Numerous politicians have used the financial crisis as an excuse for increased regulation of financial markets. For example, House Oversight Chairman Henry Waxman recently moved to regulate the credit default swap market.
Credit default swaps are a form of insurance against bond default, except that you can buy a CDS without actually owning the bonds in question. The problem with the idea that this market is in need of regulation is that it has not actually failed. For example, the CDS market weathered the 72 billion dollar Lehman storm well. The Credit Default Swap market did face a crisis when Lehman failed, but private investors in that market managed this crisis without any help from government regulators.According to Eraj Shirvani at Credit Suisse “over the last 18 months, the CDS market, not the bond market, has been the only functioning market that has consistently allowed market participants to hedge or express a credit view”. This is an interesting comment. In 1948 FA Hayek pointed out how competition “is a process of formation of opinion … It creates views that people have about what is best and cheapest”. Mr. Shirvani has pointed to the function of competition that Hayek detailed in his 1948 essay on The Meaning of Competition. Traders in financial markets, or any markets, form opinions based on their experience in these markets, based on their knowledge of the conditions that prevail in those markets. It is through unregulated competition that markets work efficiently to form prices that reflect the most astute interpretations of available data.
In contrast to the market process, the regulatory process works according to empty conjecture and perverse political incentives. Congressmen like Henry Waxman and Barney Frank are determined to enact more regulation, but who knows more about the markets in question, these Congressmen or the traders to buy and sell in these markets routinely? Mr. Frank and Mr. Waxman do understand a few points clearly: increased regulation increase their power as politicians. They surely also understand that increased power over markets translates into increased ability to raise campaign contributions.
Economist Fred McChesney has examined the phenomena of rent extraction in detail. Rent extraction is the practice of using regulatory powers to pressure private interests into donating money to politicians or political parties.
Some critics of credit default swaps claim that their unregulated nature is dangerous. One NPR story blames credit default swaps for the financial crisis. AIG bet on the wrong side of the housing market through credit default swaps, and lost. NPR business correspondent Adam Davidson claims that the size of the CDS market makes the failure of AIG a threat to the global economy. Mr. Davidson should take note of the relative stability of the CDS market during this crisis. Mr. Davidson also worries that ‘nobody knows exactly who has them (CDS’s) and where they got them from’. In reality the participants to CDS contracts each know exactly who they are and who they are trading with. There is no problem with identifying the participants to these contracts, at least as far as the market itself is concerned, and this market is functioning well.
AIG failed not because the CDS market failed, it failed because they made bad decisions in the CDS market. That is the way this market works, if you make the wrong bets, you lose.
The truth of the matter is that the credit default swap market does not need regulators or politicians; it is the other way around. Politicians and regulators see a need for regulation in the credit default swap market because it is in their political interests to extend regulation to as many markets as they can. The success of this market is also something of an embarrassment to them. Every time a market succeeds without regulation, it makes advocates of greater regulation appear foolish, and regulators themselves appear useless at best. This is not just a matter of concern to investors. Given the relative success of this relatively unregulated financial market, the usefulness of government regulators and activist politicians to the general public is questionable. It seems that we do not need to fear unregulated competition. The only thing we have to fear is the fear that demagogues like Henry Waxman want to instill in us. They want to scare us into accepting new regulations that serve their political interests at the expense of our economic interests.
The views expressed in this paper do not reflect official views of The Coast Guard.
The Meltdown that Wasn’t, in The Wall Street Journal November 15th 2008
AIG and the trouble with Credit Default Swaps. NPR September 18th 2008
The Meaning of Competition, by FA Hayek in Individualism and Economic Order 1948
Money for Nothing: Politicians, Rent Extraction and Political Extortion by Fred McChesney 1997