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Law of Selective Gravity
By Leo Melamed
Financial Innovation Conference
October 16, 2008
is no way to sugar coat it: Current economic conditions have the
earmarks not only of a severe U.S. recession but-dare I say it-the
potential of a global depression. That is about as dire as it
can get. However, for me, as tragic and ominous as that prospect
may be, it does not represent the worst consequence of today's
global economic conditions. I fear in The Law of Selective Gravity-a
cousin of one of Murphy's Laws-which postulates that "An object
will fall so far as to do the most damage."
the world knows, a couple of weeks ago, Treasury Secretary Henry
Paulson asked Congress to approve a $700 billion rescue of the
banking industry. Without this sudden, massive infusion of federal
cash, we were told, economic disaster loomed. Prompt approval,
on the other hand, would assure the solvency of the financial
sector, thaw frozen credit flows and give investors a badly needed
dose of confidence. Faced with the prospect of rising unemployment,
a plunging stock market and the inability of corporate America
to borrow, Congress approved a revised package on Friday, Oct.
3. 2008. This gave investors the weekend to contemplate the economic
value of the federal action. Were it able to inspire some confidence
and halt for a moment or two the bloodletting, one might be a
bit more charitable in assessing the panic driven action by the
captains of American capitalism. On Monday, the stock market plunged
into an abyss and the turmoil spread to Europe, Asia and South
America. The plan which Secretary Paulson and Fed Chairman Bernanke
told us we must approve to prevent a market crash did nothing
of the sort. The market crashed. Now the plan is for Government
to rescue the banks with direct capital investment, whether they
want it or not. Did you every think that maybe the market doesn't
want any more of Government plans?
don't miss the point. I am not lamenting the fact that the desperate
plan did not have an immediate medicinal effect-in all reasonableness
the Trouble Asset Relief Program (TARP) will take time to take
effect. But what I am lamenting is the fact the Executive branch
of an American administration was so desperate that it proposed
a rescue operation of gargantuan proportion which gave it unlimited
power, with minimal oversight, little accountability, no recourse,
and no judicial review. I am lamenting the mind-set that would
devise such a plan-surely its blueprint had a Venezuelan origin.
A plan that Steve Chapman of the Chicago Tribune described as "giving
the executive branch powers that a Russian czar would envy."1
am lamenting the fact that hardly anyone paid the slightest attention
to a warning by a group of 122 economists, including at least
two Nobel laureates, who stated:
the plan is enacted, its effects will be with us for a generation.
For all their recent troubles, America's dynamic and innovative
private capital markets have brought the nation unparalleled prosperity.
Fundamentally weakening those markets in order to calm short-run
disruptions is desperately short-sighted."2
am lamenting that U.S. government officials were in such a state
of panic that they abandoned market solutions in favor of Third-World
sorcery like blaming speculators and banning short-selling. I
am lamenting the fact that all the world's capitalists have turned
to the government for salvation. I am lamenting the fact that
federally inspired rescue operations were so quick to surrender
the fundamental free market principle that mistakes by the private
sector must be borne by the people who made them. As Thomas Donlan
of Barron's remarked "The U.S. and Europe are racing down the
trail marked by such economic leaders as Mexico, Argentina and
Russia."3 Or as Yale's Professor Jonathan Macey put it: "Officials
at the Federal Reserve, the Securities and Exchange Commission
and the Treasury Department are to blame for publicly losing confidence
in the very economic system they are supposed to protect."4
all, what I am lamenting is the real cost of these operations
and not in terms of billions of dollars to American taxpayers.
I am lamenting the fact that The Law of Selective Gravity will
result in the unthinkable-a renunciation of the free market. With
that-America will lose its most precious asset, the ability to
is not some fantasy of a hysterical pessimist with a propensity
for paranoid prophesies. The developing underlying blame-within
the walls of Capital Hill, Wall Street, and main street-is that
the economic disaster is the result of a laissez-faire deregulatory
mentality. Greed on Wall Street -has become the conventional theme
of both Presidential candidates. In the public vernacular that
is short-hand for the free market. "I was a free market guy,
but no more," is a common refrain heard from ordinary folks on
the streets of America. Its damning echo is resonating throughout
the pages of American newspapers, radio talk shows, and TV programs.
it is a message roundly applauded by every enemy of freedom on
is not to suggest that the financial system is not in trouble.
Or that some form of federal action was unwarranted. Nor is this
an attempt to absolve the private sector from blame. Surely, greed
played a major role in what happened. Clearly, financial institutions
in their rush for greater immediate returns irrespective of consequential
long-term risks, were guilty of irresponsible behavior or worse.
As Randal Forsyth of Barron's suggested, OTC structured investment
vehicles became the financial equivalents to steroids. Regulatory
reform, as suggested by former SEC chairman, Arthur Levitt Jr.,
is necessary pertaining to lending practices, licensing standards,
oversight of mortgage brokers, capital requirements for monoline
insurers, and transparency in the sale of OTC derivatives so that
risks associated within all forms of structured investment vehicles
will be fully disclosed.5 Similarly, as Nobel Laureate, Gary Becker
recommended, there is a need for increased capital requirements
relative to assets of banks in order to prevent the highly leveraged
ratio of assets to capital in financial institutions. 6
while endorsing regulatory reform, allow me also to draw attention
to one place, where in stark contrast to the turmoil of recent
events, the market system operated flawlessly. I speak of futures
markets, an indispensable component of the global marketplace.
While their growth in the last decade was substantially less than
in OTC derivatives, last year the CME Clearing House cleared more
than two billion futures contracts, representing more than a quadrillion
dollars in value. Which begs the question, how did exchange traded
futures perform during these unprecedented turbulent conditions?
The answer is clear: Flawlessly. No defaults, no failures, no
federal bailouts. The futures market model is a poster child for
the free market and innovation: Price transparency, liquidity,
central counterparty clearing, twice daily mark-to market, zero
debt system, and regulatory oversight.
examples: On March 14th, 2008, the last day before Bear Stearns
was acquired by JP Morgan Chase, Baer held $761 billion, in notional
value in open futures contracts for customer and house accounts
at the CME. All positions were paid for and settled. Impressive,
yes? Then how about this: On Friday, September 12, 2008-the last
weekday before Lehman Brothers filed for bankruptcy-their total
notional value of customer and house positions at CME was $1.15
trillion. No defaults, no failures, no federal bailouts. Unabated,
futures market continue to perform their essential functions:
To create a venue for price discovery, permit low cost hedging
of risk, and to innovate.
here is the rub: The free market model cannot function when it
is directed, or better still, misdirected by the heavy hand of
governmental edict. No matter how one views what happened, no
matter of what political persuasion, much if not most of its causation
has a governmental origin. First, because during the past decade
the world became awash with liquidity. Low interest rates, engineered
by world central bankers caused interest rates, especially the
U.S., to fall to the lowest level in a generation. The consequential
cheap money when combined with loan syndication and securitization
produced some highly unintended consequence. A mortgage lending
boom ensued, and bankers found ever more clever ways to repackage
trillions of dollars in loans. Professor Bob Shiller of Yale,
summed it up this way: "The housing bubble is the core reason
for the collapsing house of cards we are seeing in financial markets
in the US and around the world."
leads us to the second and most egregious culprit of the financial
collapse: two Government Sponsored Enterprises, Fannie Mae and
Freddie Mac. They were viewed in the market place, correctly as
it turns out, as government-backed buyers. These two GESs were
on an affordable-housing mission, becoming the largest buyers
of subprime between 2004 and 2007 with a total exposure exceeding
$1 trillion. It was a mission supported and backed by elected
Congressional officials who presented themselves as champions
of affordable housing.7 It fostered what Princeton's, Professor
Burton Malkial, described as the so-called NINJA loans to borrowers-no
income, no job and no assets-and poisoned the global financial
system. "The Fannie-Freddie bailout," wrote the Wall Street Journal, "is
one of the great political scandals of our age. Officials at the
federal Reserve warned about it for years, only to be ignored
by both parties on Capitol Hill."8
other words, it was a rigged game. The dictates of the free markets
are always stymied by a monopoly, a cartel, or the actions of
government. It would be a tragic misdirect and a perverted leap
of logic if the conditions that caused the global meltdown, the
transgressions that occurred within the private sector, or the
regulatory reforms that are required, were blamed on the precepts
that made this nation so great. More than any other nation on
this globe, Americans are free to think, to experiment, to innovate.
It is a legacy of the free market. A story of two miracles: an
economic miracle and a political miracle. Its application by a
people with an immigrant ancestry, of a multi-cultural heritage,
and a multi-racial composition, produced an unimaginable result.
It became a lightning rod for ideas. It created a crucible for
innovation. It combined to become the decisive driver of progress
in science, technology, and economic development.
pray that my fear is misplaced-but Murphy's Law demands that I
sound the alarm.
Chapman, Chicago Tribune, September 25, 2008.
Donlan, Barron's, October 13, 2008.
Macey Wall Street Journal, October 11, 2008.
Levitt, Jr., Wall Street Journal, March 21, 2008.
S. Becker, Wall Street Journal, October 7, 2008.
W. Calomiris and Peter J. Wallison, Wall Street Journal, September
Review & Outlook, September 8, 2008.