{"id":205270,"date":"2010-01-20T15:13:20","date_gmt":"2010-01-20T20:13:20","guid":{"rendered":"tag:business.theatlantic.com,2010:\/\/3.33861"},"modified":"2010-01-20T15:13:15","modified_gmt":"2010-01-20T20:13:15","slug":"a-free-market-needs-free-contracts","status":"publish","type":"post","link":"https:\/\/mereja.media\/index\/205270","title":{"rendered":"A Free Market Needs Free Contracts"},"content":{"rendered":"

Over at the Baseline Scenario<\/a>, Roosevelt Institute fellow Dan Geldon has an interesting guest post. He asserts that free market theorists ruined free market theory by fighting against excessive regulation. I think Geldon is close to making a good point, but doesn’t quite get there. There is a reason why the free market is having trouble these days, but I think it has more to do with the rationality constraint than not enough government intervention in contracts.<\/p>\n

Geldon’s post is quite long and very hard to sum it up in only a few words. But he essentially argues that the free market would only work if the government is there to sort of ensure fairness, through regulation. I don’t entirely disagree with that assertion. For example, I think it’s beneficial to the free market when the government takes antitrust action<\/a> when warranted. I also think it’s important that it ensures that firms can fail<\/a> — no matter how large or interconnected — without taking the economy down with them. <\/p>\n

So from a macro perspective, I see the need for the government to have its hands in certain aspects of the market. But Geldon calls for some more granular instances, like tighter control over contracts: <\/p>\n

The corporate assault on comprehensible contracts is important because contract law has been the bedrock of capitalism for a long as there has been capitalism. By enabling free choice, meaningful contracts maximize economic efficiency. The assumption behind von Hayek and other theorists is that robust contract law facilitates a vibrant economic system and minimizes the need for government intervention in the economy. But that went out the window when von Hayek’s theory itself was used to manipulate contracts. Now that products and fine print have become so perverted and incomprehensible, how can anyone expect contracts to steer the market in economically efficient ways?<\/p><\/blockquote>\n

I’m not as convinced as Geldon that lawyers or bankers drawing up tricky contracts have pictures of von Hayek hanging in their offices. But I think that the freedom to contract is important to free market theory. So while I do understand the problem that Geldon explains, let me try to put it another way. <\/p>\n

One of the base assumptions for free market theory is that the actors involved are rational. If that’s the case, precisely no one would ever enter into a contract that they don’t understand. As a result, these complex contracts would be mostly dead-on-arrival: those crafty bankers and lawyers would have no one to contract with, except for the other sophisticated parties who understand the contracts and won’t be fooled. <\/p>\n

So what happened over the past few years? Well, we live in an imperfect world where not everyone is rational. So when investors or consumers enter into contracts that they don’t understand, they often lose. This is regrettable, but it’s also just. No one is forcing those investors and consumers to buy, say, collateralized debt obligations or option adjustable-rate mortgages. I have long held a sort of Darwinian view of economics. If you’re dumb enough to risk your money through a contract you don’t understand, then you deserve to lose it. <\/p>\n

Unfortunately, life wasn’t that simple over the past few years. The mistakes of some cost many. But I would argue that this had more to do with a failure to provide for a more competitive landscape through the kind of macro regulation I support. For example, if you had an environment with higher capital requirements, lower leverage and all firms subject to failure, then the mistakes of some parties shouldn’t have affected the fate of all parties. Systemic risk mitigation is a legitimate regulatory goal. But I don’t see a place in that for contracts on a more granular level. <\/p>\n

Then, Geldon addresses something a little different and makes a fantastic observation, but comes to a slightly off conclusion. Here’s the good part: <\/p>\n

The greatest lesson from the crisis that we haven’t yet learned is that “industry interests” and “free-market interests” are not the same. In fact, they are more like oil and water, as the industry profits most in the absence of true market competition.<\/p><\/blockquote>\n

Geldon is absolutely right. Often industry will lobby government for anti-competitive advantage. That’s why big cigarette companies love current tobacco regulation<\/a>, for example. But here’s his slightly off-base conclusion: <\/p>\n

And so it should be no surprise that Wall Street has devoted itself to making contracts indecipherable, building boundless negotiating leverage and fighting for favorable breaks and regulation at every turn.<\/p><\/blockquote>\n

It’s just not this simple. As mentioned, much regulation actually benefits industries. For example, a consumer financial protection agency would likely end up benefitting big banks. They’ll understand the rules better for getting new products approved; they’ll be on better terms with regulators, which will increase the likelihood of getting their products through; they’ll have more resources through their scale to pay employees to deal specifically with CFPA issues. A CFPA would worsen competition for smaller firms in the consumer products space, but for whatever reason, big banks haven’t figured this out yet. So the idea that big banks are fighting a CFPA is actually folly on their part — ultimately they’d benefit. Smaller firms, however, would suffer. <\/p>\n

And meanwhile, consumers and investors should simply ignore products they can’t understand, or work to gain additional knowledge to enhance their understanding before buying. Then the free market would function well, without the need for an agency of bureaucrats who could very well make the same mistake that na\u00efve consumers would make through poor assumptions about finance. So actually, a well-functioning free market should conflict with a CFPA. <\/p>\n

But Geldon is also right — when it comes to systemic risk, like with leverage. There, industry interest definitely does conflict with free-market interests. Banks would lobby for unlimited leverage, but the free market would incur unlimited systemic risk as firms grow larger, more interconnected and more highly leveraged. <\/p>\n

Regulation is a complicated game, which is why I continue to say<\/a> that it should be considered as follows: will a given regulatory effort enhance or stifle competition? A good litmus test is imagining whether smaller firms will be better-off or worse-off if a regulation is enacted. Enhanced government contract control clearly fails this criterion — smaller firms would be better off with greater flexibility. Those parties should have the right to take that risk freely, so long as the economy on a whole is protected if the contract goes awry.<\/p>\n



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Over at the Baseline Scenario, Roosevelt Institute fellow Dan Geldon has an interesting guest post. He asserts that free market theorists ruined free market theory by fighting against excessive regulation. I think Geldon is close to making a good point, but doesn’t quite get there. There is a reason why the free market is having […]<\/p>\n","protected":false},"author":1535,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[7],"tags":[],"class_list":["post-205270","post","type-post","status-publish","format-standard","hentry","category-news"],"_links":{"self":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts\/205270","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/users\/1535"}],"replies":[{"embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/comments?post=205270"}],"version-history":[{"count":0,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/posts\/205270\/revisions"}],"wp:attachment":[{"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/media?parent=205270"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/categories?post=205270"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/mereja.media\/index\/wp-json\/wp\/v2\/tags?post=205270"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}