Free Will - Roy Baumeister

Do You Really Have Free Will?
Of course. Here’s how it evolved.

By Roy F. Baumeister


It has become fashionable to say that people have no free will. Many scientists cannot imagine how the idea of free will could be reconciled with the laws of physics and chemistry. Brain researchers say that the brain is just a bunch of nerve cells that fire as a direct result of chemical and electrical events, with no room for free will. Others note that people are unaware of some causes of their behavior, such as unconscious cues or genetic predispositions, and extrapolate to suggest that all behavior may be caused that way, so that conscious choosing is an illusion.

Scientists take delight in (and advance their careers by) claiming to have disproved conventional wisdom, and so bashing free will is appealing. But their statements against free will can be misleading and are sometimes downright mistaken, as several thoughtful critics have pointed out.

Arguments about free will are mostly semantic arguments about definitions. Most experts who deny free will are arguing against peculiar, unscientific versions of the idea, such as that “free will” means that causality is not involved. As my longtime friend and colleague John Bargh put it once in a debate, “Free will means freedom from causation.” Other scientists who argue against free will say that it means that a soul or other supernatural entity causes behavior, and not surprisingly they consider such explanations unscientific.

These arguments leave untouched the meaning of free will that most people understand, which is consciously making choices about what to do in the absence of external coercion, and accepting responsibility for one’s actions. Hardly anyone denies that people engage in logical reasoning and self-control to make choices. There is a genuine psychological reality behind the idea of free will. The debate is merely about whether this reality deserves to be called free will. Setting aside the semantic debate, let’s try to understand what that underlying reality is.

There is no need to insist that free will is some kind of magical violation of causality. Free will is just another kind of cause. The causal process by which a person decides whether to marry is simply different from the processes that cause balls to roll downhill, ice to melt in the hot sun, a magnet to attract nails, or a stock price to rise and fall.
 
Different sciences discover different kinds of causes. Phillip Anderson, who won the Nobel Prize in physics, explained this beautifully several decades ago in a brief article titled “More is different.” Physics may be the most fundamental of the sciences, but as one moves up the ladder to chemistry, then biology, then physiology, then psychology, and on to economics and sociology—at each level, new kinds of causes enter the picture.

As Anderson explained, the things each science studies cannot be fully reduced to the lower levels, but they also cannot violate the lower levels. Our actions cannot break the laws of physics, but they can be influenced by things beyond gravity, friction, and electromagnetic charges. No number of facts about a carbon atom can explain life, let alone the meaning of your life. These causes operate at different levels of organization. Even if you could write a history of the Civil War purely in terms of muscle movements or nerve cell firings, that (very long and dull) book would completely miss the point of the war. Free will cannot violate the laws of physics or even neuroscience, but it invokes causes that go beyond them.

The evolution of free will began when living things began to make choices. The difference between plants and animals illustrates an important early step. Plants don’t change their location and don’t need brains to help them decide where to go. Animals do. Free will is an advanced form of the simple process of controlling oneself, called agency.

The squirrel is more complex than the tree, and it does plenty of things the tree can’t. When chased by a dog, the squirrel needs to choose which direction to run. Its decision processes may be simple, but it does choose, nonetheless. Thousands of lab studies have shown how rats learn to make choices that bring them rewards. How did this simple agency evolve into the more complex style of choosing that people call free will?

Living things everywhere face two problems: survival and reproduction. All species have to solve those basic problems or else go extinct. Humankind has an unusual strategy for solving them: culture. We communicate, develop complex social systems, engage in trade, accumulate knowledge collectively, create giant social institutions (governments, hospitals, universities, corporations). These help us survive and reproduce, increasingly in comfortable and safe ways. These large systems have worked very well for us, if you measure success in the biological terms of survival and reproduction.

If culture is so successful, why don’t other species use it? They can’t—because they lack the psychological innate capabilities it requires. Our ancestors evolved the ability to act in the ways necessary for culture to succeed. Free will likely will be found right there—it’s what enables humans to control their actions in precisely the ways required to build and operate complex social systems.

What psychological capabilities are needed to make cultural systems work? To be a member of a group with culture, people must be able to understand the culture’s rules for actions, including moral principles and formal laws. They need to be able to talk about their choices with others, participate in group decisions, and carry out their assigned role. Culture can bring immense benefits, from cooked rice to the iPhone, but it only works if people cooperate and obey the rules.

If you think of freedom as being able to do whatever you want, with no rules, you might be surprised to hear that free will is for following rules. Doing whatever you want is fully within the capability of any animal in the forest. Free will is for a far more advanced way of acting. It’s what a creature might need in order to adjust its behavior to novel situations, to get what it wants while still following the complicated rules of the society.

People must inhibit impulses and desires and find ways of satisfying them within the rules. People also consciously imagine various future scenarios (“If I do this, then that will happen, whereupon I would do something else, leading to another result …”) and guide their present actions based on disciplined imagination.

That, in a nutshell, is the inner deciding process that humans have evolved. That is the reality behind the idea of free will: these processes of rational choice and self-control. It’s this or nothing. If you accept free will, this is what it is. If you insist on disbelieving in free will, these are the processes that are commonly taken for it. But either way, there is a real phenomenon here. And to understand human life, it is vital to understand how this phenomenon works.

Does it deserve to be called free? I do think so. Philosophers debate whether people have free will as if the answer will be a simple yes or no. But very few psychological phenomena are absolute dichotomies. Instead, most psychological phenomena are on a continuum. Some acts are clearly freer than others. The freer actions would include conscious thought and deciding, self-control, logical reasoning, and the pursuit of enlightened self-interest.

Self-control counts as a kind of freedom because it begins with not acting on every impulse. The simple brain acts whenever something triggers a response: A hungry creature sees food and eats it. The most recently evolved parts of the human brain have an extensive mechanism for overriding those impulses, which enables us to reject food when we’re hungry, whether it’s because we’re dieting, vegetarian, keeping kosher, or mistrustful of the food. Self-control furnishes the possibility of acting from rational principles rather than acting on impulse.

The use of abstract ideas such as moral principles to guide action takes us far beyond anything that you will find in a physics or chemistry textbook, and so we are free in the sense of emergence, of going beyond simpler forms of causality. Again, we cannot break the laws of physics, but we can act in ways that add new causes that go far beyond physical causation. No electron understands the Golden Rule, and indeed an exhaustive study of any given atom will furnish no clue as to whether it is part of a person who is obeying or disobeying that rule. The economic laws of supply and demand are genuine causes, but they cannot be reduced to or fully explained by chemical reactions. Understanding free will in this way allows us to reconcile the popular understanding of free will as making choices with our scientific understanding of the world.

Roy F. Baumeister is an eminent social psychologist with over 500 scientific publications, plus 31 books, including a New York Times best-seller, Willpower.

Article on Slate.

Piketty - Charles Gave

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The Problem with Piketty

Charles Gave

Thomas Sowell coined a marvelous phrase to describe the well-intentioned social engineers who always know what needs to be done to improve the wellbeing of the downtrodden. He called them “the anointed” and explained how their reasoning always evolves in the same three stages:

1.) They identify a problem, which may or may not exist. But whether it is real or not, they always insist the problem is caused by market failures.

2.) They propose a solution, which inevitably involves a greater role for the State—and for themselves as its  high priests (high priests do not work, except within the Temple).

3.) When their solution fails (as it invariably does), they don’t re-examine their thinking, but just complain that it has been implemented with insufficient vigor. Needless to say, they put forward a new and improved plan they insist will work better next time...

Thomas Piketty is one of France’s great (self-)anointed. Like the rest of his cohort, he eagerly supported  François Hollande in the run-up to the 2012 presidential election. Once voted in, the great man started to follow Piketty’s advice, and massively raised taxes on capital. Naturally the policy failed miserably, so Piketty has published a book which explains—predictably—that his recommendations only failed because they were not applied on a worldwide basis. Apparently this book has now become a best seller.

The extraordinary thing is that Piketty’s analysis is based on a massive logical error. His thesis runs as follows: if R is the rate of return on invested capital and if G is the growth rate of the economy, since R>G, profits will grow faster than GDP, and the rich will get richer and the poor poorer. This is GIGO (garbage in, garbage out) at its most egregious.  Piketty confuses the return on invested capital, or ROIC, with the growth rate of corporate profits, a mistake so basic it is scarcely believable.

Let me explain with an example. I happen to be a shareholder in an industrial bakery in the south west of France. It has a return on invested capital of 20%, but we cannot reinvest the profits in the company at  20%. If we were to reinvest the profits by putting more capital to work, the profits would not change at all, because nobody in the region is going to buy more bread and productivity gains there are non-existent. In other words, the marginal return of one more unit of capital put to work is zero. So instead of reinvesting in the bakery, we distribute the profits among the shareholders and they invest them elsewhere as they see  fit. In short, our bakery has a high ROIC but no profit growth.

At the other extreme, a company expanding rapidly according to a “stack ’em high, sell ’em cheap” model  might well show a low ROIC but very fast profit growth. Every company in the world can be “mapped” according to these two criteria: ROIC, and the growth rate of corporate profits.

Over the long term, the growth rate of corporate profits cannot be higher than the growth rate of GDP.  That’s simply because if it was, after a while corporate profits would rise to reach 100% of GDP, which we all know is silly. Historically, the ratio of domestic profit to GDP has been a mean-reverting variable.

In reality, all Piketty has done is to rehash the great Marxist theory about the “unavoidable impoverishment” of the working classes, recasting it as a theory in which the capitalist class gets richer and richer over time, and everyone else poorer and poorer. We only need to look at the history of the last 150  years, or of the last 20—in which two billion people have escaped poverty—to see how valid this theory has proved to be.

Still, it was fine for Marx to confuse the ROIC and the growth rate of corporate profits, because he worked  in the days before William Jevons, Eugen Böhm-Bawerk, Knut Wicksell, Joseph Schumpeter and Alfred Marshall, who between them developed the notion of the marginal return on one more unit of capital.  Alas, one cannot make the same excuse for Piketty, who is writing more than 100 years after this discovery.

The next question, then, is: why has his book become a best seller? The answer was provided a long time ago by the early 20th Century Italian economist Vilfredo Pareto, who argued that to the governing and chattering classes a theory can be:

1.) true and useful

2.) false and useful

3.) true and useless

        4.) false and useless

Here a “useful” theory is one that increases the power of the anointed, not one that benefits the population at large. Theories that fall into the “false and useful” category are grasped especially fiercely by the anointed  precisely because they help them to consolidate their political power. Keynesianism is a prime example.

Which brings us to Schumpeter. In Capitalism, Socialism and Democracy he made a fabulous remark which throws more light on the matter. He explained that the rise in living standards allowed by capitalism  through the process of creative destruction was going to drive a huge rise in the educational level of the population. The educated but uncompetitive would grow to hate the capitalist system, under which their merits were not recognized, and would try to seize control of educational and cultural institutions in order to teach the youth that markets do not work.

Much the same idea was expressed by the Italian Marxist Antonio Gramsci. If these fellows were to take control of the cultural and educational world, then 30 years later the political system would fall into their hands like a ripe fruit. Then they would be able to use the democratic process to destroy the free market, having first brain-washed the electorate.

Don’t get me wrong, I am absolutely in favor of education. But I am against a centralized educational system, easily controlled by the anointed.

This leaves open a question: why do intellectuals hate free markets? Because, as French sociologist Raymond Boudon explained, in a free market they would be paid at their real value.

Their success in controlling not ideas, which are uncontrollable, but the teaching of ideas, continued  Schumpeter, would inevitably lead to a shift from a democratic, market-based system, to tyranny and  poverty.

This is exactly what is happening in the old world today. An over-educated, self-anointed elite is fighting tooth and nail to defy market forces and preserve its position in the educational and cultural system.  Piketty, as one of this elite, is being feted accordingly.  Nothing new there.

Prom Nite

I'm only going to leave this one up for a little while.

Keynes My Early Beliefs - excerpt

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Keynes    My Early Beliefs - excerpt

   I said that we were amongst the first to escape from Benthanism.  But of another eighteenth-century heresy we were the unrepentant heirs and last upholders.  We were among the last of the Utopians, or meliorists as they are sometimes called, who believe in a continuing moral progress by virtue of which the human race already consists of reliable, rational, decent people, influenced by truth and objective standards, who can be safely released from the outward restraints of convention and traditional standards and inflexible rules of conduct, and left, from now onwards, to their own sensible devices, pure motives and reliable intuitions of the good.  The view that human nature is reasonable had in 1903 quite a long history behind it.  It underlay the ethics of self-interest – rational self-interest as it was called – just as much as the universal ethics of Kant or Bentham which aimed at the general good; and it was because self-interest was rational that the egoistic and altruistic systems were supposed to work out in practice to the same conclusions.

   In short, we repudiated all versions of the doctrine of original sin, of there being insane and irrational springs of wickedness in most men.  We were not aware that civilization was a thin and precarious crust erected by the personality and the will of a very few, and only maintained by rules and conventions skillfully put across and guilefully preserved.  We had no respect for traditional wisdom or the restraints of custom.  We lacked reverence, as Lawrence observed and as Ludwig with justice also used to say – for everything and everyone.  It did not occur to us to respect the extraordinary accomplishment of our predecessors in the ordering of life (as it now seems to me to have been) or the elaborate framework which they had devised to protect this order.  Plato said in his Laws that one of the best of a set of good laws would be a law forbidding any young man to enquire which of them are right or wrong, though an old man remarking any defect in the laws might communicate this observation to a ruler or to an equal in years when no young man was present.  That was a dictum in which we should have been unable to discover any point or significance whatever.  As cause and consequence of our general state of mind we completely misunderstood human nature, including our own.  The rationality which we attributed to it led to a superficiality, not only of judgment, but also of feeling.  It was not only that intellectually we were pre-Freudian, but we had lost something which our predecessors had without replacing it.  I still suffer incurably from attributing an unreal rationality to other people’s feelings and behavior (and doubtless to my own too).  …

from pp 95-96 of  this work

Dawn of Innovation

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Early parts from Dawn of Innovation:

Finally, political and economic power shifted decisively away from society's traditional elites, as the world's first true middle class seized control of the political apparatus. The archetypal American was almost a new species, literate and numerate, shrewd and confident, an unvarnished striver, swimming through a delightful chaos where money and opportunity were for the grasping on every side. As the United States became the world's dominant power in the twentieth century, that model of society, albeit much adapted and trammeled, became the norm in advanced countries.

The country was just too productive, too entrepreneurial, too inventive, too original not to burst into the front rank of world powers, almost regardless of its leadership.

The story of American development can be charted as an evolution from local to regional and finally to national networks. Strong regional economies emerged in the Northeast in the first quarter of the century. By the 1820s, rural New England and the Middle Atlantic region were hotbeds of industrialization, with farms and forges working cheek by jowl and the self-subsistent farm family already an anachronism.

Since interior transportation was virtually nil, there evolved a pellet economy of little self-sufficient towns clustered on riverbanks. The breakthrough was the development of the western steamboat by Henry Shreve and Daniel French. It was a cunningly adapted craft that could carry massive loads on shallow, swift water, blithely steaming upstream againt rapids.

Within a decade the region's great grain, lumber, and meat animal enterprises were centralizing in Cincinnati, as a tight-knit riverine economy took shape within the Ohio, Missouri, and Mississippi valleys.

The United States emerged as a world economic powerhouse in the 1840s and 1850s, when the railroads finally linked the Northeast and the Midwest, as it was now called, into an integrated commercial and industrial unit. The heavy industry of the Midwest flowed from its resource endowment – coal and iron, food processing, a mechanized lumber industry – as well as derivatives from steamboat building, like engines, furniture, and glass. In the Northeast, its traditional industries like clocks, textiles, and shoes grew to global scale, along with big-ticket fabrication businesses like Baldwin locomotives, Collins steamships, Hoe printing presses, and the giant Corliss engines.

The South, in the meantime, slipped into the position of an internal colony, exploiting its slaves and being exploited in turn by the Northeast and Midwest. Boston and New York controlled much of the shipping, insurance, and brokerage earnings from the cotton trade, while earnings left over went for midwestern food, tools, and engines shipped down the Mississippi and its branches.

Few Britons even noticed, as one sharp-eyed civil servant put it, that in the United States, almost all industries were “carried on in the same way as the cotton manufacture of England, viz., in large factories, with machinery applied to every process, the extreme subdivision of labour and all reduced to an almost perfect system of manufacture.”

Destructive though it was, the Civil War broke the slaveocracy's power to obstruct an American development agenda. In one of the darkest years of the war, the Republican congress passed the Homestead Act, the Land Grant College Act – no other country had conceived the possibility of educating its farmers and craftsmen – and the Transcontinental Railroad Act. The rise of a new world economic hyperpower was virtually assured.

Klavan - the conservative message inherent in the arts

Andrew Klavan – having faith in the arts

Giving a talk about “sex & German philosophy”

Our culture has been shaped largely by a triumvirate of news media, the entertainment industry and the academy.  There is now a counter-revolution because technology is democratizing media allowing people to bypass intermediaries and gatekeepers.  The significance of the arts is to convey the nature of the human experience, usually through metaphor, stories, images and symbols.  Our biggest problem is the rewriting of history by the left, both through misinformation and the censoring of truth.  An overly sexualized culture is a lesser problem.

For the left sex is the only significant human activity exempt from government control.  The reason is because at the core of leftist philosophy is an image of man as a soulless meat puppet, whereas a more holistic view of man includes a spiritual being shaped by choices and free will.  This implies the importance of the right to chose and the significance of freedom which depends upon this spiritual view.  Within this framework sex is not the goal, love is what powers people.

After Newton and the formulation of modern science there was a  juxtaposition of science and faith in the minds of many people.  This brings us to German philosophy in the form of Kant vs Nietzsche.  Kant said that science will provide reasons for what we perceive but there is a reality beyond that in which it will still make sense to believe Judeo-Christian ideals.  Nietzsche said no, god is dead, continue deconstructing morality and go beyond good and evil (atleast as interpreted by some people).

There was a spiritual revival in intellectual circles after WWII which filtered down into the population at large.  But then there was a rise of French philosophers in the 1960s pushing ideas of postmodernism, moral relativism and multiculturalism.

A concluding story: the Alan Lerner song “Wouldn't It Be Loverly?” from My Fair Lady was originally only about creature comforts – it bombed, then he added the spiritual element of love which is the climax of human yearning and it became a big hit, a classic of musical theatre.

People are spiritual beings with the right to chose for themselves.  We must take the leap of faith that there is a higher morality, something transcendent.  Conservatives need to realize that the arts will convey this message and sing the song of freedom.

NYT Poverty Article ScreenShot

On the "Edge of Poverty," we have a picture of an adequately fed male surrounded by obese women.  The one on the right is wearing Nikes.

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.

GERALD P. O'DRISCOLL JR.

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.

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved

Back to Basics on Financial Reform

The case for limiting leverage and regulating derivatives is overwhelming, but that doesn't require a new 1,300-page law.

By NIALL FERGUSON AND TED FORSTMANN

A "trilemma" is like a dilemma, only there are three things to choose from and you can have just two. The current debate over post-crisis financial regulation suggests we face such a trilemma: We can choose any two of the following, but not all three: 1) efficient capital markets 2) no bailouts to big banks and 3) a depression-free economy.

From the 1980s until 2007, we essentially opted for one and two. Financial markets operated with more freedom than at any time since the 1930s and the Federal Reserve stood ready to cut interest rates if asset prices tanked. But the idea that big banks might be able to get new capital from the Treasury was scarcely even contemplated. Choosing one and two resulted in a global financial and economic crisis worthy of the name depression.

In the aftermath, congressional Democrats are claiming that we can have three out of three. In effect, the bill introduced to the Senate by Christopher Dodd purports to prevent future depressions without sacrificing the efficiency of our financial markets or committing taxpayers to future bailouts of the banking system. This trifecta is not credible.

Either the bill really does imply future bailouts, as Republicans argue. Or, as seems more plausible to us, it is going to introduce such a wide range of new financial regulations that the efficiency of our capital markets will be significantly diminished.

The public today is in no mood for light-touch regulation. It knows Wall Street has become largely a giant casino creating bets whose only purpose is to create fees for itself—with the difference that taxpayers are expected not only to bail out the casino's biggest losers but also to endure misery in the form of lost homes, lost jobs and lost savings if the casino inadvertently triggers a depression. The charges brought against Goldman Sachs by the Securities and Exchange Commission confirm this view.

Whether or not there is any basis for the SEC's claim that it misled investors, the key point is that the synthetic collateralized debt obligation (CDO) at issue was nothing more than an elaborate wager on the future price of some mortgage-backed securities—a wager with as much economic utility as a gigantic bet on a roulette wheel or a horse race. Facilitating such bets has become a huge part of the business of the world's biggest banks.

For most of the past 20 years the explosive growth of the derivatives market—the total notional amount of derivatives outstanding in June last year was $604.6 trillion—was immensely lucrative for bankers and those who invest in bank stocks. But it increased the instability of the global financial system. And taxpayers have paid a heavy price since the system all but collapsed in late 2008.

The case for some kind of regulation of the derivatives market is overwhelming. There was never a good reason for treating credit default swaps and their ilk differently from commodity futures, which are standardized and traded on exchanges. The lack of market transparency and efficient competition in these instruments indicates that much of the profit made in the current, "over-the-counter" market is simply vigorish extracted by the financial bookies. History shows that competitive markets where standardized products are traded for low commissions do not spontaneously arise. They have to be created.

The problem is that Congress is not content to address this problem alone. On the contrary, the common characteristic of the two bills currently under discussion is their staggering length (both exceed 1,300 pages) and complexity. The nightmare possibility arises: Could the proposed cure turn out to be just another symptom of the same disease? As the rules become ever more convoluted, so the opportunities for the unscrupulous increase—and the efficiency of the financial system as a whole decreases.

There is a widespread but erroneous belief that the financial crisis has its origins in deregulation dating all the way back to the late 1970s. Therefore any steps to restore the pre-Reagan regulatory system are to be welcomed. This is really bad financial history.

First, in the more controlled capital markets of the 1970s, borrowers generally paid more for their loans because there was less competition. Lousy managements were protected from corporate raiders. Savers earned negative real interest rates because of high inflation. Deregulation—such as lifting restrictions on the interest rates banks could pay and charge—and financial innovation delivered real benefits for the U.S. economy in the 1980s and '90s.

Second, it is not at all clear that our crisis was exclusively caused by a failure of regulation as opposed to a failure of monetary policy. A very large part of the responsibility for the housing bubble and bust lies with the Federal Reserve, which underestimated the extent to which inflationary pressures had relocated themselves from consumer prices to asset prices. This was a near-term error of the period 2002-2004. It has nothing whatever to do with deregulation and everything to do with defective monetary theory.

Third, the crisis of 2007-2009 originated in one of the most highly regulated sectors of the financial system: the U.S. residential mortgage market. The mortgage originators, the government-sponsored enterprises that dominate the securitization process, the commercial banks—these were scarcely institutions ignored by Congress over the years. On the contrary, Washington constantly tinkered with the system in a misguided campaign to increase home ownership. That campaign ended in tears.

Still, it took extraordinary forces to turn a subprime bust into a global financial crisis. The key forces were excessive leverage on and off bank balance sheets, and derivatives that allowed massive but opaque side bets on the future value of U.S. homes. And it was these two factors that magnified (and exported) the losses in the mortgage market; legislators should focus on them. Instead, both the House and Senate bills are packed full of scatter-gun regulations that owe more to the prejudices of legislators than to a rational assessment of what actually went wrong.

The best example (there are many) is a provision in the bill passed by the House last year creating a mechanism to police banker compensation—before we even have the results of the bill's projected study on "whether there is a correlation between compensation structures and excessive risk taking."

By all means let us regulate the derivatives market—beginning with a reform that makes it a real market. And let's clamp down on excessive bank leverage. But let us not believe we can abolish both bailouts and depressions, other than by creating another layer of government regulation. That would be to impale ourselves on the horns of a trilemma.

Mr. Ferguson is a professor of history at Harvard University and a professor of business administration at the Harvard Business School. Mr. Forstmann is senior founding partner of Forstmann Little & Company, and chairman and CEO of IMG.

The Lesson of Basel's Bean Counters

Decades of obsession with accounting standards couldn't overcome the perverse incentives created by 'too big to fail.'

By GEORGE MELLOAN

With all this attention to banking regulation, it seems strange that something called Basel III has escaped widespread notice, even though its various new rules have been up for public discussion since January and the window closed on that opportunity on Friday, April 16. Maybe it's because the Basel Accords, a set of rules agreed to by bank regulators around the world, have been something of an embarrassment to the authors.

Basel I was fashioned in the charming old Swiss city of that name in 1988 by banking regulators from the International Monetary Fund's Group of 20 leading industrial nations. The idea was to give an increasingly globalized financial-services industry a common set of rules so that bankers could have more confidence in the solidity of their global counterparties.

The main achievement of Basel I was to set risk-based capital standards for banks. A complex formula was devised to define what value could be given various forms of capital outside "core" forms such as common stock and reserves.

The designers also tackled the more challenging task of assigning degrees of risk to a wide range of potential bank investments. In an unsurprisingly generous gesture toward national treasuries, banks were allowed to regard government-issued securities as zero risk, meaning they would require no offsetting capital. Since expanding capital is expensive, banks had a new incentive to buy government bonds.

But while this was a noble effort at international regulatory coordination—and was in fact folded into the regulatory systems of the major industrial powers—it didn't do much to ensure bank safety. Japanese banks were boasting that they were over-compliant with Basel standards right before they tanked in 1990. It seems that some of their "capital" was marked-to-market Japanese stocks and a lot of their risks were in real estate. When both stocks and real estate collapsed as a result of the decision by the Bank of Japan to prick the credit bubble, the Basel standards might just as well have not existed.

So the Basel Accord drafters went back to the drawing board and came up with Basel II, which some member states have adopted over the last few years. The standards were toughened and broadened in an attempt to take account of the changes in banking, especially increased trading in securities and derivatives. But the Basel standards proved to be largely irrelevant to the factors that caused the fall 2008 near-meltdown of global finance. For example, Lehman Brothers had close to triple the core capital required by the Basel standards when it crashed.

The international banking tumult of 2008 was not a result of insufficient rules or even primarily of noncompliance with the rules. Banking is perhaps the world's most regulated major industry. As in Japan in 1990, the imperatives of politics simply overrode what the rule makers and rule enforcers were trying to accomplish, turning their labors to dust.

The 2008 crisis resulted when the Fed-created credit bubble collapsed and soaring housing prices deflated as well. To promote "affordable" housing, Bill Clinton had excused the two giant government-sponsored housing finance agencies, Fannie Mae and Freddie Mac, from normal banking rules, allowing them leverage ratios far in excess of the limits on ordinary lenders. Banks were forced to write risky mortgage loans, a large number of which were then folded into mortgage-backed securities that Fannie, Freddie and others sold internationally with triple-A ratings.

This business seized up, crippling banks throughout the world, when holders began to realize that the assets that backed the securities, home mortgages, were going under water at an alarming rate. One of the great ironies of our times is that the two strongest defenders of the Fannie-Freddie shell game, Chris Dodd and Barney Frank, are now in charge of reforming banking regulation.

Through all this the Basel Accord designers have been soldiering on, this time coming up with Basel III, which further tightens and broadens risk-based capital rules. This new effort to raise the cost of banking is not going down well with bankers and even some central banks. At any rate, implementation is years off at best and the main state of play at the moment is the Dodd bill.

Aside from giving Washington an even tighter grip on the banking industry, the Dodd bill partly institutionalizes what Ben Bernanke at the Fed, Henry Paulson at Treasury, and Timothy Geithner at the New York Fed did ad hoc in the fall of 2008. It permits backdoor bailouts and gives enormous additional powers to the same Fed that created the housing bubble.

Like the Basel Accords, it assumes that the bank regulators will some day get things right before the industry wrecks itself by depending too much on rule compliance and not enough on sound banking judgment. Even a 1,336 page bill is not sufficient to guide the government in its endeavors to micromanage banking, as the prodigious efforts of the Basel committee have demonstrated.

An assessment of Basel III is provided on the Web site of a London based organization called the Asymmetric Threats Contingency Alliance (ATCA), which came into being in 2001 to promote online discussion of global issues. It concludes, quite plausibly, that "Despite promises that regulators will be vigilant and central bankers more watchful, banks are certain to get into trouble again, as they always have throughout history. The way to protect taxpayers, the Basel III argument goes, is to compel banks to have buffers thick enough to withstand higher losses and longer periods of extreme volatility in financial markets before they call for government intervention."

As the ATCA paper notes, in the days before banks could rely on governments to save them they carried large capital buffers, with core capital sometimes as much as 15% to 25% of assets, as opposed to as little as 2% under current rule. Of course, that made banking more expensive, and bankers were choosier about risks than in today's world, where the U.S. government has chosen to treat some banks as worthy of taxpayer help because they are "too big to fail."

One thing seems certain, the promise of bailouts and better regulation is unlikely to restore better risk judgment to the profession of banking. The opposite is more likely.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved

Parsing the Health Reform Arguments

Some of the shibboleths we've heard in recent weeks don't make much sense.

by GEORGE NEWMAN

The health-care debate continues. We have now heard from nearly all the politicians, experts and interested parties: doctors, drug makers, hospitals, insurance companies, even constitutional lawyers (though not, significantly, from trial lawyers, who know full well "change" is not coming to their practices). Here is how one humble economist sees some of the main arguments, which I have paraphrased below:

- "The American people overwhelmingly favor reform."

If you ask whether people would be happier if somebody else paid their medical bills, they generally say yes. But surveys on consumers' satisfaction with their quality of care show overwhelming support for the continuation of the present arrangement. The best proof of this is the belated recognition by the proponents of health-care reform that they need to promise people that they can keep what they have now.

- "The cost of health care rises two to three times as fast as inflation."

That's like comparing the price of hamburger 30 years ago with the price of filet mignon today and calling the difference inflation. Or the price of a 19-inch, black-and-white TV 30 years ago with the price of a 50-inch HDTV today. The improvements in medical care are even more dramatic, leading to longer life, less pain, fewer exploratory surgeries and miracle drugs. Of course the research, the equipment and the training that produce these improvements don't come cheap.

Corbis

- "Health care represents a rising proportion of our income."

That's not only true but perfectly natural. Quality health care is a discretionary, income-elastic expense -- i.e. the richer a society, the larger the proportion of income that is spent on it. (Poor societies have to spend income gains on food and other necessities.) Consider the alternatives. Would we feel better about ourselves if we skimped on our family's health care and spent the money on liquor, gambling, night clubs or a third television set?

- "Shifting funds from health care to education would make for a better society."

These two services have a lot in common, including steadily rising cost. What is curious is that this rise in education costs is deemed by the liberal establishment smart and farsighted while the rise in health-care costs is a curse to be stopped at any cost. What is curiouser still is that in education, where they always advocate more "investment," past increases have gone hand-in-hand with demonstrably deteriorating outcomes. The rising cost in health care has been accompanied by clearly superior results. Thus we would shift dollars from where they do a lot of good to an area where they don't.

- "Forty-five million people in the U.S. are uninsured."

Even if this were true (many dispute it) should we risk destroying a system that works for the vast majority to help 15% of our population?

- "The cost of treating the 45 million uninsured is shifted to the rest of us."

So on Monday, Wednesday and Friday we are harangued about the 45 million people lacking medical care, and on Tuesday and Thursday we are told we already pay for that care. Left-wing reformers think that if they split the two arguments we are too stupid to notice the contradiction. Furthermore, if cost shifting is bad, wait for the Mother of all Cost Shifting when suppliers have to overcharge the private plans to compensate for the depressed prices forced on them by the public plan.

- "A universal plan will reduce the cost of health care."

Think a moment. Suppose you are in an apple market with 100 buyers and 100 sellers every day and apples sell for $1 a pound. Suddenly one day 120 buyers show up. Will the price of the apples go up or down?

- "U.S. companies are at a disadvantage against foreign competitors who don't have to pay their employees' health insurance."

This would be true if the funds for health care in those countries fell from the sky. As it is, employees in those countries pay for their health care in much higher income taxes, sales or value-added taxes, gasoline taxes (think $8 a gallon at the pump) and in many other ways, effectively reducing their take-home pay and living standards. And isn't it odd that the same people who want to lift this burden from businesses that provide health benefits also (again, on alternate days) want to impose this burden on the other firms that do not offer this benefit. What about the international competitiveness of these companies?

- "If you like your current plan you can keep it."

In other words, you can keep your current plan if it (and the company offering it) is still around. This is not a trivial qualification. Proponents have clearly learned from the HillaryCare debacle in the 1990s that radical transformation does not sell. What we have instead is what came to be dubbed "salami tactics" in postwar Eastern Europe where Communist leaders took away freedoms one at a time to minimize resistance and obscure the ultimate goal. If nothing else, a century of vain attempts to break the Post Office monopoly should teach us how welcoming Congress is to competition to one of its high-cost, inefficient wards.

- "Congress will be strictly neutral between the public and private plans."

Nonsense. Congress has a hundred ways to help its creation hide costs, from squeezing suppliers to hidden subsidies (think Amtrak). And it has even more ways to bankrupt private plans. One way is to mandate ever more exotic and expensive coverage (think hair transplants or sex-change operations). Another is by limiting and averaging premiums and outlawing advertising. And if all else fails Congress can always resort to tax audits and public harassment of executives -- all in the name of "leveling the playing field." Then, in the end, the triumphal announcement: "The private system has failed."

- "Decisions will still be made by doctors and patients and the system won't be politicized."

Fat chance. Funding conflicts between mental health and gynecology will be based on which pressure group offers the richer bribe or appears more politically correct. The closing (or opening) of a hospital will be based not on need but which subcommittee chairman's district the hospital is in. Imagine the centralization of all medical research in the country in the brand new Robert Byrd Medical Center in Morgantown, W.Va. You get the idea.

- "We need a public plan to keep the private plans honest."

The 1,500 or so private plans don't produce enough competition? Making it 1,501 will do the trick? But then why stop there? Eating is even more important than health care, so shouldn't we have government-run supermarkets "to keep the private ones honest"? After all, supermarkets clearly put profits ahead of feeding people. And we can't run around naked, so we should have government-run clothing stores to keep the private ones honest. And shelter is just as important, so we should start public housing to keep private builders honest. Oops, we already have that. And that is exactly the point. Think of everything you know about public housing, the image the term conjures up in your mind. If you like public housing you will love public health care.

Mr. Newman is an economist and retired business executive.

Printed in The Wall Street Journal, page A13

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved

This recession

July 6, 2009

Blame Not the Deregulator It was market distortions that created the bubble STEPHEN SPRUIELL Last month, Paul Krugman launched a campaign to pin the financial crisis on “Reagan and his circle of advisers.” It was “Reagan-era deregulation,” Krugman wrote, that led us to the “mess we’re in.” The substance of Krugman’s screed was so tissue-thin that even ultra-liberal columnist Robert Scheer responded to it with bafflement: “How could Paul Krugman, winner of the Nobel Prize in economics and author of generally excellent columns in the New York Times, get it so wrong?” So let’s not credit Krugman with making a serious argument, rather than throwing a partisan grenade. The broader narrative into which Krugman’s column fits, however, must be addressed. Left-wingers and Democratic partisans are united in a vigorous effort to blame deregulation for the financial crisis. Scheer, for example, agreed that deregulation set the meltdown in motion; he disagreed with Krugman only on who, specifically, was to blame. In Scheer’s less partisan version of the narrative, Bill Clinton and his advisers are the “obvious villains” for having backed various deregulatory acts during the 1990s. (Of course, Republicans are hardly absent from this version of the story: Former senator Phil Gramm is portrayed as the architect of the late-Nineties deregulation that allegedly brought down the banking system.) The argument that a lack of regulation caused the crisis is seductive in its simplicity; it completely ignores the other side of the government equation. Regulation is seldom necessary unless the discipline of a truly free market is absent — such as when the government indemnifies companies or industries against failure, or when it juices markets with generous subsidies. In the case of the housing bubble, both of these distortions were present. Wall Street titans, led by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, juiced like Jose Canseco until they grew “too big to fail.” In retrospect, it looks like a failure to regulate; in fact, regulations wouldn’t have been necessary if the government hadn’t provided the steroids. Krugman argued that the 1982 Garn–St. Germain Depository Institutions Act sowed the seeds for the 2008 financial crisis — and that, because President Reagan signed it, the blame for 2008 lies on his doorstep. Never mind that Garn–St. Germain passed by veto-proof margins in both chambers; that it was co-sponsored by prominent Democrats, including Steny Hoyer and Charles Schumer; and that it was the second of two bills that deregulated the savings-and-loan industry, its predecessor — the Depository Institutions Deregulation and Monetary Control Act of 1980 — having been signed by President Carter. The line supposedly connecting Garn–St. Germain to the mortgage meltdown is itself more crooked than Lombard Street; it exists, finally, only in Krugman’s imagination. For while Garn–St. Germain did pave the way for the kinds of adjustable-rate and interest-only mortgages that Wall Street gorged on during the housing boom, this result was not inevitable: Scheer points out that “as long as the banks that made those loans expected to have to carry them for 30 years, they did the due diligence needed to qualify creditworthy applicants.” What happened, according to Scheer and other subscribers to the less partisan version of the blame-deregulation narrative, is that a series of deregulatory moves in the late 1990s and early 2000s enabled the market for mortgage-backed securities and other derivatives to grow huge while disregarding risk. The 1999 Gramm-Leach-Bliley Act allowed depository institutions to acquire investment-banking and insurance arms. The 2000 Commodity Futures Modernization Act (CFMA) allowed derivatives (such as credit-default swaps) to be traded over the counter, with little regulatory oversight. And a 2004 rule change at the Securities and Exchange Commission allowed investment banks to operate with debt-to-equity ratios of over 30 to 1. Paul Krugman: mythmakerPaul J. Richards/AFP These policy changes certainly contributed to the size of the crisis, which is why the blame-deregulation narrative seems plausible at first. It is true that without Gramm-Leach-Bliley, Citigroup could not have grown as large as it did. But there is no evidence that Citi’s size or diversity of business lines had anything to do with its overinvestment in mortgage-backed assets. Financial institutions that did not diversify made the same mistake, and they arguably fared worse during the crisis. Bear Stearns, the first investment bank to collapse under the weight of its bad assets, did not have a commercial-banking arm. Furthermore, without Gramm-Leach-Bliley, commercial bank J. P. Morgan could not have mitigated the consequences of Bear’s collapse by acquiring it. (On the other hand, the Federal Reserve’s facilitation of the sale of Bear created the hazardous expectation that every failed firm would get a bailout.) As for the CFMA, Kevin D. Williamson and I have written in these pages that institutions buying credit-default insurance should be required to have a real insurable interest at stake. As it stands, an institution can buy insurance on a bond it doesn’t even own. That said, losses on credit-default swaps have been smaller than expected, because so many transactions are “netted” — institutions buy credit protection and then sell it at a higher price, so their exposure is hedged. When Lehman Brothers declared bankruptcy, institutions that sold credit protection on Lehman bonds were projected to lose as much as $400 billion. After all the transactions cleared, though, sellers had lost only $6 billion on their Lehman trades. AIG’s portfolio of credit-default swaps presented a bigger problem, as the mortgage-backed assets they insured started to sour. But, contra Scheer, deregulation was not the primary or even secondary reason that mortgage lending spun out of control. Government promotion of homeownership set the table for a massive run-up in real-estate borrowing, and the Federal Reserve’s loose monetary policy in the early 2000s rang the dinner bell. Add to these factors Wall Street’s ability to skirt rules and influence regulators, and it is far from clear whether any amount of regulation could have quelled investors’ appetite for seemingly safe mortgage debt. By now, the case against the GSEs is well rehearsed, but it’s worth restating in this context because it provides such a vivid illustration of why regulation is needed when market discipline is absent. Fannie and Freddie’s role as government-chartered companies with public missions gave investors the (correct) impression that Uncle Sam would never let them fail. Thus the GSEs enjoyed borrowing costs only slightly higher than those of the federal government, and they used this subsidy to expand rapidly, doubling the amount of mortgage debt on their books every five years since 1970. (When they finally collapsed last year, they owned or guaranteed over $5 trillion in debt.) For years, it was conservatives who argued that Fannie and Freddie had grown dangerously large and needed stronger oversight. The GSEs’ old regulator, the Office of Federal Housing Enterprise Oversight, had neither the experience nor the authority to rein them in. Democrats and Republicans alike ignored these warnings, though President Bush and the Republicans made a failed effort to reform the GSEs after a series of accounting scandals at the companies in 2003–04. (The bill died when Democratic senator Chris Dodd threatened to filibuster it.) But both parties were complicit in giving the GSEs “affordable housing” goals to meet. In 1995, the Clinton administration lifted restrictions on the kinds of mortgages the GSEs could purchase to meet these targets; Bush increased the affordable-housing goals during his presidency. As Peter J. Wallison and Charles W. Calomiris pointed out in a study for the American Enterprise Institute last fall, this enabled Fannie and Freddie to purchase or secure more than $1 trillion in subprime and Alt-A loans between 2005 and 2007 alone. Unlike the deregulatory acts that Scheer and others are blaming, this contributed directly to the inflation of the housing bubble. Wallison and Calomiris wrote: “Without [the GSEs’] commitment to purchase the AAA tranches” of the bulk of the subprime mortgage-backed securities issued between 2005 and 2007, “it is unlikely that the pools could have been formed and marketed around the world.” To be sure, the investment banks were more than happy to buy up the rest of the toxic debt, but one reason these banks took on too much leverage was their confidence that, in the event of a downturn, the Fed would cut interest rates — and keep them low — to stimulate the economy. They called this “the Greenspan put” after former Fed chairman Alan Greenspan (a “put” is a financial option purchased as protection against asset-price declines). The Fed had cut interest rates to stimulate growth after the tech bubble burst, and it had cut them to historically low levels after the 9/11 attacks. From late 2001 to late 2004, the Fed held interest rates under 2 percent, making investors desperate for a decent rate of return. Mortgage-backed securities met that need. Harvard professor Niall Ferguson recently contended in the New York Times Magazine that “negative real interest rates at this time were arguably the single most important cause of the property bubble.” The Left continues to propagate the myth that a zeal for deregulation did us in, because it prefers government interference in the marketplace. That’s why it’s important to remember that, for the current economic disaster, government interference bears much of the blame.

Diminished Returns

May 17, 2009

The Way We Live Now

By NIALL FERGUSON

If financial crises were distributed along a bell curve — like traffic accidents or people’s heights — really big ones wouldn’t happen very often. When the hedge fund Long-Term Capital Management lost 44 percent of its value in August 1998, its managers were flabbergasted. According to their value-at-risk models, a loss of this magnitude in a single month was so unlikely that it ought never to have happened in the entire life of the universe. Just over a decade later, many more of us now know what it’s like to lose 44 percent of our money. Even after the recent stock-market rally, that’s about how much the Standard & Poor’s 500 index is down compared with October 2007.

Financial crises will happen. In the 1340s, a sovereign-debt crisis wiped out the leading Florentine banks of Bardi, Peruzzi and Acciaiuoli. Between December 1719 and December 1720, the price of shares in John Law’s Mississippi Company fell 90 percent. Such crashes can also happen to real estate: in Japan, property prices fell by more than 60 percent during the ’90s.

For reasons to do with human psychology and the failure of most educational institutions to teach financial history, we are always more amazed when such things happen than we should be. As a result, 9 times out of 10 we overreact. The usual response is to introduce a raft of new laws and regulations designed to prevent the crisis from repeating itself. In the months ahead, the world will reverberate to the sound of stable doors being shut long after the horses have bolted, and history suggests that many of the new measures will do more harm than good. The classic example is the legislation passed during the British South-Sea Bubble to restrict the formation of joint-stock companies. The so-called Bubble Act of 1720 remained a needless handicap on the British economy for more than a century.

Human beings are as good at devising ex post facto explanations for big disasters as they are bad at anticipating those disasters. It is indeed impressive how rapidly the economists who failed to predict this crisis — or predicted the wrong crisis (a dollar crash) — have been able to produce such a satisfying story about its origins. Yes, it was all the fault of deregulation.

There are just three problems with this story. First, deregulation began quite a while ago (the Depository Institutions Deregulation and Monetary Control Act was passed in 1980). If deregulation is to blame for the recession that began in December 2007, presumably it should also get some of the credit for the intervening growth. Second, the much greater financial regulation of the 1970s failed to prevent the United States from suffering not only double-digit inflation in that decade but also a recession (between 1973 and 1975) every bit as severe and protracted as the one we’re in now. Third, the continental Europeans — who supposedly have much better-regulated financial sectors than the United States — have even worse problems in their banking sector than we do. The German government likes to wag its finger disapprovingly at the “Anglo Saxon” financial model, but last year average bank leverage was four times higher in Germany than in the United States. Schadenfreude will be in order when the German banking crisis strikes.

We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street. New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers. And the globalization of finance played a crucial role in raising growth rates in emerging markets, particularly in Asia, propelling hundreds of millions of people out of poverty.

The reality is that crises are more often caused by bad regulation than by deregulation. For one thing, both the international rules governing bank-capital adequacy so elaborately codified in the Basel I and Basel II accords and the national rules administered by the Securities and Exchange Commission failed miserably. It was the Basel system of weighting assets by their supposed riskiness that essentially allowed the Enronization of banks’ balance sheets, so that (for example) the ratio of Citigroup’s tangible on- and off-balance-sheet assets to its common equity reached a staggering 56 to 1 last year. The good health of Canada’s banks is due to better regulation. Simply by capping leverage at 20 to 1, the Office of the Superintendent of Financial Institutions spared Canada the need for bank bailouts.

The biggest blunder of all had nothing to do with deregulation. For some reason, the Federal Reserve convinced itself that it could focus exclusively on the prices of consumer goods instead of taking asset prices into account when setting monetary policy. In July 2004, the federal funds rate was just 1.25 percent, at a time when urban property prices were rising at an annual rate of 17 percent. Negative real interest rates at this time were arguably the single most important cause of the property bubble.

All of these were sins of commission, not omission, by Washington, and some at least were not unrelated to the very considerable political contributions and lobbying expenditures of the financial sector. Taxpayers, therefore, should beware. It is more than a little convenient for America’s political class to blame deregulation for this financial crisis and the resulting excesses of the free market. Not only does that neatly pass the buck, but it also creates a justification for . . . more regulation. The old Latin question is highly apposite here: Quis custodiet ipsos custodes? — Who regulates the regulators? Until that question is answered, calls for more regulation are symptoms of the very disease they purport to cure.

Niall Ferguson is a professor at Harvard University and the Harvard Business School and the author most recently of “The Ascent of Money: A Financial History of the World.”

Copyright 2009 The New York Times Company

Questions from Obama to Palin

I think this Rush Limbaugh piece is a lot of fun! RUSH: I want to go over this experience business another way. The libs are saying that Sarah Palin doesn't have any experience. Neither does Obama. I want to illustrate that. Let's say that Obama and Sarah Palin got together. What are some of the questions that Sarah Palin would have for Senator Obama? I can't think of anything he could teach her. What, however, could she teach him? So, Senator Obama's first question would be: Can you show me the proper and safe way to handle and fire a gun? And are all NRA members as pretty as you are? Second question, Obama to Sarah Palin: Is hunting scary? And when you go fishing, do you bait your own hooks? I mean you could cut your finger doing that. Do you do it yourself? Next question, Obama to Sarah Palin: When you found out your baby would be born with Down syndrome, did you consider killing it before or after the due date? You mean you had the baby? You really had the baby? Question number four: What's it like to be a governor, Mrs. Palin? Do you worry that you're going to be held responsible for your decisions? Question number five, Obama to Sarah Palin: Did you believe all that garbage that we've said about women at the Democrat convention? Are you worried that breaking the glass ceiling will just make a big mess? Question number six, from Obama to Sarah Palin: Is it fun or scary to ride a snowmobile? Don't you get cold? Question number seven, Obama to Sarah Palin: Is it scary to live so close to the Russians? Question number eight, Obama to Sarah Palin: Your son's in the army. Did you teach him how to shoot guns? Question number nine, Obama to Sarah Palin: Since you're a former sports broadcaster, if I bet on a football game, can I call you for advice? Question number ten, Obama to Sarah Palin: Come on, tell me the truth: Can we really drill for oil and not destroy the planet? Algore says we're destroying the planet, but your husband works in that business. Can we really drill for oil and not destroy the planet? Well, I don't know what Sarah Palin would ask Obama. She wouldn't want a sweetheart mortgage. That's the thing. Mr. Obama, could you tell me how to get a sweetheart mortgage or maybe get some crook friend to sell me, you know, a little strip of his land below market value? She wouldn't ask that question. Obama did. She might reference it in a debate if it comes up.

Quotes

Government remains the paramount field of unwisdom because it is there that men seek power over others - and lose it over themselves. --Barbara Tuchman

Monetary Policy Surrounding The Great Depression

From Secrets of The Temple by William Greider, pp. 296-303.

Ben Strong, the dominant central banker in America during the Fed's first formative decades, understood the political advantage in blurring the central bank's influence over prices and the economy. The Fed would always be caught between the conflicting interests of consumers and producers, between finance and farmers, between lenders and borrowers. "There you are," he said, "between the devil and the deep sea."

"It seems to me that if the Federal Reserve System is recognized as a price regulator," Strong explained, "it is going to be somewhat in the position of the poor man who tried to stop a row between an Irishman and his wife. They both turned in and beat him.^„16

Benjamin Strong died in October 1928, and one year later, the Fed­eral Reserve System suffered its historic disgrace. The stock market crashed and the American economy collapsed with it. The "new era” of permanent properity was abruptly demolished, followed by the Great Depression with unemployment at 25 percent and desperate poverty for tens of millions of Americans. Tens of thousands of busi­nesses were bankrupted, and the panic of bank failures also returned —destroying more than forty percent of all American banks. The Fed­eral Reserve was blamed for failure to act on both sides of the Great Crash—first for letting it happen, then for failing to reverse the dev­astation. The Fed's defenders liked to imagine that had Benjamin Strong lived, maybe the worst of the disaster could have been averted. It sounded like wishful thinking in hindsight.

Certainly, Strong saw the outlines of the gathering crisis before others did. In the summer of 1928, three months before his death, he warned a colleague that banks and investors were caught up in a dangerous frenzy of speculation, borrowing heavily to make specula­tive stock-market forays, bidding up prices so high that the rosy ex­pectations could not possibly be fulfilled. The nation was giddily enjoying the Republican prosperity. The New York Fed was privately worrying about its collapse.

"The problem now," Strong wrote, "is so to shape our policy as to avoid a calamitous break in the stock market, a panicky feeling about money, a setback to business because of the change in psychology, and at the same time accomplish if possible some of the purposes enumerated above." The Reserve Banks, he said, must dampen credit and restrain the speculative lending, but without setting off that "ca­lamitous break."

This was a tricky business, though Strong thought it could be done. After his death, his successors tried fitfully and failed. They applied "moral suasion," pleading with commercial banks to stop making loans for stock-market speculation. When that failed, they argued among themselves. Without Strong to impose his will, the Reserve Banks and the Federal Reserve Board were stalemated through most of 1929. Belatedly, they voted a modest Discount increase in August, intended to slow down the rapacious bank lending. The speculative bubble continued. Stock-market prices went higher and higher.

On October 24, 1929—Black Thursday—the bubble burst, the "ca­lamitous break" that Strong had feared. Within a matter of days, the Standard and Poor's composite index of stocks fell from 245 to 162, wiping out more than one-third of the stock market's value. Something on the order of $7 billion in bank loans to financial investors was rendered worthless. A "panicky feeling about money," as Strong had called it, swept the nation and the world.

In the tendentious postmortems over what exactly caused the Crash of '29, Strong was himself blamed for the debacle. Adolph Miller of the Federal Reserve Board, among others, charged that Strong had personally engineered the major easing of credit in the summer of 1927—Discount-rate reductions and open-market purchases of $340 million—that pumped excessive liquidity into the banking system and permitted the artificial investment boom to take off. Strong's easy-credit policy in 1927, Miller said later, "was father and mother to the subsequent 1929 collapse."

The 1927 error, if it was an error, was at least motivated by Strong's desire to aid the real economy. When he had leaned on his colleagues at the other Reserve Banks to reduce their Discount rates, he was worried. Employment was slipping, wholesale prices were declining again and business appeared to be sliding back into recession. The easier credit was intended to avert another contraction. But Strong had another more controversial motive—helping out the central banks of Europe. Presiding at the New York Fed, Ben Strong regularly col­laborated with the central bankers of England and the Continent, trying to stabilize things so the gold standard could be restored inter­nationally. The great international banking houses, from Morgan to Rothschild, had always worked closely with one another, borrowing and lending capital among themselves to balance out the worldwide demands for credit. From the start, Strong discreetly assumed the same role for himself—personal responsibility for representing Amer­ica in global financial coordination, in an era when most Americans still thought of their nation as totally independent.

In mid-1927, Montagu Norman of the Bank of England called on Strong and urged him to ease U.S. credit. Strong promptly agreed to do it. The Fed would provide excess liquidity for the American bank­ing system and that money could flow abroad, through foreign loans, to ease credit in the European financial markets, where tightening conditions threatened to push up interest rates. If rates rose sharply in London and Paris and Vienna, that would depress business and perhaps set off a general contraction. The explanation would certainly have rankled citizens of the United States if they had known it. World War I had left a great tide of isolationism in its wake. The suspicion that the Federal Reserve secretly served the needs of international banking at the expense of domestic interests would become a peren­nial source of resentment.

As Strong himself argued, however, the U.S. assistance was also self-interested—what damaged European business would in time also damage America's. If Europe's economies contracted, for instance, then Midwestern grain farmers would find no buyers for the surplus crops they exported. Like it or not, the world's industrial economies were already closely interlocked, through both finance and produc­tion, long before the Federal Reserve came into existence. The "global economy" celebrated by modern commentators was different only in the degree of complexity, the volume and speed of international trans­actions. Despite his autocratic manner, Strong was ahead of his time in his internationalism.

Strong's maneuver, in any case, did not work. It backfired. Given the weakened state of the real economy, the flush of excess liquidity he had pumped into the banking system was not needed for transac­tions in real commerce or production. The surplus of money flowed, instead, into financial markets—artificially inflating financial values and fueling the run-up of stock prices that ended abruptly in the autumn of 1929.

After the crash, the Federal Reserve System did nothing. If Ben Strong had been alive and in charge, perhaps he would have acted to stop the collapse. At least, when he was expressing his fears of a ^"calamitous break" back in 1928, Strong understood that the Federal Reserve could quickly reverse such a disaster.

I think you realize, as I do [Strong had written to a colleague], that the very existence of the Federal Reserve System is a safeguard against any­thing like a calamity growing out of money rates. Not only have we the power to deal with such an emergency instantly by flooding the street with money, but I think the country is well aware of this and probably places reliance upon the common sense and power of the System. In former days the psychology was different because the facts of the banking situation were different. Mob panic, and consequently mob disaster, is less likely to arise.

Strong was mistaken about the "mob" and its faith in the Fed. When the market broke, the same psychology that had driven banking panics in 1907 and earlier took hold, swept across America and Eu­rope, and ultimately destroyed 9,800 U.S. commercial banks over the next five years. But Strong was making a more fundamental point: the Federal Reserve had ample power to stop such a crisis almost instantly "by flooding the street with money."

That is what his successors failed to do. At first, they accepted the ruinous deflation as a natural, even desirable outcome. As the contrac­tion deepened, they bickered among themselves about the correct reponse. Finally, rather late in the crisis, they tried briefly to reverse the decline, then abandoned the effort before it had a chance to suc­ceed.

Money disappeared on a massive scale. As billions of dollars of bank debt were liquidated by defaults and bankruptcies in the economy, involving farmers and businesses along with the stock-market specu­lators, the process naturally extinguished money and the supply of money contracted. From 1929 to early 1933, U.S. money shrank in volume by more than one-third. The Federal Reserve could have in­tervened to reverse the contraction. It could have reduced interest rates sharply to stimulate renewed borrowing and business activity. More importantly, it could have purchased millions or billions in gov­ernment securities—pumping new money into the banking system to reverse the price deflation and restart the dead economy. Instead, as President Herbert Hoover lamented, the Fed became a "weak reed for a nation to lean on in time of trouble." ¹⁷

Long afterward, the 1929 debacle left the general impression in political circles that it could never happen again. The Fed would not permit it. If another similar collapse ever occurred, the central bank would simply begin pumping up the money supply, creating new money abundantly until the crisis was reversed. When the Great Crash occurred, it was said, the failure stemmed from the Federal Reserve's ignorance and impotence. Fed officials lacked sufficient knowledge of the economy to understand what was happening. They lacked the proper monetary tools to intervene successfully.

Comforting as the mythology was, it was not quite right. It was not that Federal Reserve governors lacked the tools to reverse the waves of failure after 1929. They could have pumped money into the econ­omy by open-market purchases—"flooding the street," as Strong had said—and that would have restarted the economic engine. But the governors argued among themselves over whether to use these powers to halt the collapse—and they decided against it. The Federal Re­serve's failure was a failure of human judgment, not the mechanics of money. Unless one assumed that the Fed had subsequently become all-wise, such decisive errors would always still be possible.

The central bankers of 1929 did not view the economic collapse as an unfolding tragedy, at least in its opening phases. On the contrary, they regarded it as a normal correction to excess. Ten months after the stock-market crash, amidst soaring unemployment, collapsing prices and an ominous new wave of bank failures, George W. Norris of the Philadelphia Fed sounded almost pleased by developments.

The consequences of such an economic debauch are inevitable [Norris told his fellow Reserve Bank officers]. We are now suffering them. Can they be corrected or removed by cheap money? We do not believe that they can. We believe that the correction must come about through re­duced production, reduced inventories, the gradual reduction of consumer credit, the liquidation of security loans and the accumulation of savings through the exercise of thrift. These are slow and simple remedies, but just as there is "no royal road to knowledge," we believe that there is no shortcut or panacea for the rectification of existing conditions.

The leading commercial bankers who advised the Fed agreed. The Federal Advisory Council urged the central bank to let nature take its course. "The present situation will be best served if the natural flow of credit is unhampered by open-market operations," the council de­clared in November 1930.

Andrew Mellon made the same case with chilling clarity. The way out of the Depression, he confided to President Hoover, was more failure and unemployment, more liquidation. "Liquidate labor, liqui­date stocks, liquidate the farmers, liquidate real estate," Mellon de­clared. The Treasury Secretary believed, and many other Fed officials agreed, that panic and recession were good for people. "It will purge the rottenness out of the system," Mellon explained. "People will work harder, live a more moral life. Values will be adjusted and enter­prising people will pick up the wreck from less-competent people."

Hoover was not so sure this was the answer, but the President had little influence over the independent leaders of the Federal Reserve System. Herbert Hoover, of course, became the political scapegoat for their failure; his name would be invoked by a generation of Demo­cratic orators as the symbol of Republican indifference to human suf­fering.

As the Depression deepened, the Federal Reserve persisted in its passivity in part because the Fed's money principles—the "real bills" doctrine—called for passivity. Again and again, in their private min­utes and memoranda, the Reserve Bank officials insisted that the Fed's role was merely to provide Discount loans to the commercial banks that asked for them—accommodating the credit needs of the economy. Of course, almost nobody was asking for new loans in 1930 or 1931. The economy was contracting and the banking system did not need expanded credit from the Fed. On the contrary, banks found themselves floating in an excess of reserves—a pool of surplus lending capacity—because they could find no customers who wanted to borrow.

When others urged the Fed to inject more money into the financial system, Norris of the Philadelphia Fed reminded his colleagues of the operating principle thay had formally adopted in 1923 on the System's tenth anniversary: "The Federal Reserve supplies the needed addi­tions to credit in times of business expansion and takes up the slack in times of business recession." That was the whole idea of an "elastic currency"—expanding or shrinking the money supply in response to business demands for credit. Norris complained that even the modest steps the Fed had taken on its own initiative would be regretted. "We have been putting out credit in a period of depression, when it was not wanted and could not be used," he warned, "and will have to withdraw credit when it is wanted and can be used."

Logical as it sounded, the theory was fatally flawed. The "real bills" approach meant the Federal Reserve would always be passively fol­lowing the direction of the economy and exaggerating its cycles on both the upside and the downside—providing more and more new money to banks during a period of expansion and withdrawing more and more money during an economic recession. Thus, the Fed's be­havior deepened the great contraction through its self-imposed stance of impotence. The Discount rate, its principal means of control, was like an empty sail on a becalmed sea.

What was needed, as some Fed officials recognized, was an activist money policy that pulled against the economic tide rather than drifting with it—a countercyclical policy, economists would say, rather than the procyclical policy implicit in the "real bills" doctrine. In short, the Fed must be willing to inflate the currency on its own initiative—"flooding the street with money"—in order to counteract the natural forces of deflation and contraction that were under way. The Federal Reserve System had neither the desire nor the courage to do that.

Federal Reserve officers had another reason not to act—a rather ugly reason considering the human suffering abroad in the land. Reserve Bank presidents held back because they were anxious to protect the earnings of private commercial banks. That sounded callous and narrow-minded, but political scientist Thomas Ferguson and econo­mist Gerald Epstein found confirming evidence in their research of the central bank's archives—blunt private statements by the Reserve Bank presidents that no more additional money should be supplied because it was hurting the important banks in their districts.

For two years, some Fed officials, including the board chairman in Washington, Eugene Meyer, had pleaded with their colleagues to in­ject massively through open-market purchases. That would pull down interest rates and get prices and wages rising again, restimulating economic activity. In October 1931, the Reserve Banks actually did the reverse—raising the Discount rate by two percentage points in two weeks. Industrial production fell another 26 percent in the next six months. The money base shrank by another $90 million.

Finally, by April of 1932, Meyer and others prevailed, supported by the Morgan bank and important Wall Street financiers. They per­suaded the Reserve Banks' open-market committee to pump up the money supply and quickly. The New York Fed began buying Treasur­ies on an unprecedented scale—$100 million a week for eleven weeks, $1.1 billion in additional reserves. If the campaign had continued, it would have produced a turnaround in the economy.

But, in early summer, the Reserve Banks abruptly abandoned the initiative. The bold experiment was over. When the contraction re­sumed a few months later, a third wave of bank failures swept the country, more severe than the first two. Another five thousand banks would close.

James McDougal of the Chicago Fed was among the Reserve Bank presidents who objected to the Fed's attempted activism. Major banks in the Chicago district, he complained, were suffering an earnings squeeze because of the Fed's easy money. The expanded money sup­ply drove down interest rates on government securities to a minuscule level, and in these slack times, the banks held large portfolios of government securities as their principal source of income. "We be­lieve that the additional (open-market) purchases made were much too large," McDougal wrote a colleague, "and have resulted in creating abnormally low rates for short-term government securities."

Norris of the Philadelphia Fed agreed: "Further increases in excess reserves would adversely affect bank earnings. . . ." Owen D. Young of the Boston Fed, who had voted against the open-market initiative in the first place, was "apprehensive that a program of this sort would develop the animosity of many bankers." ¹⁸ All in all, the episode was perhaps the starkest evidence in support of historian Gabriel Kolko's estimate of the Federal Reserve as a political institution: it was cre­ated to serve the most important banks and, in this instance, it did, despite the horrendous losses it was to cause the nation at large.

The Federal Reserve backed off. The infusions of new money were halted. And nature followed its course to a climax of destruction. By early 1933, as Franklin D. Roosevelt awaited his Inaugural, a new wave of collapsing banks was under way, accompanied by still higher unemployment and many more business failures. As Democrats came to power, the national economy was ruined and the American banking system was ruined with it. Also destroyed was the reputation of the Federal Reserve System.