WSJ
April 20, 2010
An Economy of Liars
When government and business collude, it's called crony capitalism. Expect
more of this from the financial reforms contemplated in Washington.
*
By _GERALD P. O'DRISCOLL JR._
(http://online.wsj.com/search/term.html?KEYWORDS=GERALD+P.+O'DRISCOLL+JR.&bylinesearch=true)
Free markets depend on truth telling. Prices must reflect the valuations of
consumers; interest rates must be reliable guides to entrepreneurs
allocating capital across time; and a firm's accounts must reflect the true
value
of the business. Rather than truth telling, we are becoming an economy of
liars. The cause is straightforward: crony capitalism.
Thomas Carlyle, the 19th century Victorian essayist, unflatteringly
described classical liberalism as "anarchy plus a constable." As a
romanticist,
Carlyle hated the system—but described it accurately.
Classical liberals, whose modern counterparts are libertarians and
small-government conservatives, believed that the state's duties should be
limited
(1) to provide for the national defense; (2) to protect persons and
property against force and fraud; and (3) to provide public goods that markets
cannot. That conception of government and its duties was articulated by the
Declaration of Independence and embodied in the U.S. Constitution.
Modern liberals have greatly expanded the list of government functions,
but, aside from totalitarian regimes, I know of no modern political movement
that has shortened it. While protecting citizens against force, both at home
and abroad, is the government's most basic function, protecting them
against fraud is closely allied. By the use of force, a thief takes by arms
what
is not rightfully his; he who commits fraud takes secretly what is not
rightfully his. It is the difference between a robber stealing brazenly on the
street and a burglar stealing by stealth at night. The result is the same:
the loss of property by its owner and the disordering of civil society.
And government has failed miserably to perform this basic function.
Why has this happened? Financial services regulators failed to enforce laws
and regulations against fraud. Bernie Madoff is the paradigmatic case and
the Securities and Exchange Commission the paradigmatic failed regulator.
Fraud is famously difficult to uncover, but as we now know, not Madoff's.
The SEC chose to ignore the evidence brought to its attention. Banking
regulators allowed a kind of mortgage dubbed "liar loans" to flourish. And so
on.
We have now learned of the creative way Lehman Brothers hid its leverage
(how much money it was borrowing) by the use of a Repo 105. The Repo 105
meant Lehman temporarily swapped assets (such as bonds) for cash. A Repo, or
repurchasing agreement, is a way to borrow money. But an accounting rule
allowed Lehman to book the transaction as a sale and reduce its reported
borrowings, according to a report by the court-appointed Lehman bankruptcy
examiner, a former federal prosecutor, last month.
Are we to believe that regulators were unaware? Last week Goldman Sachs was
accused in a civil fraud suit of deceiving many clients for the benefit of
another, hedge-fund operator John Paulson.
The idea that multiplying rules and statutes can protect consumers and
investors is surely one of the great intellectual failures of the 20th century.
Any static rule will be circumvented or manipulated to evade its
application. Better than multiplying rules, financial accounting should be
governed
by the traditional principle that one has an affirmative duty to present
the true condition fairly and accurately—not withstanding what any rule might
otherwise allow. And financial institutions should have a duty of care to
their customers. Lawyers tell me that would get us closer to the common law
approach to fraud and bad dealing.
Public choice theory has identified the root causes of regulatory failure
as the capture of regulators by the industry being regulated. Regulatory
agencies begin to identify with the interests of the regulated rather than the
public they are charged to protect. In a paper for the Federal Reserve's
Jackson Hole Conference in 2008, economist Willem Buiter described
"cognitive capture," by which regulators become incapable of thinking in terms
other
than that of the industry. On April 5 of this year, The Wall Street
Journal chronicled the revolving door between industry and regulator in
"Staffer
One Day, Opponent the Next."
Congressional committees overseeing industries succumb to the allure of
campaign contributions, the solicitations of industry lobbyists, and the siren
song of experts whose livelihood is beholden to the industry. The
interests of industry and government become intertwined and it is regulation
that
binds those interests together. Business succeeds by getting along with
politicians and regulators. And vice-versa through the revolving door.
We call that system not the free-market, but crony capitalism. It owes more
to Benito Mussolini than to Adam Smith.
Nobel laureate Friedrich Hayek described the price system as an
information-transmission mechanism. The interplay of producers and consumers
establishes prices that reflect relative valuations of goods and services.
Subsidies distort prices and lead to misallocation of resources (judged by the
preferences of consumers and the opportunity costs of producers). Prices no
longer convey true values but distorted ones.
Hayek's mentor, Ludwig von Mises, predicted in the 1930s that communism
would eventually fail because it did not rely on prices to allocate resources.
He predicted that the wrong goods would be produced: too many of some, too
few of others. He was proven correct.
In the U.S today, we are moving away from reliance on honest pricing. The
federal government controls 90% of housing finance. Policies to encourage
home ownership remain on the books, and more have been added. Fed policies of
low interest rates result in capital being misallocated across time. Low
interest rates particularly impact housing because a home is a pre-eminent
long-lived asset whose value is enhanced by low interest rates.
Distorted prices and interest rates no longer serve as accurate indicators
of the relative importance of goods. Crony capitalism ensures the special
access of protected firms and industries to capital. Businesses that stumble
in the process of doing what is politically favored are bailed out. That
leads to moral hazard and more bailouts in the future. And those losing
money may be enabled to hide it by accounting chicanery.
If we want to restore our economic freedom and recover the wonderfully
productive free market, we must restore truth-telling on markets. That means
the end to price-distorting subsidies, which include artificially low
interest rates. No one admits to preferring crony capitalism, but an expansive
regulatory state undergirds it in practice.
Piling on more rules and statutes will not produce something different than
it has in the past. Reliance on affirmative principles of truth-telling in
accounting statements and a duty of care would be preferable. Deregulation
is not some kind of libertarian mantra but an absolute necessity if we are
to exit crony capitalism.
Mr. O'Driscoll is a senior fellow at the Cato Institute. He has been a
vice president at Citigroup and a vice president at the Federal Reserve Bank of
Dallas.
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