily lay claim to our dollars compels them, quite without the need for violence, to serve consumers and respond to changes more quickly and dexterously.

Through its various housing policy bodies, the federal government subsidized and encouraged the very riskiest home buyers, those with poor FICO scores, low down payments, and spotty employment records. Collectively, the government-sponsored enterprises known as Fannie Mae and Freddie Mac were, by a large margin, the biggest buyer of the high-risk, low-quality obligations known as subprime mortgages.

These organizations, free banking economist Lawrence H. White notes, “grew to own or guarantee about half of the United States’ $12 trillion mortgage market.” Thus a dangerous combination of artificially low interest rates, effected by the Federal Reserve, and enormous subsidies to bad loans yielded an economic catastrophe the repercussions of which reached around the world. Blaming the free market, then, betrays a remarkable ignorance either of events or the definition of the free market.

It has likewise become fashionable of late to blame derivatives like CMOs and CDOs — that is, to blame complexity itself — for the financial crisis. But to blame complexity is to blame the very ideas that enriched the modern world by orders of magnitude never before imagined, ideas like comparative advantage and the division and specialization of labor.

We don’t all have to understand everything. What is important is that we permit the freedom of contract and exchange that allows us to avoid the kind of breakdown we saw in 2008, the result of subsidized misallocation on a massive scale.

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