Montreal, January 15, 2009 • No 263


Harry Valentine is a
free-marketeer living in Eastern Ontario.






by Harry Valentine


          Many years ago, George Stigler was one of several economists awarded the Nobel Prize for his landmark historical research undertaken over several decades that illustrated how economic regulation ultimately failed over the long term. A colleague at the University of Chicago received the same prize for having used econometric methods to prove the same result. One likely explanation: as other pro-free market economists have observed, most regulators actually come from the very industries and economic sectors they are intended to regulate, and those regulated industries ultimately "capture" the regulatory process and use it to protect and further their own commercial interests.


          For example, Professor Robert Murphy of Hillsdale College recently undertook research into how the now notorious investment broker Bernard Madoff was able to operate his elaborate Ponzi scheme for as long as he did despite being under the watchful eye of the Securities and Exchange Commission (SEC). Murphy discovered that Madoff had several relatives and friends who worked for the SEC, and it was ultimately his sons who turned him in. The economic turmoil caused by the unexpected meltdown of the housing mortgage market led to the exposure of Madoff's Ponzi scheme. He succeeded for so long not only despite SEC regulation, but ultimately because of it.

Political Manipulation and Distorted Signals

          In the years that preceded the mortgage meltdown, the US Federal Reserve pumped billions of dollars of new currency into money markets with interest rates having dropped to 1%. As a means of encouraging greater economic activity in the USA, government regulators revised the rules of the game, and did so at a time of ultra-low interest rates that did not reflect any actual market conditions. This combination of below-market interest rates and revised regulation did create new economic activity in the American housing market. It also encouraged a massive malinvestment boom in the American housing market, accompanied by rapidly escalating housing prices that bore no relation to events in a market that would have been free from political manipulation.

          The ultra-low interest rates and revised regulations spread beyond the housing market. They infiltrated securities markets and sent distorted economic signals into many related markets. Entrepreneurs and businesses base their economic decisions on signals that emerge from market activity. One of the reliable methods by which to test for signals is to allow prices to fluctuate and to haggle in order to discover the peak prices the market will bear for various levels of production for numerous products and services. The market, however, can only provide reliable signals when it is free from political manipulation and when interest rates accurately reflect events and developments in various sectors of the market.

"A market that is rife with political manipulation and in which interest rates bear no relation to actual market events not only generates grossly distorted signals; most businesses and entrepreneurs simply have no way of discerning the accuracy of those signals."

          A market that is rife with political manipulation and in which interest rates bear no relation to actual market events not only generates grossly distorted signals; most businesses and entrepreneurs simply have no way of discerning the accuracy of those signals. If they want to remain in business, they have little choice but to respond to the signals they do get, irrespective of whether those signals accurately reflect the nature of the market or whether they are providing a distorted caricature of what is actually happening in the real economy. The meltdown of the American mortgage market illustrates the destructive effects of distorted signals propagated through the markets.

Hair of the Dog

          That meltdown is having a ripple effect throughout the American economy, as well as the Canadian economy. It has led to a decline in the demand for oil and a consequent fall in world oil prices that has in turn begun to have an impact on the economy of Alberta. Escalating oil prices over a year ago were caused by excess printing and circulation of new currency in the USA and distorted market signals for the automotive sector. American monetary policies that date back to before the escalation of oil prices created events in the American economy that led to a demand for large private vehicles like sport utility vehicles (SUVs).

          The combination of monetary policies, natural events, and political events caused oil prices to rise and remain high over an extended period of time. The American automotive sector received those market signals when sales of large vehicles dropped, leaving large stockpiles in manufacturers' parking lots. As a result, production and employment in Ontario's automotive sector have declined significantly. Politicians have agreed to bailout the automotive sector with easy loans to produce small, fuel-efficient vehicles beginning during a time of declining world oil prices. Somehow, the market is generating signals that lead decision makers to such a conclusion at a time of 1% interest rates.

          The American government has announced that it will increase spending in order to stimulate the economy. Leading politicians are calling for new money and more regulation as means of "getting the economy going." The problem is that the printing of new money and changing economic regulations are what created the current economic debacle in the first place. It's like trying to get a drunk sobered up and out of the gutter by giving him more booze to drink. Restrictions will be placed on him to regulate his behavior, to be sure, but they will simply be more elaborate versions of the kinds of restrictions in his life that caused him to drink to excess in the first place. Fortunately for actual drunks, Alcoholics Anonymous and similar programs are privately run and free from political intervention. If only the same could be said for the economy as a whole.