This issue Current issue

April 2009

The Failure of Free Markets

By Jonathan Wallace


            The “trickle down” theory of economics posits that measures such as tax cuts which benefit the rich, will eventually aid the poor as well, because the wealthy are encouraged to increase investment, grow businesses and otherwise stimulate production.

           Actually, economists complain that, formally speaking, there is no “trickle down” theory, that it is a frequently pejorative political phrase and not an economist’s term. “Trickle down” was frequently used as a synonym for “supply side” economics, later termed “Reaganonomics”, which posits that most good is done by actions such as tax cuts which reduce pressure on the suppliers, rather than the consumers, of goods and services. “Trickle down” and “supply side” were conflated by Reagan’s budget director, David Stockman, who told journalist William Greider in 1981, “"It's kind of hard to sell 'trickle down,…so the supply-side formula was the only way to get a tax policy that was really 'trickle down.' Supply-side is 'trickle-down' theory."

           The phrase “trickle down” traces as far back as the Great Depression and may have first been used sarcastically by comedian Will Rogers, who said that “money was all appropriated for the top in hopes that it would trickle down to the needy."

           According to Wikipedia, “Trickle down” was preceded in the 1890’s by the related concept of “horse and sparrow” economics, which held that if you fed enough straw to the horse, some would “pass through” to the sparrow (presumably this meant through the horse’s digestive system).

           Conservatives have usually disclaimed the phrase “trickle down”, if not the ideas underlying it, presumably because it is a queasy metaphor. It always made me imagine a raised wooden platform on which super-wealthy people toasted each other in champagne so wildly that they spilled much of each glass. Standing below the platform, their mouths open, were the desperately poor and homeless, hoping for drops of that now-filthy champagne.

           A rather more neutral metaphor one often hears in the same discussions is that “a rising tide lifts all boats”. This has been attributed to John F. Kennedy and to Irish prime minister Seán Lemass, and stands for the proposition that “improvements in the general economy will benefit all participants in that economy, and that economic policy, particularly government economic policy, should therefore focus on the general macroeconomic environment first and foremost.”

           This one, though not disgusting, is rather less successful as a pure metaphor, because the tide runs on its own moon-determined schedule. So it fails to communicate the idea of an action taken by government to benefit the wealthy which may also benefit the poor. It also misleadingly communicates a sort of economic equality: all boats, large and small, are at the same level, at low tide and high. There is no sense that the small boats are all chained to the large ones, and cannot be lifted on their own but only dragged higher by the others.

           Thirteen years ago, I came up with my own metaphor, that capitalism is like a lion harnessed to a sled. To a person of the left, which I am not entirely, this metaphor, it occurs to me now, might seem perfectly reversed: Capitalism rides the sled and the poor run in front, pulling it. Instead, I envisioned that American society rides (or is) the sled, politicians and businessmen the power which pulls it forward. The danger, of course, was that left unmanaged by a clever and attentive driver, the lion would eventually devour the riders. And I believe that has finally happened, this year.

Bubbles and slumps

           In the 1980’s, I first heard of Charles Mackay’s 1841 book, “Extraordinary Popular Delusions and the Madness of Crowds”, which was adopted as a sort of Bible by young Wall Street folk. Mackay, in clear, amusing language, sketched the history of a number of notorious early financial bubbles including the South Seas and Mississippi scandals and the even earlier tulip mania. (My favorite story from Mackay is that of the ignorant sailor who, mistaking it for an onion, ate a fabulously expensive tulip bulb he found lying on a merchant’s table.) I thought at the time that Wall Street people turned to Mackay for a better understanding of what to avoid, but in retrospect, I think the book may have been used an operating manual for the behavior which brought us the 1980’s real estate and S&L bust, the 1990’s Internet bubble and the subprime mortgage bubble of the 2000’s. (Semi-irrelevant note: I am very bothered that the shorthand we use to denominate the decades of history begins with the twenties, and the first two decades of a century have no nickname. I propose using “the oughts” and “the tens” and will henceforth do so.)

           The word “extraordinary” in Mackay’s title, if not mere hyperbole to sell the book, suggests that bubbles are not business as usual, but happen rarely and unexpectedly. This implicates another common belief, or, as it may be, ordinary popular delusion, the  idea of progress, which suggests that human society inevitably improves over time, attaining new levels of morality, comfort, technological capability, physical health, etc. Historian J.B. Bury, in his book “The Idea of Progress”, revealed the concept to be a Renaissance invention, departing from a Greek and Judeo-Christian fatalistic idea of history as a cyclical process, an “eternal return” of redemption and destruction.

           In public school in Brooklyn in the 1960’s, and I suspect in American education more broadly at least since the inception of the republic, we were fed the “idea of progress” as if it were mother’s milk, uncritically and as the cornerstone of everything we believed about democracy and capitalism. We were taught that the reality of democratic progress was demonstrated by the end of slavery and the increasing of civil rights in America. On the capitalistic side, it was illustrated by an eternally growing Dow, the rising tide lifting all boats. A few weeks ago, my brother forwarded an amusing email, listing books still available for sale on with names like “Dow 30,000” and “Dow 100,000”.

           It seems evident to me, based on my 54 years on earth and particularly the 44 or so I have been sentient enough to read “The New York Times” and understand the human spectacle, that the idea of  progress is a crock.   In order for human life consistently to get better, healthier and safer over time, we would have to be able (as a necessary but not sufficient condition) to learn from, and avoid our mistakes, instead of consistently making the same ones over and over again. If we do the latter, then history is indeed cyclical.

0.                  R.L. Nisbet stated that the idea of progress has the following components: i. value of the past; ii. nobility of Western civilization; iii. worth of economic/technological growth; iv. faith in reason and scientific/scholarly knowledge obtained through reason; v. intrinsic importance and worth of life on earth. In fact, we pay mostly lip service to these five principles, each of which is largely ignored (faith in reason), denied (worth of life),  or turned to destructive ends (technologic growth).


           Contrast Gibbon’s famous statement in Vol. I, Chapter 3 of “Decline and Fall of the Roman Empire”, that history is “indeed little more than the register of crimes, follies, and misfortunes of mankind.” This stunning insight has always resonated for me on the same level as Mr. Kurtz’s “Exterminate all the brutes”; to understand human history too well, is to journey to the heart of our darkness. In my senior year of college, after submitting a thesis charting the ways in which Roosevelt’s failing health contributed to his making too many concessions to Stalin at Yalta, I was instructed by my advisor to graft on a “theory of decision making” to my work. (“Take this fish and put legs on it.”) I learned that day how shapeless and depressing an unvarnished account of reality is, even to very intelligent people.

           From 1995-2000, thus during the height of the Internet bubble, I was the CEO of a small Internet consulting firm hoping to go public, and a shareholder and director of a larger software consultancy which did go public. I totally bought into the idea that Internet firms were “exceptional” in the fundamental sense of the word (not bound by traditional rules of commerce). However, when the Internet bubble ended, I had that mental click which alerts you something absurd is over, and we have reverted to the harsh realities of known rules. As if gravity and even entropy had been suspended a while, then kicked back in.

           Now that the subprime mortgage bubble,born during the last spastic spatterings of the Internet bubble, has collapsed, I wonder, for the first time, whether bubbles really are extraordinary. I seem to have spent my whole work life, 1980 when I took my first law job to 2006 when I retired, living from bubble to bubble with momentary contractions (80’s real estate and savings and loan; 90’s Internet; Oughts’ mortgage). If bubbles and  slumps are the exceptions, where does one find the baseline? The bubble which ended in 1929 led to a slump, the Great Depression, which wasn’t corrected until the 1940’s. Stocks did not recover their pre-1929 values until the 1950’s. If we can point to the 50’s and the 60’s as a time of slow, steady and safe economic growth, is this really the baseline or is it, itself, the exception? By analogy, are wars extraordinary events, or the peace which occurs between them? Was the 20 years of relative stability between the end of World War I and the outbreak of World War II a baseline or the extraordinary occurrence which interrupted it?

           I believe that we do not learn from our mistakes; that our history is cyclical, rather than a straight progressive line; and that the norms of our economic life are bubbles and slumps.

Tiny bubbles

           The economics of stock trading are very far removed from the economics of running a business. Stocks triple in value or crash sometimes based on mere rumors, or without anyone even knowing why except for a select few going long or short on them (who may themselves be cynically trying to produce a result without any inside information). In the meantime, in the real worlds of retail, construction, food service and the like, businesses rarely if ever triple their value legitimately in the space of a year, let alone a week or a day. This kind of swing is reserved for the stock market, where stocks are bid up based on rumors or on analysts’ evaluation of news, speculation, SEC filings and press releases.

           Wikipedia defines an economic bubble as ““trade in high volumes at prices that are considerably at variance with intrinsic values”. While we tend to use the phrase to denote periods in which large masses of individual stocks go wild, this definition tells us that a single stock which trades in excess of its intrinsic value is “bubbling”. Since this phenomenon is the reason why anyone invests in public stocks, instead of stashing their money in T-bills or CD’s, it means every investor is hoping that a bubble will occur, and that the stock market is fueled by daily bubbles in one stock or sector or another. Every investor is gambling on two things: that one or more individual bubbles will benefit him; but there won’t be so many simultaneous bubbles, growing so rapidly at once, that the entire market will crash, depriving him of his individual gains.

           Looked at this way, it becomes evident that the market is a commons and that a bubble is a tragedy of the (unregulated) commons. In the original parable, every shepherd wanted to graze as many sheep as possible on the local fields, while counting on the sum of all shepherds not to add so many sheep that the fields are destroyed.

           Everyone is relying on collective wisdom without displaying it individually, and in fact the system gives no individual any direct incentive to be wise. A factor accelerating the destruction this time around was that every player, from the CEO to the lowest of the traders, was paid on a bonus or commission scheme where immediate results were encouraged, and long term thinking was penalized. It is as if every shepherd was paid a certain sum per sheep. Add enough this year and you can earn enough to retire on; fuck the future and those who come after.

The invisible hand

           What the hell is the “invisible hand” of the market, which is supposed to prevent bad things from happening?

           Adam Smith first used the phrase in book IV of “The Wealth of Nations” (1776), discussing the unintentional good resulting from a merchant’s preference for domestic manufactures for his own protection:

By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.  

           The Libertarians have taken this concept and run it through the goal-posts, off the field and into the next county. According to them, or at least their youngest, most ideological adherents, businesspeople will always be led by self interest to make the exact choice which serves the long term interests of all. In their opinion, the tragedy of a commons is solely that it has no individual owner; if it did, it would never be over-grazed. In a 1997 article, “Why I Am Not A Libertarian”, , I proposed a thought experiment in which coral reefs had private ownership. Here is a variation on that idea. Imagine that Florida’s formerly magnificent Pennekamp Coral Reef was deeded to an individual owner, who made a half million dollars a year selling permits to individual scuba divers and snorkelers who wished to visit it. By carefully regulating the number of people who visit the reef every year, the owner ensures that it will survive in good condition to be passed on to his children for their support (and also possibly encourages demand by limiting its fulfillment). However, one day the owner becomes aware of a new, transient fad (or bubble) in coral jewelry and does a private calculation that if he dynamites the reef, and sells the pieces, he will be able to realize five million dollars (ten years’ revenue) at once. He can invest this money at five percent and make $250,000 per annum without any overhead or the headache of actually running a business, and still have something to leave to his children and grandchildren. A rational businessman without any moral qualms and without any government regulation limiting his freedom of action, would be extremely likely to dynamite the reef. I noted in the 1997 article that there are two kinds of Libertarians, the older, more cynical ones, who know the owner would dynamite the reef and think (in the world of private property and limited government) that that is really all right; and the young and foolish ones who firmly believe that the “invisible hand” would never let that happen.

Who do the Libertarians blame?

           The Cato Institute is the pure, uncompromising bastion of Libertarian thought, untainted by the deals with the devil of big government other self proclaimed conservatives always seem to make. In a briefing paper issued last November entitled “How Did We Get Into This Financial Mess?”, ( Cato adjunct Lawrence H. White, an economics professor at the University of Missouri, disposes of the issue of blame in one stunning paragraph:

Some commentators (and both presidential candidates) have blamed the current financial mess on greed. But if an unusually high number of airplanes were to crash this year, would it make sense to blame gravity? No. Greed, like gravity, is a constant. It can't explain why the number of financial crashes is higher than usual. There has been no unusual epidemic of blackheartedness.


           This is a great example of an a priori fallacy, or what I call hanging one’s argument from a skyhook; there is nothing the least bit empirical about any of the assertions made in the foregoing (“greed like gravity is a constant”?). Like other documents asserting that things are “self evident” which are not (of which the Declaration of Independence is a prime offender), White’s report assumes as true things which need to be investigated and proved.


           Instead, White blames the same government which Presidents Reagan, Bush, Clinton and Bush stripped of much of its remaining authority over markets:

The actual causes of our financial troubles were unusual monetary policy moves and novel federal regulatory interventions. These poorly chosen policies distorted prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions.


I remember a Somali businessman, interviewed some years ago in the New York Times, longing for a strong central government in that anarchic land, so that he and every other entrepreneur would be relieved of the need of providing his own military security. I called Somalia then the “libertarian paradise”, a not very original trope--search for it on Google and it pops up in hundreds of exemplars, most of them linked to essays mocking the Libertarian creed. I found a number of angry responses, pointing out that Libertarians do not support violent disorder, gang killings, rule by strong-men, and other features of Somali daily life. But, supporting the proposition that sufficiently ideological Libertarian creeds are virtually indistinguishable from satire, here is an article on the Ludwig Mises Institute website which actually does defend the proposition that Somalia is better off without a government: “Stateless in Somalia, and Loving It” by Yumi Kim,


Somalia has done very well for itself in the 15 years since its government was eliminated. The future of peace and prosperity there depends in part on keeping one from forming.


           Kim, writing in 2006, blamed the violence occurring then not on statelessness, but on the threat of a state:

Rival gangs are shooting each other, and why? The reason is always the same: the prospect that the weak-to-invisible transitional government in Mogadishu will become a real government with actual power.

           One of the rules of the Libertarian playbook seems to be: always blame the government, no matter how weak it is, even if it is vestigial or nonexistent.

Who Do Other Players Blame?

           I was interested to see what people who actually wielded power in the 1980’s and 1990’s said on the subject of deregulation, greed and an unfettered scope of activity for the invisible hand.

           In my opinion, one of the big unsung villains of our era is former Texas senator Phil Gramm, who championed the effort to deregulate banks and insurance companies and to keep the government from monitoring the new, abstruse forms of derivatives such as credit default swaps. One of Gramm’s successful crusades was the repeal of Glass-Steagall, the depression-era law which separated commercial and investment banking, so that banks could never again bet their deposits on highly speculative securities. At the 1999 signing ceremony for Gramm-Leach-Bliley, the repeal act, Senator Gramm proudly said:

In the 1930s, at the trough of the Depression, when Glass-Steagall became law, it was believed that government was the answer. It was believed that stability and growth came from government overriding the functioning of free markets.

We are here today to repeal Glass-Steagall because we have learned that government is not the answer. We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom.

           In a 2008 interview with U.S. News, Gramm, now a private lobbyist, refused to see any link between the repeal and the disaster that ensued:

On a related point, there has been harping of late on the repeal of Glass-Steagall in 1999. Was that a good idea in retrospect? 
I see no evidence whatsoever that the subprime problem was in any way caused by making our financial structure more competitive by allowing banks and securities companies and insurance companies to compete against each other. I have seen no evidence whatsoever to substantiate that claim.


The subprime problem came from an extraordinary run-up in housing values beginning in 2000 as we were in a recession and the Federal Reserve cut interest rates; it was a very unusual recession in that investment had collapsed but home building and consumption were strong, so the monetary policy that was aimed at stimulating the economy [also] stimulated an industry that was in boom condition. Housing prices rose faster than at any time except right after World War II, when wage and price controls came off, and that created this speculative demand.


And secondly, America's policy to try to encourage home ownership by making down payments lower and lower and lower until they were  that has anything to do with banks and securities companies and insurance companies competing with each, nor did it have anything to do with the syndication of mortgages, which were old hat by that point. So I think that what always happens in these cases is that it depends on what your agenda is, as to what you want the cause of the problem to be.

           Gramm, like White and Kim, hews to the Libertarian playbook and blames the same government which he successfully prevented from regulating the banks. Gramm entertainingly said last fall that the economy was fine and that its problems were caused by our imaginations, because we are a “nation of whiners”. After this comment he was forced to resign from the McCain campaign.

           The most poignant quote I found was from Bill Clinton, who also has his own legacy to protect. Clinton was smart enough and compassionate enough to make a good liberal president, but also something of a fuck-up. When faced by strong Republican opposition ready to stonewall him on every front, Clinton went with the flow, which included signing Gramm-Leach-Bliley. Here is a Businessweek interview:

BW:Mr. President, in 1999 you signed a bill essentially rolling back Glass-Steagall and deregulating banking. In light of what has gone on, do you regret that decision?


Clinton:No, because it wasn't a complete deregulation at all. We still have heavy regulations and insurance on bank deposits, requirements on banks for capital and for disclosure. I thought at the time that it might lead to more stable investments and a reduced pressure on Wall Street to produce quarterly profits that were always bigger than the previous quarter. But I have really thought about this a lot. I don't see that signing that bill had anything to do with the current crisis. Indeed, one of the things that has helped stabilize the current situation as much as it has is the purchase of Merrill Lynch (MER) by Bank of America (BAC), which was much smoother than it would have been if I hadn't signed that bill.

BW:Phil Gramm, who was then the head of the Senate Banking Committee and until recently a close economic adviser of Senator McCain, was a fierce proponent of banking deregulation. Did he sell you a bill of goods?

Clinton: Not on this bill I don't think he did. You know, Phil Gramm and I disagreed on a lot of things, but he can't possibly be wrong about everything. On the Glass-Steagall thing, like I said, if you could demonstrate to me that it was a mistake, I'd be glad to look at the evidence. But I can't blame [the Republicans]. This wasn't something they forced me into. I really believed that given the level of oversight of banks and their ability to have more patient capital, if you made it possible for [commercial banks] to go into the investment banking business as Continental European investment banks could always do, that it might give us a more stable source of long-term investment.

           Clinton is not alone in his reference to Bank of America; commercial banks being strong enough to step in and putatively save faltering investment banks was a major theme of conservative voices last fall, defending the Glass-Steagal repeal. Immediately afterwards, we learned that America’s biggest banks, BOA and Citi, would fail immediately without government subsidies. BOA in fact has almost choked to death on Merrill. Nonetheless, the right wing punditry has not lined up to issue any mea culpas or to acknowledge that repealing Glass-Steagal may have been an error. So much for the idea of progress, and especially the proposition that we learn from our mistakes.

Meanwhile, in the real world….

           Try a Google search along the lines of “Lehman greed” or “Merrill greed” and the screen will flood with articles attributing everything that has gone wrong to the greed of one institution or another, or to bankers, traders and CEO’s in general. The New York Times for March 17 reports on a lawsuit brought by the state of New Jersey against the defunct Lehman Brothers, seeking to recover $118 million in pension funds:

The suit, filed in State Superior Court in Trenton, contends that a “thirst for profit” and “simple greed” by the Lehman executives, including the former chief executive Richard S. Fuld Jr., caused the firm to misstate its financial position when the state bought $182 million of Lehman shares in April and June 2008.

From a September 2008 article in the UK edition of Money magazine, entitled “How the Lehman Brothers' Greed Affects You”:

Lehman et al have been engaged in a feeding frenzy of greed for decades, ever since the Thatcher/Reagan axis removed market controls that were put in place specifically to prevent the kind of insane risk taking that precipitated the 1920s crash and subsequent depression.

CBS co-anchor Harry Smith writes in an article entitled “Greed, Hubris Led Up To Lehman's Fall “:

it looks more and more like some of biggest players on Wall Street simply didn’t know when to back away from the table. That greed and smug awareness that they could do no wrong will cost them houses in the Hamptons, and some of the other baubles that go with their positions.

           While pundits run in packs, yammering today’s sound-bite, sometimes the obvious perception is the correct one. If not greed and associated stupidity, why did CEO’s bet the entire business on bad paper? Noblesse oblige? Civic responsibility? Because the government asked them to?

           Greed satisfies Occam’s Razor: it is the simplest, most credible explanation for the mess we are in.

Is Greed Ever Good?

           Even if greed is a constant in every human heart, like every human vice it’s harmful effects can be punished by government action or encouraged by government complacency. Laws, which are at least somewhat useful in deterring murder, rape and burglary, may also be applied to deter the predation caused by greed. In fact, aside from self regulation which has resoundingly failed every time it has been tried, (we don’t leave it to the rapists or burglars to regulate themselves), the chief means of restraining greed in the financial world is government action.    

           Getting back to the sled metaphor: is it possible that the only means to advance our interests and well-being is to harness our sled to an animal which may devour us at any time, which in fact regards devouring us as being the cornerstone of its philosophy? Does the invisible hand really mean that every day, we have to hope the predators pull us instead of turn on us? Following the through-line of the metaphor, Libertarians tell us that we are not permitted to whip, or even to guide, the lion pulling the sled, because it knows best where to go, and will refuse to pull if any coercion is applied.

           Libertarians and others scream that big government leads to Socialism, which ends in the expropriation of property. What would you call the fact that forty percent of my net worth vanished last year, due to business manipulations I had no part in? I have no mortgage, no credit cards, no debt and I personally never traded in any kind of subprime securities. I call what happened to my money, and that of millions of other Americans, an expropriation by the greedy few, who gambled my belongings away along with their own.

           Are we required to accept bubbles and slumps as the “price we pay for liberty”? Does Phil Gramm privately believe that depressions (and the dynamiting of coral reefs) are ordinary occurrences, facts of life, bumps in the road of free markets?

           Here is another thought experiment I favor. If handed the opportunity to colonize a brand new Earth-like planet with 10,000 friends, what position would you take on your new government’s responsibilities in the meeting held the first week of colonization to frame it? Would you want it to protect you against frauds and cheats, against greed and exploitation? I would.