Wednesday, November 20, 2019

Capital market freedom

I gave a presentation on "capital markets" at the Hoover Centennial series on Tuesday.  Caroline Hoxby gave a clear  presentation on human capital, and George Shultz told  some great  stories  from his time in government. Judging from the questions, Caroline was the star and  I put them to sleep. Finance always does that. The  video:

Here is the text of my  presentation

Hoover  stands for freedom: ideas defining a free society is our motto.  And economic is a central freedom: You can’t guarantee political freedom, social and lifestyle freedom, freedom of speech and expression, without economic freedom.

Economic freedom applies to capital; to financial  freedom, as much as to goods, services, and labor.  Freedom to buy and sell, without a government  watching every transaction. Freedom to save, and invest your capital with the most promising venture, at home or abroad, or to receive investment from and sell assets to anyone you choose — whether the investments conforms to a government’s plans or not.

But freedom is not anarchy. Economic and financial freedom depend on a public economic infrastructure. They need functioning markets, property rights, an efficient court system, rule of law; They need a stable and efficient money, and a government with sound fiscal affairs  that will not inflate, expropriate, or repress finance to its benefit, and freedom from confiscatory taxation.

Here lies our conundrum. The government that can set up and maintain this public architecture can restrict trade and finance. Businesses, workers and other groups can demand protection. The government can control finance for political ends and to steer resources its way. And that ever-present temptation is stronger for finance. Willie Sutton, asked why  he  robbed banks,  responded   “that’s where the money is.” Governments have noticed as well.

Ideas matter. People care about prosperity, too. Citizens and voters must understand that their own freedom, and that of their neighbors, is the best guarantor of their and the common prosperity. 250 years after  Adam Smith, most of US still really does not trust that fervent competition is their best protection, not extensive regulation. See our rent control and labor laws. That necessary understanding remains even more tenuous in financial affairs

Can a more free financial, payments, monetary, and capital market system work? How? It is our job — ours, the ideas-defining-a free-society people  —  to put logic and experience together on this question. And the answer is not obvious. Finance paid for our astonishing prosperity. But the history of finance is also full of crashes, panics, and imbroglios. Government finance won wars, but also impoverished nations.  Economic freedom does  not mean freedom to  dump garbage in neighbor’s back yard. Just where this parable applies to financial markets is an important question.

The last 100 years have been a great  ebb and flow of freedom in financial and monetary affairs. The immediate future is cloudy, suggesting more ebb, but offering some hope for flow

Hoover scholars have been and are in the midst of it. Milton Friedman spent a quarter century here, advancing free exchange rates, free trade, open capital markets, sound money, and sound fiscal policy. John Taylor took up that baton. Allan Meltzer, author of the magisterial history of the Federal Reserve, was a  frequent visiting fellow here.  George Shultz spearheaded the transition to floating exchange rates and free capital movement, fought valiantly against price controls, and anchored the Reagan Administration’s effort to eliminate inflation and fix  the tax code. Many others contributed, and Hoover is just  as alive  today.

We  could  spend  an afternoon on the financial history of the last 100 years. I’ll just focus  on three pivotal stories.

Bank and financial panics have been central to the ebb and flow of financial freedom for all of the last hundred years. The banking  panic of 1933 was surely the single event that made the great depression great. It was centrally a failure of regulators and regulation. The Federal Reserve was set up in 1914, to prevent another panic of 1907.  And it promptly failed its first big test.  Micro-regulation failed too. Interstate banking and branch banking were illegal. So, when the first bank of Lincoln, Nebraska failed, it could not sell assets to JP Morgan, who could have  reopened the bank the next day. The bank could not recapitalize by selling shares.  So the people who knew how to make loans were out selling apples.

As usual, the response to a great failure of regulation was... more regulation. Deposit insurance protected depositors. But offering insured deposits to bankers is like sending your brother-in-law to Las Vegas with your credit card. So the government started extensively regulating how banks invested, and forbade banks to compete for deposits. But people in Las Vegas with  your credit card, for 20 years, get creative. From Continental Illinois to the savings and loan Crisis, to the Latin American and Southeast Asian crises, to LTCM, and Bear Stearns, and finally the great crisis of 2008, we repeated the same story: bailout larger classes of creditors, add regulations to try to stop more creative risk taking, add power to regulators who really really will see the next one ahead of time, promise it won’t happen again. Dodd Frank, and today’s “macroprudential” policy are not new, they are just the last logical patch on the same leaky ship.

An alternative idea has been around since the  1930s. Financial crises are runs, period. Runs are caused by a certain class of contract, like deposits, which promise a fixed value,  first-come first-served payment, and the bank fails if it cannot pay immediately. Then, if I hear of trouble at the bank, I run  down to get my money before you do, and the bank  fails. The solution is simple —  let  banks get their money largely by issuing equity and long term debt.  Such banks need no asset regulation, and no protection  from competition, as  they simply  cannot fail. Run prone short term debt financing is the garbage in the neighbor’s back yard, and eliminating it is the key to financial freedom — and innovation.

Many of us at  Hoover have been advancing this idea, adapted to modern technology, along with reform of the bankruptcy code so that large banks can fail painlessly, a lesson we should have learned from the 1930s. It is slowly gaining traction in the  world  of ideas, though not  yet in the world of policy. A lot of vested interests will lose money in this free world, not the least of which the vast regulatory bureaucracy and economists who serve them more welcome ideas.

Second, let’s talk about international trade and capital flows.  Financial freedom includes the right to buy and sell abroad as you see fit, and to invest your money or receive investment from wherever you wish, even if that crosses political boundaries. As always that freedom leads to prosperity.

The world learned a good lesson from the disastrous Smoot-Hawley tariffs of the 1930s. So, the  postwar order built an international system aiming for free trade and free capital markets.  Now  free trade and capital should be easy. They take one-sentence bills, ideally that start “Congress shall make no law…” But each government faces strong pressure and temptations to protect its weak industries, and their employees, and to redirect its citizens’ savings to pet projects, favored sectors, and to government coffers, mixed with frankly xeonophobic fears of “foreign ownership.” So the postwar order was a long hard slog, with international institutions, long international agreements that are more managed mercantilism than free trade, and consistent US leadership.  Capital  freedom took even  longer than trade freedom. As recently as the 1960s, US citizens were not allowed to take money abroad. Many people around the world still fact such restrictions.

This time, a crisis helped. The Bretton Woods system of 1945 envisioned free trade but little net trade, so it wanted fixed exchange rates and allowed capital controls to continue. The US deficits and inflation of the early 1970s blew that apart, leading to floating exchange rates and open capital markets.

By the 1990s, the world entered an era of vastly expanded trade and international investment, strong economic  growth. The last 30 years  have seen the greatest decline  in poverty around the globe in all human history. Now much-maligned “globalization” and “neo-liberalism” was a big  part of it.  I think we shall remember it nostalgically alongside the free-trade and free-capital pax Britannica of the late 19th century.

But crises often lead to bad policy in international finance as  well. The Latin American and Southeast Asian crises of the 1990s, even before the great financial crisis of 2008 unsettled many nerves. To me the stories look  familiar: Latin American governments borrowed too much money, again, and US banks found a way to leverage their  too-big-to-fail guarantees around the supposedly wise oversight of  risk regulators, again. East Asian governments were on the hook for their banks' short term borrowing and big American banks were lending again.

But the policy community, and countries wanting cover for bailouts and expropriations, convinced themselves that dark forces were at work, “hot money” “sudden stops,” and that all foreign capital — not just short-term foreign-currency debt — is dangerous and must be controlled. Now even the IMF, formerly the bastion of free exchange rates, free capital flows, and fiscal probity, advances capital controls, exchange-rate intervention, and government spending on solar cells and consumer subsides, in the name of climate and inequality, even in times of crisis.

Moreover, I think the world of ideas failed really to understand what it had created. For a generation economists scratched their heads that countries seemed to invest mostly out of their own savings rather than borrow from abroad, and called this a puzzle. When the world started to look like our models, and huge trade and capital surpluses and deficits emerged, economists pronounced “savings gluts” and “excessive volatility” needing “policy-makers” to “manage flows,” and lots of  clever economists  to  advise them.  Time-tested verities do not get you famous in economics.

Let me close by speculating a bit about the future. It will be an… well an exiting time for those of us who value ideas in defense of a free society and who think about money, finance, and capital.

Sooner or later, if  our path does not change, the western world will confront a sovereign debt crisis. Our governments have  made  promises they cannot keep, buttressed  by economists bearing the singularly bad idea  that  debts do not have to be repaid.  Since government debt is the core of the financial system, most of which counts on a bailout of borrowed money, the subsequent financial crisis will be unimaginably awful.

Payments,  technology and financial  innovation will force some fundamental  choices.

We are headed to a world of  electronic rather than cash transactions.  But cash has one great freedom-enhancing virtue: anonymity. If the government  can watch everything you buy and sell, or exclude people from the ability to transact, all sorts of freedoms vanish.  Now Governments have good reasons to monitor transactions  to better collect  taxes, and to make life difficult for criminals, drug smugglers, and terrorists. But governments have many bad reasons: to impose capital controls and trade barriers, to prop up onerous domestic regulations, and to punish political enemies, foreign and domestic.

So a great battle of financial freedom will play out. Will the emerging electronic payments  system work on the Chinese social credit model? Or  will innovation undermine leviathan — and  undermine even basic law enforcement efforts? Can we reestablish a balance between anonymity, freedom, and optimally imperfect enforcement of often ill-conceived financial laws and regulations?

In a larger sense, Silicon Valley is trying  to do to finance what Uber did to taxis. Will the Fed and Congress  allow narrow banks, electronic  banks, payments networks like Libra, and internet lenders to compete and serve us better? Or  will they continue to defend by regulation the oligopoly of banks and credit card companies?

Larger questions hang over us. On one political side seems to lie business as usual — unreformed, highly regulated banks, the usual subsidies  such as Fannie and Freddy, student loans, and so on, with increasing restrictions on international trade and investment. On the other side lies a large increase in bank regulation, direction of credit to green new deal projects and favored constituencies, and extreme levels of capital taxation. From the Fed, central banks, IMF, OECD, BIS, CFPB, and so on, I hear  only projects for ever larger expansion  of their role in directing finance.

I do not hear many voices for patient liberalization. Ideas defining a free society will be sorely needed.


The Q&A was interesting. John Raisian wisely preempted  the usual "what about inequality?"  question. My main regret was not answering cogently enough the questioner who asked (paraphrase) "Now that unions are gone, who will speak for the little guy (or gal)?" What I should have said, in addition to what I did say:

The little guy or gal voluntarily dropped out of unions, and voted against pro-union politicians, because they felt unions did not speak for them. If you're a Republican, a Libertarian, a fan of school  choice, concerned about pension debt, unions do not speak for you. A lot of formerly union people voted for Trump. Unions became government-supported advocates  for  one wing of one political party, and their members left in droves. Political  parties "speak for" you if you  wish someone to do that.  Not unions.


  1. Re: "The bank could not recapitalize by selling shares."

    Could you tell us why not?

  2. Re: "Now free trade and capital should be easy. They take one-sentence bills, ideally that start “Congress shall make no law…”"

    How can that work without going into the constitution?

  3. I largely agree with this post, but egads this is a horrible sentence:

    "See our rent control and labor laws"

    The movement for rent control almost always follows the imposition of property zoning.

    I dearly wish my free-market friends would be as fervent about the total and complete abolition of property zoning as they are about the total and complete and immediate abolition of rent control or minimum wage laws.

    Even worse, I think property zoning threatens to corrode free markets everywhere. Look at a Hong Kong, a Los Angeles, a New York, a London Toronto, a Montreal, a Sydney and Santigo. People are losing faith in free enterprise as rents are soaring out of control.

    Macroeconomists must engage in voodoo hedonics to conclude that people in those cities have higher living standards than a couple generations ago.

    A one-bedroom apartment in Los Angeles rents for an average of $2,500. But what the free marketeers tell to residents of Los Angeles is that the solution to their problem is to eliminate rent control and open borders for immigration and free trade.

    Do you wonder why Trump is in the White House, and that Warren maybe next?

  4. Excellent. But the elephant in the room is the government's power to coerce. Political freedom as espoused by Friedman; Political freedom means the absence of coercion of a man by his fellow men. The fundamental threat to freedom is power to coerce, be it in the hands of a monarch, a dictator, an oligarchy, or a momentary majority. The preservation of freedom requires the elimination of such concentration of power to the fullest possible extent and the dispersal and distribution of whatever power cannot be eliminated — a system of checks and balances.
    Ch. 1 The Relation Between Economic Freedom and Political Freedom, p. 15

    1. The way law leads to "freedom" is by creating laws that re-direct mans's selfish tendencies toward helpful behavior. An economic system that rewards helpful behavior will mean that the government doesn't have to do all that much "coercion."

      One huge missing link is the incentives of the government itself. The closer the government and it's officials are aligned with the well-being of the state, the better they will function. This would happen if the government collected revenues in terms of land value, or something else that's a proxy for the quality of life in the state.

      And, obviously officials should be precluded from owning assets that are not aligned with the national well-being. In 2019, with ETFs that track national real-estate, which follows the value of being able to live in a given country, officials should be prohibited from owning assets in anything but such instruments.

      If the above are implemented, the government's selfish tendencies will be re-directed toward improving national well-being

    2. Mr. Goldstein, You are conflating selfish with self interest. Clearly there is a difference with a distinction. Out of self interest, two parties enter into a contract voluntarily where both benefit. If there is a dispute between individuals, it is adjudicated by a court. I hardly trust that government and its (not it's) officials are aligned with the well-being of the state.

    3. OK, so let's change it to self-interest:

      The way law leads to "freedom" is by creating laws use mans's self-interest to promote helpful behavior.

    4. I also trust that government and not its (not it's) officials are aligned with the well-being of the state.

      Corporations have used stock-based incentives for a long time to much success. If governments implemented the same sort of governance that corporations do, they may end up with the same strategic abilities that corporations have. National governments should meet the standards of governance required by the SEC.

  5. Dr. Cochrane - I really enjoyed your exposition over the last 100 years, especially the bit and role about financing. I think economic freedom has a prerequisite of access to opportunity in order to experience that freedom. If the opportunity isn't there, how can this freedom emerge as a reality? Laws play a role in this because they confine or expand available choices.


  6. Sooner or later.... unimaginably awful. > It's coming people, and while one can't control the tide , one had sure as shit make sure their boat doesn't have any leaks. The Great Depression happened once, a greater depression will happen again.

  7. There's a huge problem with talking about "freedom" as if this were a solution. It is not.

    For example, "Freedom to buy and sell, without a government watching every transaction." sounds great, but we do need a law that requires transactions to be voluntary. How do you differentiate sales from thefts? At some point, you're going to have a law that applies to every economic act.

    Rather than just focusing on freedom without lending any rationale to why this would work, consider the following.

    - The point of law is to redirect selfish desires toward helpful behavior.
    - This is done by creating a game where those who help others gain the most.
    - The definition of "helpfulness" will be left, as much as possible, for individuals to define.

    What we mean by "freedom" is freedom to define what I consider "helpful" to me. This is done by my decisions on whether to pay for a service. When governments let people determine prices, they are "freeing" people to define what they consider helpful.

    Markets are a wonderful mechanism that converts individual sentiments about helpfulness into measurable prices. So obviously, we want to use that technology to define "helpfulness" rather than have the government do it.

    However, we still need the government to make sure the market-mechanism is working correctly. Many in the market have incentive to try to break it. The key things markets need are:
    - Accurate information (on pricing, goods available)
    - Open participation (which enables competition of buyers and sellers)
    - Enforcement of Human, contractual, and property rights.

    So, while we push for freedom on the definition of "helpfulness" we'll still need rigid enforcement of to enable the market to function in a way that maximizes net helpfulness.

  8. 'Freedom' is not the be-all or end-all that Dr. Cochrane's presentation makes it out to be. He mentions anarchy, a state of affairs in which there is an absence of governance or authority that controls the actions of individuals and groups in a society. Anarchy, however, is not the antithesis of Freedom--it is the logical result of unbridled freedom.

    Dr. Cochrane's notion of freedom requires that freedom be curtailed, that freedom be limited and strictly bounded. What Dr. Cochrane describes is a certain type of Utopia. In that ideal state, all will be free to enter into contracts of various forms to pursue ends that disadvantage none and only give rise to benign social outcomes. Absent governance and authority, attainment of such a state is not practicable. The strong will exploit the weak; naifs will part with their gold in exchange for glittery dross.

    Free trade is another Utopian ideal. The British advocated for it and tried it on, and lost their shirts. They conceived the Imperial System whereby raw commodities produced by the colonies would be acquired cheaply by manufacturers located in Britain for conversion into finished goods that were exported at dear prices to the colonies, creating, in effect, a system that stripped wealth from those colonies for the enrichment of British capitalists. The thirteen colonies were the first, but not the last, to rebel against that system.

    The Dominion of Canada announced that it would eliminate tariffs on goods imported from the United States in the hope that the States would reciprocate in kind. The U.S. did nothing of the sort, but flooded Canada with cheap manufactures that led to distress amongst Canadian manufacturers who could not compete and were pushed into bankruptcy. The Dominion's experiment with free trade was an abject failure; tariffs on imports from the US. were restored to the relief of the surviving firms. Free trade was demonstrated to be a fool's gambit, bar none, and Dominion has not repeated that folly since but continues to be entranced by the lure of a vision of the United States as some sort of benign uncle who will look out for its own interests all the while allowing its northern nephew to play in his backyard sandbox without fee or restraint. Today, Canada's freedom is in the gift of the United States.

    Do we have free trade today? Far from it. Though tariffs have fallen in many instances, non-tariff barriers to trade have increased to more than off-set the reduction in import excise taxes. Ironically, it is the U.S. which is the greatest impediment to free trade, even as it promotes free trade agreements that seek to dismantle its trading partners' tariff systems and usurp those governments' control over their internal domestic laws and programmes in order to serve American special interests both commercial and political while giving up none of its own internal controls and anti-free trade legislation.

    Little wonder, then, that Dr. Cochrane's presentation met with a tepid response. They've heard it all before. Water off the back of duck.

    1. The fundamental problem globally is that governments tend to cater to suppliers at the expense of consumers. The Canadian suppliers had a hard time, but the typical Canadian consumer benefited greatly.

      Because consumption is more closely aligned with happiness than supply, (in other words, you'd rather take a vacation than earn the money for it) a government that prioritizes consumption over supply when they come into conflict will, in the long run, end up with a better more wealthy country.

  9. The old "freedom equivocation" has reappeared, above in the flow of comments. What has been omitted is the idea of 'Rule of Law' as a distinctive component of 'Freedom' in a peaceful society. [viz. Hayek]
    This does not mean a Sheriff, but first it does mean some definition of Property Rights, and the development of tort law by consensus. That is freedom in society.
    Gorillas can have their wildlife freedom, but they cannot build a technological civilization. Freedom must be understood in human context.

  10. It's an interesting thing to think about that all types of freedom that you could name all really coincide with each other. You cannot have one without the other and they are all reliant on certain infrastructures. Loved the video and post and looking forward to what you post in the future Thank You!

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