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The Market and Uncertainty

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Relying on the mass media for accurate economic analysis is like relying on a mobile home for shelter from a tornado. It’s a rather bad idea. Two items in the news demonstrate this beyond a shadow of a doubt: JPMorgan Chase’s big loss last spring and the role of private equity in an economy.

It’s widely believed that JPMorgan Chase’s recent $2 billion-plus loss proves we need the comprehensive banking regulation called for by the 2010 Dodd-Frank law.

That belief is wrong.

In thinking about the loss, remember that the future is always uncertain. It’s easy to look back on a bad decision — especially someone else’s bad decision — and claim the mistake was preventable. The notion that regulators have knowledge superior to that of people acting in the marketplace is ridiculous. Economic activities are based on local and often unarticulated knowledge that regulators could never acquire. It’s a fallacy to think that because imperfect human beings make mistakes, government oversight is necessary. Government also is populated by imperfect human beings, and, on top of the usual fallibility, they also suffer from this particular “knowledge problem,” as identified by Nobel-laureate economist F.A. Hayek.

But that is not all they suffer from. Even if we ignore the knowledge problem, we must confront the incentive problem. What reason do we have for believing that government regulators would do the right thing even if they knew what it was? Political economists have been aware of the principle of “regulatory capture” for many years. It refers to the near-inevitability that a regulated industry will have far more influence over a regulatory body than anyone else. Often the industry has a hand in writing the rules, which is what is going on with the writing of the myriad Dodd-Frank rules now under way. Regulators cannot be assumed to be as pure as the driven snow. Many come out of the regulated industry and plan to return when they retire from government “service.” Regulation is fraught with such perils, which those who see government as an all-knowing, all-good deity routinely overlook.

Guarantees and private-equity firms

A further error made by those who see a panacea in regulation is the belief that banks can harm us because government has kept its hands off. That couldn’t be less true. Throughout American history governments at all levels have partnered with banks, ostensibly in the public interest but actually in the interest of the bankers.

Commenting about JPMorgan’s loss, Barack Obama stumbled onto the truth — but didn’t realize it — when he said that, since the taxpayers could be on the hook for large bank mistakes, vigilant regulation is needed. But why are the taxpayers on the hook?

The most important thing to understand about the banking industry is that the government maintains a safety net of guarantees in case a big bank stumbles. And it is that safety net which makes the stumbling more likely. This is known as “moral hazard.” A bank with a government guarantee will be less careful than a bank without one. The crisis of 2008 is a textbook case study in banking moral hazard.

One government guarantee has mostly been overlooked: federal deposit insurance. It’s the sacred cow of banking programs, which originated in the New Deal, even though Franklin Roosevelt feared it would encourage bank irresponsibility. (Unfortunately, he signed the bill anyway.) The FDIC is usually thought of as a guarantee for bank depositors, but in reality it is a massive privilege for banks. If government assures depositors that they cannot lose a penny in their bank accounts, they no longer need to be wary about their banks’ conduct. Why worry, if the FDIC will make good? But that guarantee eliminates the customer scrutiny that would otherwise keep banks prudent. No promises by regulators can match depositor vigilance in reining in banker recklessness. (In a competitive market, nothing would prevent the offering of private insurance or other devices to prevent bank runs.)

Roosevelt was right:

The general underlying thought behind the use of the word “guarantee” with respect to bank deposits is that you guarantee bad banks as well as good banks. The minute the Government starts to do that the Government runs into a probable loss.… We do not wish to make the United States Government liable for the mistakes and errors of individual banks, and put a premium on unsound banking in the future.

The only way to minimize systemic damage from banking without stifling productive innovation is to end all guarantees and all barriers to competition. Free-market advocates must emphasize that deregulation is not enough. It must be combined with the removal of all privileges accorded the banking and finance industry, from the most explicit to the most implicit. Eliminating restrictions without also eliminating guarantees and bailouts is an injustice against the taxpayers, as Rep. Ron Paul understood in 1999 when he voted against Gramm-Leach-Bliley, the bill to repeal parts of the New Deal Glass-Steagall law, which separated commercial from investment banking. Libertarians must think dialectically: that is, they must not fail to look at things in their full context and realize that many government interventions are interrelated. In other words, what may look like a step in the direction of free markets may not be.

The other hot economic item in the news is the role of private-equity firms, the best-known of which at the moment is Bain Capital, founded and run by Republican presidential candidate Mitt Romney before he went into politics. Romney’s primary opponent Newt Gingrich charged Romney with engaging in job-destroying activities when he was at Bain’s helm, undercutting Romney’s claim that he was a job-creator. That charge has now become a central theme of Obama’s reelection campaign. Obama argues that since Romney has offered his business credentials, specifically as a job-creator, as his top qualification to be president, his record at Bain is fair game. That record, Obama and his supporters argue, shows that Bain created wealth for its investors but not jobs, and in fact that it presided over the bankruptcy of companies, leading to job losses.

I will make no judgment of Bain. That would require looking deeply at its particular projects and sorting out allegations that it stiffed workers who had contractual agreements with their companies for retirement and medical benefits. I will note that in all that has been said about Bain, I have not heard anyone say it broke the law or breached a contract. Nevertheless, I pass no judgment on Bain per se.

Rather, I want to examine the claim that private-equity firms “create wealth not jobs.” Further, I want to say something about the impression that if a company is taken over and then downsized or even later closed, something unseemly has taken place.

A private-equity firm is one that, among other things, pools investors’ money in order to, as Wikipedia puts it, “[provide] working capital to a target company to nurture expansion, new product development, or restructuring of the company’s operations, management, or ownership.” That’s a fairly wide range of purposes, so let’s zero in on the restructuring aspect.

In a free market, what makes the activities of private equity possible is human fallibility.

Scarcity and fallibility

As the Austrian school of economics emphasizes, purposeful human action entails the execution of plans in a state of uncertainty about the future. A business is not merely a loose collection of land, machines, materials, and workers. It is the embodiment of someone’s plan aimed at the production of goods that will (ultimately if not immediately) satisfy a consumer demand. As noted, plans are always formulated in the fog of ignorance, specifically uncertainty about the future. A business assembled according to a plan at one time may, because of new knowledge, look like a foolish idea at another time. If so, what should the business do? Persist no matter what? That would be futile because it would lead to bankruptcy and perhaps extinction of the firm. Adjustment to new conditions — including even liquidation — is in order.

To complicate things, what if the business management doesn’t quite realize what the problem or solution is? It is entirely possible, however, that someone outside the firm does understand things more clearly or has a more accurate estimate of what the future holds, and so has a sounder new plan for the company. Private equity is one device for enabling such outsiders to bring their ideas to companies that are struggling or falling short of their potential.

Why does that matter? The political controversy surrounding private equity spotlights the profits of the investors. But what is overlooked is Adam Smith’s insight: people seeking profit in the market are led as if by an invisible hand to create benefits that are (or may be) no part of their intention. Assuming no government favors, one makes money by providing things that other people find useful and are willing to buy.

We live in a world of scarcity. Indeed, were that not the case, there would be no need for economics. Our ends exceed the means available for achieving them. Thus resources and labor devoted to one purpose cannot at the same time be devoted to other purposes. People do not rank all their purposes as equally important. So we care how resources and labor are used. As the Austrians, especially F.A. Hayek, have taught us, the free market, particularly the price system, provides the best indication possible of what consumers prefer among all the possibilities to which resources and labor may be devoted. Prices guide entrepreneurs in formulating their plans. But human infallibility is pervasive. Plans are based on estimates of future prices, which may in turn be based on “present” prices. However, present prices are recent history, and the future cannot be absolutely counted on to be like the past.

The upshot is that if a business assembles resources and labor for purposes that time proves to be out of sync with consumer demand (because of, say, changing tastes or innovation), the price system provides ways (losses) for the error to be detected and corrected so that those scarce things can be redirected as consumers would prefer.

Of course, that may entail eliminating jobs or closing facilities or even shutting down the entire company. That surely creates hardship for employees who built their own personal plans around the company. But it is a consequence of inescapable features of our world: scarcity, ignorance, and change. In such a world it is entirely possible that a business will unwittingly hire too many people or build too many plants relative to consumer demand — a fact that did not reveal itself until the investment was made. What to do in such circumstances? Stick with the plan? That can’t be in the longer-run interest of anyone, including those dependent on the company.

On the other hand, if the failing company’s resources are redeployed to purposes more consistent with consumer demand, new opportunities for work and investment will arise. As Frédéric Bastiat taught, we must look for the “unseen” as well as the “seen” in economic matters. The closing or downsizing of a company releases scarce factors of production, including labor, for purposes hitherto out of reach. Ironically, Romney seems not to understand this. He boasts of the jobs Bain directly created (at, for example, Staples), but I have yet to hear him say that his activities indirectly created jobs by freeing up resources and labor for new projects.

Thus the dichotomy between producing wealth and producing jobs is false in a free market. A private-equity firm may have as its only goal the creation of wealth for its investors, but the activities aimed at that goal, if successful, will create employment opportunities, new products, and new wealth in general. The reason the pundits can’t see that is that they are skeptical or ignorant of “invisible hand” explanations. In a free market one does not need to set out to “create jobs” to actually do so.

Note that I have often qualified my remarks with “in a free market.” That is crucial. We don’t live in a free market, but rather in a mixed corporatist economy. Government regulations, tax rules, favors, and guarantees could well convert activities that would serve the general interest in a free economy into activities that are inimical to the general interest. (Someone familiar with corporate tax law once told me that most mergers are arranged for tax purposes, not because they improve efficiency in serving consumers.) That is why one cannot give a priori approval to the conduct of Romney’s Bain Capital and similar firms. A final judgment must await close examination of their activities in light of government corporatist intervention. But I wouldn’t expect that from the mass media.

This article was originally published in the August 2012 edition of Future of Freedom.

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    Sheldon Richman is vice president of The Future of Freedom Foundation and editor of FFF's monthly journal, Future of Freedom. For 15 years he was editor of The Freeman, published by the Foundation for Economic Education in Irvington, New York. He is the author of FFF's award-winning book Separating School & State: How to Liberate America's Families; Your Money or Your Life: Why We Must Abolish the Income Tax; and Tethered Citizens: Time to Repeal the Welfare State. Calling for the abolition, not the reform, of public schooling. Separating School & State has become a landmark book in both libertarian and educational circles. In his column in the Financial Times, Michael Prowse wrote: "I recommend a subversive tract, Separating School & State by Sheldon Richman of the Cato Institute, a Washington think tank... . I also think that Mr. Richman is right to fear that state education undermines personal responsibility..." Sheldon's articles on economic policy, education, civil liberties, American history, foreign policy, and the Middle East have appeared in the Washington Post, Wall Street Journal, American Scholar, Chicago Tribune, USA Today, Washington Times, The American Conservative, Insight, Cato Policy Report, Journal of Economic Development, The Freeman, The World & I, Reason, Washington Report on Middle East Affairs, Middle East Policy, Liberty magazine, and other publications. He is a contributor to the The Concise Encyclopedia of Economics. A former newspaper reporter and senior editor at the Cato Institute and the Institute for Humane Studies, Sheldon is a graduate of Temple University in Philadelphia. He blogs at Free Association. Send him e-mail.