February 5, 2009

A free market distinction: commerce vs. finance

Free market ideology needs to grasp the distinction between commerce and finance. The basic libertarian ideology revolves around the government only preventing "acts of force or fraud." So, we don't need a whole Indian-style Permit Raj to tell Procter & Gamble whether or not they can bring out a new flavor of Crest. If the new flavor of Crest poisons people, well, they can sue P&G and win hefty settlements, and P&G knows that, so P&G doesn't poison all that many people.

On the other hand, in the financial sphere, there's a huge gray area over whether something will turn out to be fraud or not.

I take my money and deposit it in the bank, which tells me that I can take it out anytime I want. And then the bank decides that rather than lend my money to Procter & Gamble at X% interest to build a new toothpaste factory, it would be a great idea to buy a mortgage-backed security consisting of the lowest tranche of the second mortgages (i.e., the mortgages that enable the first mortgages to be, net zero money down) on a bunch of loans to roofers in Compton that they bought from Countrywide because it pays 2X% and, besides, they need the CRA credits to get regulatory approval to buy another bank.

So, one day I go to take my money out of the bank and there's a big line of angry depositors banging on the locked doors, and then a man comes out to say the FDIC has taken over the bank and you'll all get your money back (assuming you didn't put too much in the bank). So, I've got that going for me in my role as a depositor, but that's not so great in my role as a taxpayer.

Therefore, it's clear that libertarians should not be seduced by free market ideology when it comes to finance. It's a different beast than cash-on-the-barrelhead commerce. Fraud, including unwitting fraud, is always a big risk in finance.

On the other hand, non-libertarians shouldn't expect the government to do a good job of regulating the finance industry. Take a look at what blew up the world. Bill Clinton, George W. Bush, and Barack Obama all strongly wanted your bank to make zero money down loans to those roofers in Compton.

My published articles are archived at iSteve.com -- Steve Sailer


Anonymous said...

"Take a look at what blew up the world. Bill Clinton, George W. Bush, and Barack Obama all strongly wanted your bank to make zero money down loans to those roofers in Compton."


I was under the impression that you thought affirmative action handouts were one of many significant factors in the economic downturn.. now you seem to be saying that it was THE main factor... is that correct?

I've been following your articles and I think you've provided solid evidence that NAMs were a disproportionate portion of the foreclosers.. How exactly do you conclude that this was the CENTRAL cause of the crisis?

Anonymous said...

Uh, Steve, fractional-reserve banking is a fraud. Where's the gray area?

Anonymous said...

Simple, create two types of financial institutions: the regulated and the unregulated. For the regulated, you rely on all the wisdom of the government protectors -those people who reduced the capital requirements of investment banks during the credit bubble, For the unregulated you rely on private insurers or rating agencies, like Underwriter's Labratory for electrical device. Each person makes their judgment - trust the government or trust the real market - and let the chips fall where they may. Only government cannot confiscate to make up for their mistakes, their patrons have to suffer the loss if there is any for their side or it won't work. Otherwise the govt backet investment is always safest because they have the laws and the handcuffs.

Acilius said...

I'm far from a libertarian, but I don't really buy your distinction. To me, it seems that markets, whether commercial or financial, can be stable only when investors' hope for gain is balanced by their fear of loss. Every subsidy that reduces the fear of loss therefore must be coupled with a regulation that reduces the hope for gain. The financial reforms of the Bush-Clinton-Bush years have reduced the regulatory burden in finance considerably but have not reduced subsidies a bit.

Anonymous said...

Anonymous #1 scores -- Steve, commercial banks are cartelized and regulared by the Federal Reserve. There is almost nothing "free market" about them.

Anonymous #2 is onto something fundamental too, but I'm skeptical on two points: first, the ratiings agencies (S&P, Moody's) are also a government-sponsored cartel, since the 70s -- this has perversely put them to work for bond sellers instead of buyers. Hence the AAA-rated toxic "securitized" debt. Second, the government always bails out the insiders. Libertarians appeal to principle here, but since when are winning politicians principled?

Where is free market finance? It doesn't exist. If that is your point, it ain't necessarily so. We have yet to try freeing the market for money.

Anonymous said...

Let's not forget, if you are the victim of a bank collapse with an FDIC bailout, you won't get your money back tomorrow or next week. You could be waiting months while your bills go unpaid and you can't eat.

Do your creditors care, or will your credit score go undamaged? Dream on.

Anonymous said...

Every "anonymous" here has made cogent comment.

But I'm of the opinion that, while we're seeing cracks in the structure of the fractional reserve system, the roots (and the instability) go deeper. And I mean much deeper.

My belief, after 35+ years studying (Austrian) economic theory, is that fractional reserve is just the tip of the iceberg and that a "return to sound money" (the classical gold standard) would not remedy the malaise more than very temporarily. What worked fairly well up to the 19th century is not necessarily something that could work today, with the extant greater population and interconnectedness. And that's in addition to the inherent political weakness of the gold standard (its vulnerability to cooption and "management" by authority). We need protection, in this case, FROM the law, not BY the law.

My (impossible of indisputable proof, I grant) contention for at least 20 years is that we shall witness the breakdown of the entire world monetary system and that the eventuality is more inevitable than imminent: we're feeling tremors but whether they're close to the end or not is competely unknowable.

Again, fractional reserve central banking is a problem but it's just one of several characteristic of the underlying: the very idea that authority (gov't.) is the source of money or its value (as are provided in the US Constitution and the laws of every other nation on the planet).

What is needed by the world-embracing market is a universally acceptable medium of exchange with no connection to authority whatsoever and change in law to repeal "legal tender" laws and substitute prohibitions against
political interference in monetary affairs.

Gold is,universally, money. Most is in gov't. possession. That must end, with gov't. forbidden to own more than a militarily "strategic" stock. Government must be limited to using paper money of which it could print any amount desired and which no one would be obliged to accept except government employees (at all levels, not just federal) and contractors; conversely, only the government paper could be required for any payment of any kind due to the government. (This would guarantee that government would not inflate their own money because they and their employees and contractors would be the only ones to suffer the diminution. Turn-about is fair play, I allus sez.)

I even know pretty much what it will look like, how it will be produced, and how much its production and distribution will cost (zero, zip, zilch) the benefitted population.

I shit you not.

Christopher said...

"Fraud, including unwitting fraud, is always a big risk in finance."
Under the common law, there's no such thing as 'unwitting fraud' as one of the elements of fraud is the speaker’s knowledge of the falsity of the representation. What you mean by unwitting fraud sounds like just giving your money to idiots or otherwise misallocating it; too bad so sad. We can include our government representatives and their boondoggles within the rubric of idiots and misallocations. It's our own damn fault.
The risk of denying this is that we may be tempted to impute fraud to whole categories of financial agreements a la the commies. Me, I'd invest with guys like Jim Rogers and Peter Schiff, who called these things years ago.

Anonymous said...

Steve, your intuition is correct, but I can explain it in more clear terms. In the real economy, profit comes by way of wealth creation. However, the financial system is a parasite on the economic body, producing no wealth, but siphoning it off. Banking also has inverted values, because in banking, debt is an asset. Banking profit comes at the expense of the real economy, and too much banking assets (debt) is deadly to a healthy economy. As we are now finding out. For that reason, the banking industry has to be carefully regulated.

Anonymous said...

Jubilee Year:

There is a certain well-meaning substrate to your comment but it's completely insufficient to any more than superficial understanding.

First off, "profit" and "wealth creation" are neither the same thing nor even quite as intimately related as you seem to suppose. I'm a pretzel vendor and sell you one, which you eat. If I've run my business correctly, I end up with a profit but haven't done much by way of wealth creation. That's true even if you've got a leftover nickel which you'd have had to pay to patronize another vendor. What's more, it's obvious that there'd be more wealth around if I still had the pretzel and you still had the money (unless you count your satisfaction after consumption as "wealth"). Even further, "wealth" can be simply the result of a new way of behaving or believing. A man who acquaints the world with a new use for an abundant resource (as glassmaking or the fractional distillation of air) may create enormous wealth (or potentiality for wealth), wether he himself does or does not derive some fraction of that wealth from his discovery./

By now (with apologies for not having the gift of brevity), you should be getting the idea that "wealth" is a slippery concept, not easily defined. But, like the judge said (in defining pornography): "I know it when I see it," (to which I'd add the word "usually").

Therefore, you'll be able to appreciate that neither the "financial system" nor "banking" (as general entities) are necessarily parasitic on the "economic body." In exchanging with one another, all participants in the market economy benefit from the existence, at least, of commonly-accepted "media of exchange," the rudiment of any finacial system: they are made "wealthier" by the very concept in streamlining the exchange of their individual productive efforts. Likewise, "banking" serves and enriches the entire body through provision of efficient storage and exchange of the accepted media and also for the brokerage of loans, through which those with wealth help those without to realize their (often productive and wealth-generating) ideas sooner rather than "later" (or "never").

These matters should be of interest to almost everyone but are, unfortunately not, except as topics of "bull-session" discussion pursued with relative lack of depth; they are the subject matter of Economics (and my views are those typical of the much-marginalized Austrian School).

If you'd be interested in learning much more of the subject, the best introduction, I'd suggest, is "ECONOMICS IN ONE LESSON" by Henry Hazlitt. You might find a passion for actually understanding such stuff (something which has never occurred to most of our "leadership").

Anonymous said...

Gene, I digested that book when I was a teenager. I am finding it is typical of those, like yourself, who profess Austrian allegiance, to love to lecture at length on ideal economic principles, without ever actually engaging anyone's point. Yes, we all know the ideal function of banks, and what economic utility they offer. But the simple fact is, if all banks and money magically disappeared off the face of the earth tomorrow, we would not be one iota poorer for it. Our current banking system is just one way to organize our commerce, and frankly, it is not working out too well. Economically, they are parasitical, and they have unleashed the powerful cancer of unsustainable debt into our commercial system. You might want to engage reality, rather than repeat pompous Austrian mantras about how the economy should be.

Anonymous said...

Jubilee Year:

I'll admit to being pedantic (and I'd already admitted to being less than brief) but you're making the long-recognized error of mistaking the person of the messenger for the content of the message.

I didn't make the world nor the various physical and economic laws in operation in it; I merely have a better "handle" on some of those than others. Unlike those in the "natural sciences," neither have I the advantage of illustrating the correctness of my position by pointing to the fact that machines operate as expected and that bridges aren't falling down. In economic science, the theory must comprehend behavior characteristic of humans everywhere, not just at certain times and under certain special circumstances. Moreover, since such behavior is heavily influenced by the attitudes of majorities (and rulers) toward their organization, economic theory also cannot be unmindful.

If I could make my case in fewer words or with simpler explanations, I'd be glad to do so: it would assure a wider audience for what I know to be important.

But at least allow me to be as brief as you want to require of me and to do so specifically with regard to one of your (rather ill-informed and advised) statements.

"If all banks and all money magically disappeared off the face of the earth tomorrow, we would not be one iota poorer for it."

If only one of those came true, i.e., the disappearance of money (a universal media of exchange), I can make some relatively accurate predictions of the result. That would be that millions would starve. Many of these would be inhabitants of relatively remote areas but others would be those who live in relatively prosperous but naturally under-endowed places like Germany, Austria, the UK, and Japan; also urban agglomerations everywhere, who can't live without food and fuel from elsewhere for more than a few weeks at best and, even short of the most extreme, will be plagued by barbarism and predation, not to mention actual plagues from reduced sanitation, safe drinking water, and health-maintenance. Without money, how will those charged with "keeping the peace" be compensated and induced to continue vital activity? Who will make the wherewithal available to farmers to plant their next crops, let alone to part with ones they've got on their hands presently? And truckers to haul it? And fuel for the trucks? And on and on.

Each diminution of the present state of interconnectedness and economic level condemns certain people to death: those "at the margins" of survival who don't number so many presently (but more than a million or so) but with decline in productivity (including ease of turnover), greater numbers become ever closer to that margin.

My own estimate of the number "at risk" in the event of monetary collapse is between one and two billion. But that's just my guess, of course. As they say, your mileage may vary.