Sunday, November 13, 2011

The True Cost of "Free Markets" without Regulation

The other day I attended a Continuing Legal Education ("CLE") class on the new Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank") which, if you didn't know, is the law created by Congress as a direct response to the events which led to the 2008 recession that we still find ourselves in today. I won't bore you with all the details, but the course basically talked about which parts of Dodd-Frank have already been put into place, which parts have yet to be implemented (which is most of it) and how we as attorneys should advise our Wall Street clients going forward.  During the presentation, the speakers brought up an interesting political fact: since the 2010 midterm elections, the Republican majority in the House of Representatives has consistently voted to defund the two branches of government most responsible for drafting the details of the regulations that Dodd-Frank requires: the Securities and Exchange Commission ("SEC") and the Commodity Futures Trading Commission ("CFTC").  Without funding, the SEC and CFTC literally do not have the money to hire the lawyers they need to draft the new Dodd-Frank regulations.

It struck me and most of my colleagues in the room as odd that, after what America has just recently gone through -- and for the most part is still going through -- that anybody could actually oppose putting regulations on Wall Street.  After all, has it not become painfully obvious to everybody that, if left unregulated, Wall Street -- like any other free market -- will invariably crash the economy?  That's what greed does.  It doesn't stop to notice that it is too big to fail, it just focuses on getting fatter.  And then when it fails, all people can say is "oops."  As if they didn't know it was coming.  But maybe that's the problem: people simply don't know.  There's a saying that those who don't know history are doomed to repeat it.  After hearing the behind-the-scenes measures that the Republicans have taken against Dodd-Frank, it appears to me that many Americans are in need of a history lesson.

The first market crash ever recorded was the Dutch "Tulip Mania" crash of 1637.  Tulips were first introduced to Europe from Turkey around the 1590's, and, for reasons that we may never understand, tulips (yes, the flower pictured to the right) became more popular than pants with pockets.  People began buying tulips as if tulips were the next iPhone.  The demand for tulips became so high in the Netherlands that the Dutch actually created tulip exchange markets (like today's stock markets) where people bought and sold contract orders for tulips (what we would call "futures contracts" today).  At the height of the market, one (1) tulip bulb was being sold for 3,000 Dutch florins; to put this into perspective, the average worker in the Netherlands during that time period made about 150 to 300 florins a year.  One (1) tulip was recorded as being sold for 200 pounds of wheat, 400 pounds of rye, 4 oxen, 8 pigs, 12 sheep, 2 cases of wine, 1,024 gallons of beer, 2 tons of butter, 1,000 pounds of cheese, a bed, a suit of clothes, AND a silver drinking cup.  All of that was paid for 1 tulip.  One European was on record as selling 12 acres of land for 2 tulips.

As you can see, folks were losing their damn minds.  The market for tulips was out of control, but the Dutch government did nothing to regulate the tulip exchange markets. The private Dutch Florist Guild, the body responsible for trading tulips on the open market, was "self-regulating."  Eventually, the inevitable happened.  On February 3, 1637, the price for tulips became too high for buyers and traders and, as a result, the tulip market crashed, leaving thousands of Europeans (ranging from the common man to the wealthy land owner) holding worthless tulip contracts.  As a response, the Dutch Parliament (the equivalent of our Congress) passed a law which allowed people to get out of their tulip contracts by paying a small fee, but this was too little too late.  The economy in the Netherlands and in Europe was damaged for many years to come.

About 100 years later, England experienced its first major market crash during the South Sea Company bubble of 1720.  Long story short, the British Parliament transferred the bulk of its national debt over into the hands of one trading company, the South Sea Company, in exchange for granting to them the exclusive right to trade stock on behalf of all of England with the South American colonies.  In addition, Parliament passed laws which prevented other trading companies (nicknamed "Bubbles") from competing with South Sea Company.  Furthermore, many members of Parliament and the British Crown invested heavily in the company's stock. This would be the modern equivalent of Congress buying stock in Goldman Sachs, transferring our entire national debt over to Goldman, and then passing laws to block JP Morgan, Merrill Lynch, Citi Bank, Morgan Stanley and the rest from competing with Goldman.  A veritable recipe for disaster indeed.  As you can imagine, South Sea's stock rose from £128/share in January of 1720 to nearly £1,000/share in August of the same year. Looking to capitalize on people's greed, South Sea Company actually loaned money to people on credit who wished to buy stock in the company.  When the first round of loan payments become due in August 1720, many people did not have the money to pay South Sea for what they owed.  All they had was a certificate of stock. Thus, many people were forced to sell their stock in order to make the loan payments to South Sea Company.  This rapid selling of stock by multiple people all at once dropped the stock price from £1,000/share in August to £150/share one month later in September. In other words, the market crashed.  The financial fallout from the market crash was widespread, affecting millions of people.  The people of England held recall elections and tossed out the entire British Parliament, replacing it with a new membership that put regulations in place that were effectively meaningless to the thousands of folks who had already declared bankruptcy.

Do any of these market crashing scenarios sound familiar to anyone?

The fact of the matter is, history is replete with scenarios where a market goes unchecked, the greedy masses jump on board, and then the bubble pops leaving everybody screwed:

  • 1637 - the Tulip Mania market crash.
  • 1720 - the South Sea Company bubble.
  • 1769 - the Bengal bubble.
  • 1796 - the land speculation bubble in England and the U.S.
  • 1797 - the Bank of England crash.
  • 1837 - the U.S. Bank financial crisis.
  • 1873 - the long depression in England and the U.S.
  • 1882 - the French stock market crash.
  • 1901 - the U.S. stock market crash.
  • 1907 - the U.S. stock market crash.
  • 1929 - the "Black Tuesday" U.S. stock market crash which led to the "Great Depression."
  • 1973 - the "Bretton Woods" stock market crash in the U.K.
  • 1987 - the "Black Monday" stock market crash of the U.S., Europe and Asia.
  • 2000 - the "Dot Com" bubble.
  • 2008 - the Sub-Prime Mortgaged Backed Securities market crash.

The obviousness of this historical pattern in the free market is beyond denial.  The only question is how many more times will we have to see it before people will begin to realize that we actually do need regulations on the free market?

Now before anybody accuses me of being a capitalism-hating communist, let me be clear: I'm not saying that capitalism or the free market are bad things.  Bubbles will happen naturally as the price of the next big shiny thing, whatever that happens to be, rises with demand and then falls after the demand is gone.  That, in and of itself, is fine.  So let me repeat, bubbles will happen.  Such is life.  What I take issue with, however, is the lack of common sense regulations that prevent the rest of the entire economy from going down the crapper along with everybody who decided to ride the bubble.

During the past several Republican Presidential debates, all of the GOP candidates have taken the position that the free market can do no wrong.  This could not be further from reality.  At some point we have to be honest with ourselves and admit that the unfettered market will not regulate itself as some conservatives like to claim.  History has shown us in unequivocal terms that when it comes to the free market there is one universal truth: the free market WILL ALWAYS need government regulation - the only question is whether we will choose to put that regulation in place before the market has a chance to crash or after the market has already done so.

1. What is your take on free market vs. regulations?
2. Are we doomed to repeat history?
3. Should Dodd-Frank be repealed as the GOP presidential candidates have suggested?
4. What can we learn from this brief history of the free market?
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