The Rules of the Game?

I've been thinking about "the rules of the game." Consider this from a recent ProPublica article by Jesse Eisinger and Jake Bernstein on Magnetar, the hedge fund that took short positions on CDOs it helped create and that it appears also helped to fail (thereby realizing large gains from its short positions):

 From what we've learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn't cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.

“The rules in place,” I said to myself. “What does this remind me of?” And then I remembered:

 There is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception and fraud.

               --Milton Friedman, Capitalism and Freedom, Ch VIII

Clearly, if the ProPublica article is accurate, Magnetar scores high on “deception and fraud.” The problem is, as the article notes, perverse private incentives led to suboptimal social outcomes yet no laws were broken. Magnetar was playing by the rules of the game while betting against the American dream.

Friedman had great confidence that the rule of law was sufficient in combination with competitive market forces and a modicum of self-interest to assure individual virtue, societal cohesion, and economic growth. That confidence resulted in a role for government limited mainly to determining and enforcing the rules of the game:  

 The existence of a free market does not of course eliminate the need for government. On the contrary, government is essential both as a forum for determining the "rules of the game" and as an umpire to interpret and enforce the rules decided on. What the market does is to reduce greatly the range of issues that must be decided through political means, and thereby to minimize the extent to which government need participate directly in the game. The characteristic feature of action through political channels is that it tends to require or enforce substantial conformity. The great advantage of the market, on the other hand, is that it permits wide diversity. It is, in political terms, a system of proportional representation. Each man can vote, as it were, for the color of tie he wants and get it; he does not have to see what color-the majority wants and then, if he is in the minority, submit.

                                    --Capitalism and Freedom, Chapter 1

Fortunately, each woman can also vote for the color of scarf she wants. Unfortunately, at present, representation in both markets and the political system appears to be proportional to corporate size and income. And we, the economically and politically less powerful majority, are being asked to disregard that last little tremor in the financial sector so that the “wide diversity” of financial “innovation” can continue to misdirect capital, both financial and human, to where it will evaporate when the next bubble or Ponzi scheme implodes.

Magnetar and the challenges of financial regulation remind me of the early challenges in US food and drug regulation. You can read about them in Philip J. Hilts book, Protecting America's Health, in the chapter titled “Capitalism in Crisis.” Admittedly, Hilts appears to be no fan of capitalism, but the account he provides was also reported by Cynthia Crossen in the Wall Street Journal on October 3, 2005 (How Elixir Deaths Led US to Require Proof of New Drugs’ Safety). I note that the article appears no longer to be available from the WSJ, but I have a pdf version of it downloaded at the time that agrees in substance with Hilts.

In Hilts’ book we learn that it was difficult to get food and drug regulation in the US for a variety of reasons, most of which amounted to variants of the reasons we are having trouble getting financial regulation now. Like the more complex products of the finance sector, there was considerable information asymmetry in food and drugs markets. Manufacturers were not obligated to provide detailed information on contents, except the amount if any of alcohol, opium, cocaine, morphine, chloroform, marijuana, acetanalide, chloral hydrate and eucaine. (You can thank the Food and Drug Act of 1906 for saving us from unwittingly becoming a nation of addicts.) Manufacturers were not obligated to test products for efficacy or safety. They could label tap water as mineral water and sell it as a cure for rheumatism. They could claim cures for cancer or diabetes. Worse, they could put sugar in a drug marketed for treatment of diabetes or morphine in a drug marketed as a cure for addiction with little fear of prosecution under existing law. As long as their intent was to heal, there was little legal recourse if they killed people.They were playing by the rules of the game.

A confluence of jointly necessary, but individually insufficient, events eventually provided us with better food and drugs regulation. One reason I like the story is that an economist, Rexford G. Tugwell, figures prominently and positively. Tugwell was part of Franklin Roosevelt’s transition team in 1933, a professor of economics at Columbia, who was second in command at the US Department of Agriculture. As an economist, he knew that in the absence of full information, consumers could not be relied on to make efficient choices and he knew that there was nothing in the law or the prevailing social institutions that would compel drugs manufacturers to reveal all the contents of their products, much less test them for safety or efficacy. Nor would market forces make it happen. The preceding years had seen multiple deaths from improper canning techniques, loss of eyesight from use of aniline dyes in mascara, and pure and simple deceptions about ingredients in foods and drugs. Despite these, manufacturers persisted in producing and selling dangerous or useless products. When caught or when someone died, some simply changed the product name and continued to produce it.

Over a period of about four years from 1933 to 1937, Tugwell and Walter Campbell, head of the Food and Drug Administration (FDA), attempted to move a bill through the US congress that would strengthen the regulatory power of the FDA. In fact, one bill had already passed both houses of congress. I quote from Hilts, p. 88:

Eventually, one[bill] passed both houses of Congress, was agreed to by a conference committee of the two houses, and was killed by a Republican maneuver in the House of Representatives just before it could be sent for the president’s signature. Representative Clarence Lea of California killed the bill; he was close to fruit growers there, and they were incensed with the FDA’s attempts to cut back on the chemicals used to preserve fruit in drying and shipping.

Sound familiar?  Here’s Hilts again.

Drugmakers wrote that the bill would “Sovietize” drug sales in America and produce a “virtual dictatorship over trade.  

Sound familiar?

So how did we get an FDA that has some power to regulate?

Hilts tells us there were two critical elements: 1) a bill was already present in Congress and 2) legislators and significant portions of the public were paying attention when a crisis hit.

The crisis took the form of 107 deaths, most of them children, from a drug, Elixir Sulfanilamide, produced by the Massengill Company of Bristol, TN, in 1937. Massengill, in an effort to respond to customer preferences, had tried to make a sweet liquid version of the pill and powder form sulfanilamide that they already manufactured. So far, this seems like an example of the good that the market can do.  Sulfanilamide was a sulfa drug used to treat strep throat and respiratory infections. A sweeter, liquid version would be easier to administer to children. Market forces were working, just as Friedman predicted, to produce something more palatable to consumers. Good. Massengill’s head chemist determined that diethylene glycol (DEG), which has a sweetish taste, would solvate the sulfa drug. DEG is poisonous to humans, which was apparently not known (at least to the head chemist) at that time. Massengill bottled the elixir without testing on humans and shipped 240 gallons in early September 1937. Bad.

By October 11, the AMA had received an inquiry about the drug because six people in Tulsa, OK, had died after taking it. By the end of November, 107 were dead, not counting Massengill’s head chemist who committed suicide. FDA investigators had recovered 90% of the original 240 gallon shipment within 4 weeks of the first report of a problem.

The only law under which Massengill could be prosecuted was that the drug had been mislabeled (substances labeled "elixirs" had to contain alcohol). Massengill was fined $26,000 (about $240/death or, if I’ve done my arithmetic correctly, the equivalent to about $4,000/death in 2010 dollars based on the St Louis Fed's All Consumer CPI.) 

Samuel Massengill wrote to the AMA that the deaths were regrettable, but “I have violated no law.” Indeed, he had not. There was no law on the books that required his company to test for efficacy or safety any of the products they sold and that would be ingested by humans. Mr. Massengill and his company were playing by “the rules of the game.”

Representative Lea, under pressure from outraged consumers, released the bill and Franklin Roosevelt signed the Food, Drug and Cosmetic Act into law on June 15, 1938. It required manufacturers to demonstrate safety prior to marketing and it codified a scientific approach to doing this. In the long run, it proved a great boost to the drugs industry by sweeping out the low price, low quality, low or negative marginal benefit chaff that tends to dominate in unregulated markets where information is asymmetric. That it led to other problems is a topic for another blog.

The FDA story has always caused me to wonder: how does it happen that US voters are sympathetic or neutral to corporate pleas for protection from regulation that would benefit consumers? And why must children die or an economy fail before US voters are willing to apply sufficient pressure to lawmakers to obtain regulatory reform?

In the case of the FDA in the 1930s, consumers received very distorted news reporting because patent drugs advertising represented a large portion of newspaper revenues at that time. Hilts discusses the distortions that resulted from that conflict of private incentives and public interest. Modern news distortions may have less to do with advertising revenues and more to do with campaign contributions coupled to wholly-owned media outlets. The effect is much the same.

But I think it is more than that. I think voters are sympathetic, not to investment bankers, but to an idea. The idea results from uncritical acceptance of a syllogistic fallacy derived from American beliefs that we now take to be self-evident. Adam Smith may have said it first and best: “I have never known much good done by those who affected to trade for the public good.” The modern variant is "government is the problem." The logical fallacy is to conclude that, if true, it implies that those who affect to trade for private good always and everywhere benefit the public “which was no part of [their] intention;” that the pursuit of their own self-interested intention promotes the interest of society “more effectually than when [they] really intend to promote it.”  

In my very humble opinion, both Smith and Friedman were right only in very limited senses. Market forces will “reduce greatly the range of issues that must be decided through political means, and thereby to minimize the extent to which government need participate directly in the game.” But there are many markets where market forces are dampened or non-existent and where private and public interests will diverge without regulation. It seems to me that as we evolve and progress, new and complex innovations and even the quantity and nature of information itself have tended to obscure transactions thereby increasing the costs of and the need for determining and enforcing "the rules of the game." For these reasons, I’m almost certain that Smith would view the financial sector as more like the East India Company than like the butcher, brewer or baker, at least in terms of the public benefits it is likely to yield without regulation.

Contrary to Friedman, this is no “game.” In 1937, 107 (mostly children) died because basic, common sense regulation was not in place. In 2009, millions in the US became unemployed and thereby lost both their main source of income and their health insurance, many more lost value on their primary asset, their home. All of this because the regulation that would have prevented it, the rules of the game, had been dismantled over the last 30 years and what regulation remained was very weakly enforced.

Now (or soon) there will be a bill in Congress. A crisis has occurred. People are paying attention (not always to the best sources of information, but still paying attention). The rhetoric and tactics used by investment bankers are remarkably similar to those used prior to the 1938 passage of the Food, Drug and Cosmetic Act. I know I could have written all of this about Glass-Steagall, but I think it’s important to understand that this happens over and over and over again in many different markets and about many different issues that relate to the public good. The rhetoric seems never to change: “sovietize,” "socialist," "socialism," "stifled innovation," "liberty," "freedom," "hurt America." It doesn’t matter what the details are. It is a one-size fits all obstructive strategy that protects the interests of business and power at the expense of consumers, taxpayers, future generations, and the country as a whole. And it works nearly every time.

I fear that George Santayana was right and that we are doomed to repeat the Great Depression over and over again because we appear to have forgotten the lessons it taught us. I fear that Milton Friedman is right and that this is a “game” to some. I fear that Adam Smith is right and that “as merchants their interest is directly opposite to [the public] interest.” And I fear that misplaced tea bagger rage, unlike misallocated capital, is more newsworthy, more interesting and more understandable than CDOs and the ways in which Gyges gains unearned power and wealth, hidden behind the opacity of complex investment instruments. 

The rules of the game must be changed. They must be changed now. And they must be changed in ways that serve the public interest. Investment banks and bankers must be regulated. Leverage, transparency, size. I'm sure there is more. Toxic assets, toxic instruments, and toxic casino-like speculation are no different from toxic patent medicines. They harm us all.

Comments

[rjs]

unleashed again!

of course, i had been unfamiliar with the history behind the FDA, but the reaction of the drugmakers to attempts to strengthen it seem to me to be remarkably similar to the reaction of the banksters in this time magazine article it seems i was reading only yesterday...

http://www.time.com/time/magazine/article/0,9171,745617,00.html#ixzz0lqeB5Ghm

[Maxine Udall (girl economist)]

Unleashed, indeed, rjs, and VERY glad to be back. :-)

Wonderful link. I took the liberty of changing out my original Wikipedia link to Glass-Steagall for the one that you provided. Thank you very much.

It's interesting how regs opposed by the industry often benefit the industry (but not all firms) once they are adopted. In the case of the FDA pre-1938, HJ Heinz was developing methods to produce better ketchup with fewer additives, which there was some evidence that consumers preferred. The methods included fresher tomatoes, more sterile conditions, higher temps, etc. More costly, but a better, safer product. Heinz pushed for adoption of industry standards (which would have given them considerable market share at least at first so I doubt they were motivated by altruism in this). It was opposed by other firms because of the higher costs and the fear that they would be unable to compete successfully, losing mkt share. Since quality could not be easily observed, and in the absence of regulatory standards, competition on price resulted in a race to the bottom in food and drugs. I know Robert Frank has written about this. I hadn't given it much thought until I did the research for this blog. Your link seems to provide further evidence that firms are not necessarily the best judges or prognosticators of regulation effects.

Always nice to hear from you, rjs. :-)

[miguelitoh2o]

A big part of framing the message here is that those millions of unemployed Americans don't really resonate with the public sentiment vis a vis financial reform to the extent that 107 poisoned consumers did in 1906 with regard to the pharmaceutical industry. Unfortunately establishing a causal relationship between poorly designed financial products and deficient regulatory paradigm leading to lost wages and increased mortality rates is less obvious, (master of understatement am I), than that of bad drugs/food is with the food and pharmaceutical industry. Somehow, that relationship needs to be defined or described, if only in qualitative terms to drive this point home in terms, that might appeal to the sensationalism the press finds so irresistible in the drama of the tea-bagging contingent.

[rjs]

strangely enough, maxine, right after i posted the above comment i went to a site where they were complaining about this FDA action:

http://www.wnd.com/index.php?fa=PAGE.view&pageId=144557

i really didnt want to take you off the change the rules for the banksters topic, but im curious how you'd view this kind of enforcement...with the lax oversight on some more serious problems (ie, salmonella outbreak caused by tomato imports from Mexico) you'd think their resources could be better deployed...

(full disclosure: im in an Amish neighborhood)

[Maxine Udall (girl economist)]

rjs, I will be the first to admit that regulation is at best second best and I'm generally not in favor of it when markets work. On the other hand, what little I know about raw milk makes me think that restricting sales to the public might not be such a bad idea. As you point out, though, policing produce imports (and I'll add Chinese pharmaceuticals to the list) might be a better use of publicly funded time and money. Maybe domestic producers are easier, cheaper targets?

I keep wondering if maybe we have to admit we need guvmint oversight of some things before we can develop effective and efficient oversight methods? As long as we think it's the problem, we're not likely to get very good at it. Your link suggests we may have a ways to go. :-)

Miguelito, good to hear from you! You are right. I was hoping that by drawing an analogy between toxic patent meds and toxic financial assets, it might provide a framework for non-economists to think about financial regulation, the causal links you mention, and to recognize the importance in this case of changing the rules of the "game."

[K Ackermann]

Great article. I'm glad I clicked through to here.

I find the need for regulation to be self-evident. I hear complaints about regulation limiting profit, but every time regulations are relaxed, people die or economies crash.

[rjs]

Maxine: Jimmy Stewart is dead: Break up the banks

http://theautomaticearth.blogspot.com/2010/04/april-25-2010-jimmy-stewart-is-dead.html

;-)

[Maxine Udall (girl economist)]

Thanks, K.A. Click through anytime. :-)

Good link, rjs (as always). Is it Jimmy Stewart or George Bailey who is dead, I wonder? Jimmy's dad owned a hardware store in a small town and Jimmy, the actor, is indeed dead. I think we need George Bailey. :-)

[Peter T]

re Friedman's beliefs - does an informed quick glance around the world - or even the US - of now suggest more or less diversity than, say, 40 years ago?

One can believe in "markets", "biological destiny"", "the one true church" or whatever. I really have no problem with the belief. But any and all do not substitute for reality.

[rjs]

of course there are a lot of bloggers advocating reform and breaking up the banks, but knowing the Mr Potter / George Bailey metaphor was part of your repertoire, i couldnt resist linking you to that one...now the question becomes, if we change the rules of the game, how do we get enforcement of those rules if everyone is bought and paid for?

http://online.wsj.com/article/SB10001424052748704508904575192430373566758.html

[Maxine Udall (girl economist)]

Amen, Peter.

And speaking of reality...thanks for the link rjs. I had seen it. It's funny how you can agree with someone on the fundamentals and disagree on the conclusion. I seem to remember things deteriorating as we deregulated, esp repealing Glass-Steagall, and that they got worse as we experienced 8 years of laissez-faire regulation. I seem to remember that before Glass-Steagall was passed, we had more "volatility" in markets. (I'm practicing understatement here.) Interestingly, while I agree that capture is a problem and I worry about it, I keep thinking of people like Brooksley Born and Elizabeth Warren. I have trouble imagining them captured. If capture is the problem, maybe it's just a matter of picking the right regulator. O'Driscoll seems to be hoping we can call forth or transplant an "impartial spectator" within the breast of all accountants, raters, traders, CEO, loan officers. I actually think that over time that might be possible with significant changes in our cultural norms and narrative. (Don't ask me how that would happen.) To rely on an "inner regulator" as a strategy now seems unrealistically Utopian in light of recent experience. I think I would have to take a short position on it. :-)

[rjs]

sorry, maxine, im back with more reality; something i was just reading made me recall this:

The person who may be responsible for more food-related illness and death than anyone in history has just been made the US food safety czar. This is no joke.

http://www.huffingtonpost.com/jeffrey-smith/youre-appointing-who-plea_b_243810.html

[Maxine Udall (girl economist)]

My dear, dear rjs, There was a reason why I included the following in the above blog: "That it led to other problems is a topic for another blog." Your link demonstrates one of the problems: capture.

I in no way meant to imply that the FDA was perfect. The 1938 act was a marked improvement over the contemporaneous state of the world (much as the House and Senate finance reform bills would be an improvement over what we (don't) have now IMHO).

Capture, of course, creates regulatory inertia, makes it unlikely that any regulatory changes that do manage to be effected will benefit the consumer, and results in foxes appointed to guard the hen house. So what should we do? We're in a second best world, so it's going to have to be some combination of regulation, law, market forces when they work, and a personal commitment to ethical principles. (As I said above, I'm shorting the last.) Personally, I think it would help if people paid attention, but that's probably as Utopian as yearning for an impartial spectator to start whispering ethics to investment bankers in their sleep.

So my second best solution is regulation, now, before the next crisis.

Sorry if I left you with the impression that I think the FDA is a paragon of regulation. Thanks for the link. :-)

[ecrive]

Excellent analysis & well written. As for the implications for and challenges to implementation, the consequences of Public Choice (theory) and political contributions reform may dwarf financial industry reform.

[Peter Kurze]

A couple of weeks ago in reaction to this post over at Baseline Scenario,
http://baselinescenario.com/2010/04/13/michael-lewis-big-short/#more-7147 I started this:
___________

When I read stuff like this I can't help but think that it will never be enough to hem this game in with regulation. We need, to take a figurative phrase and apply it literally, a game changer. The game itself is wrong. These guys don't need to worry about blocking whatever regulatory scheme is proposed, all they need are a couple of little pinholes and regulation is a party balloon.

I keep coming back to something Wayne Gretzky said, “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.” I have no idea (and the regulators are pretty much in the same boat) what kind of schemes these guys will come up with to game the system, but I know what they are after, and for me, when all of the pluses and minuses have been tabulated, I would be willing to deny it to them by fiat. Let's just put a cap on income.

This is admittedly a draconian solution, and I am not even sure I like it much, but I like the simplicity of it. I like the idea of creating counter incentives, as opposed to rewards, for market distorting activity. I know there are lots of legitimate exceptions, but I do not see in general that at the high end of the income distribution curve there is that much meritocracy. If that is true, and I'm not entirely sure that it is, the question is, does the harm done to the exceptions outweigh the benefit to society of putting an effective end to this culture of malfeasance.

The standard argument against highly progressive tax schemes is that it destroys the incentive to work hard. I really cannot buy this argument. In the first place, if 500K isn't enough to get you up out of bed in the morning and doing your best, you are either a.) not motivated by money at all, b.) so jaded I don't want you anywhere near the finances of my nation, or c.) enough past it that it is time you focused on your begonias. But more importantly I don't believe that people who are passionate about accomplishing some worthwhile goal are going to be dissuaded by the fact that the financial upside is not infinite. If your goal is the acquisition of money for its own sake, without actually producing something of value, then it would be much more of a disincentive, and personally I'm just fine with that.

It's not even that I would object to a few people making an inordinately large fortune playing these kinds of games if the net effect was to accomplish something vital that is consistent with the concept of the general welfare. Instead though, what we have is a system that by its very nature poisons and distorts the ethos of the larger society. The term investment has for most become synonymous with speculation and ethical behavior in business has been redefined as just avoiding prison.
____________

I'm not sure I'd be willing to stand by it in a technical sense, but I wanted to throw it out there to stir the pot. Perhaps put another way it makes more sense. Would you be willing to forgo the possibility of ever becoming an oligarch in exchange for a guarantee to live in a world freed from oligarchy?