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):
“The rules in place,” I said to myself. “What does this remind me of?” And then I remembered:
--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:
Freedom , Chapter 1
, 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:
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.
wrote that the bill would “Sovietize” drug sales in America and produce a
“virtual dictatorship over trade.
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.