The deregulation initiated by Thatcher and Reagan in the 1980s was a corrective, inspired by economic theory, for the U.S. and U.K. governments that had gone too far in their zeal to protect consumers. A new book argues that now the corrective has gone too far.
Market distortions
In 1971 I had just finished graduate school in pure mathematics and was trying to decide what to do next. A friend in the math department told me that a company called A. G. Becker was, “doing interesting things with mathematics.” I went for an interview, they offered me a job, and without thinking about it much, I took it.
In graduate school I had a stipend of $250 a month and supplemented it with earnings from computer programming at $3.50 an hour. Because of those side jobs, I was richer than most other graduate students. I bought an old car every year or two for about $25. I had few money worries. When Becker offered me $15,000 a year, I thought it was a princely sum. It was so excessive that later, friends of mine found uncashed paychecks in the glove compartment of my car.
Pure math teaches you little about the real world. When I joined A. G. Becker I didn’t know what stocks and bonds were. I may have thought they were different names for the same things. But I learned.
The cash cow of the division I was in, the funds evaluation division, was a study of the rates of return on investment on corporate pension funds. The study was presented to clients quarterly in a loose-leaf book filled with perhaps 100 graphs and tables, all displaying the same set of statistics in different configurations and different ways.
When I first heard how much Becker charged for this book, called the corporate funds evaluation service (CFES), I assumed I heard wrong: $20,000. It must have been $20, I thought. But then Becker started another service for institutional money managers, the ones who managed the corporate pension funds, called the institutional funds evaluation service (IFES) and sold it for $30,000. At this point I decided the numbers must be right but there was something about it that I wasn’t understanding. They couldn’t have been real numbers.
Indeed, they weren’t. Or rather, they were real to Becker – Becker received $20,000 or $30,000 a year depending on the service – but they weren’t exactly real for the client.
The $20,000 was in “directed brokerage,” also called soft dollars. Because the rates charged by brokers for transacting in a stock were fixed by the government – and were high – brokers couldn’t compete with each other by lowering their fees. So they competed by offering supplementary “free” services in exchange for a client’s promise to direct a certain amount of brokerage business to the broker. The client had to direct that brokerage somewhere, anyway1, so they might as well trade with the one that offered them the best “freebies.”
When I was at Becker, there was talk about the “big bang” that would come on May 1, 1975, in which broker fees would be deregulated, so the soft dollar model wouldn’t work anymore. I left the firm around that time so I don’t know what they did after that.
The luxury of flying in 1971
I was benefitting from another regulated industry while working for Becker, but didn’t realize it until I recently read the book, The Economists' Hour: False Prophets, Free Markets, and the Fracture of Society, by New York Times journalist Binyamin Applebaum.
Becker’s travel policy was that if you took a flight that was more than a certain number of miles (a flight between Chicago and New York qualified) you could fly first class. Most of the time, I flew first class. The food was fit for a king. The alcohol never stopped flowing. On some flights there was a regular bar you could go to, and other perks. I wondered how they could spare the room.
The reason was government regulation of airfares. In his book, Applebaum describes even more lavish services on airplanes that I don’t remember or wasn’t aware of. “Unable to compete by cutting prices,” Applebaum says, “airlines instead increased spending. In the spring of 1971, American Airlines removed forty seats from coach class on some of its 747s and installed a wall-to-wall lounge with a bar, armchairs, and cocktail tables for passengers on transcontinental flights. United responded by installing two lounges on its 747s. So American put a piano on each plane… A Wall Street Journal reporter sent to interview United management found guitarists waiting to audition.”
As we all know, air travel changed drastically after the Carter administration deregulated the airline industry in 1978.
The gas shortage
In the winter of 1977 I was part of a four-man partnership that consulted to institutional investment managers. One of our clients was a bank in Indiana. When we went to see them that winter, we found them in their freezing offices wearing several layers of sweaters under their suits.
The problem was a shortage of natural gas for heating. In the 1970s the theory of “peak oil” and “peak gas” received a lot of attention. The geologist M. King Hubbert had predicted in 1956 that U.S. oil production would peak and begin to decline in about the year 1970. He also predicted peak gas.
He proved right about the oil. U.S. production did peak in 1970 and began to decline after that; but as we know now, it was only temporary. New ways of extracting oil and gas from the earth have kept production increasing over time.
Nevertheless, when there were natural gas shortages such as the one our bank clients experienced in 1977, it was assumed that it was because we were running out of gas.
But the shortage wasn’t a real one – it was not a shortage of natural gas in the ground that could be extracted economically with current technology. It was a result of interstate price regulation. Prices for gas piped from one state to another were regulated at a low level, but prices for gas piped intrastate were not. As a result, gas producers preferred to ship gas within their own state, leaving consumers in non-producing states short.
The low interstate price and the limited number of customers in producing states where prices were higher meant that producers had little incentive to develop and commercialize producing fields. This caused shortages in some places. In the next year, the Natural Gas Policy Act of 1978 would deregulate gas prices, after which gas miraculously became abundant again.
The theory outruns its instantiations
Although these deregulations were counterintuitive to many at the time, and there was much protest and doubt about them, we now “know” that they were the right thing to do.
How do we “know”?
The reason is that we have internalized economists’ claims that deregulation frees up the market to reach its most economically efficient state. And we have internalized the implication that reaching the most economically efficient state is equivalent to achieving something like the 18th century philosopher Jeremy Bentham’s ideal of “the greatest good for the greatest number.”
But “the greatest good for the greatest number” has never been satisfactorily defined. Is it the aggregate of all “goods” summed over all people? What if a few people’s “goods” are a million times as valuable as the “goods” of hundreds of thousands of other people, whose “goods” are not very valuable at all. If that sum is as high as possible, is it still “the greatest good for the greatest number?”
Alternatively, does Bentham’s phrase imply some sort of maximin criterion, such as maximizing the minimum good? These are obviously two very different interpretations – though in the most extreme form of the economic theory that has been internalized by many, it satisfies both criteria.2
What about the criterion of minimizing absurdity? It seemed absurd to me that A. G. Becker charged $20,000 to $30,000 for a book of humdrum statistics, each page dumping much the same data in a different way. (In spite of what my accursed graduate school friend said, Becker was not, “doing interesting things with mathematics.”) It seems absurd now that American and United airlines put pianos and guitarists on their planes, taking up room that could have held passengers. And it seems absurd that natural gas in the ground that could have been sent to Indiana to heat a bank wasn’t sent there because of regulations.
But…is it less absurd now that air travel means being wedged into the minimum possible space – less than minimum for many Americans – and being served the equivalent of bad dormitory food, and sitting next to someone who may have paid one-fifth the airfare that you paid because of the peculiarities of profit-maximizing airline pricing?
The answer to those questions is that in the deregulation of broker fees, airfares and natural gas pricing, the situation is better now than it was before deregulation.
But that doesn’t mean that every deregulation improves the situation. Nevertheless, those who have too fully internalized the economists’ message that leaving things to the market will maximize economic efficiency tend to believe that the not-so-ironclad rules of economics say that it does.
In the case of airline industry deregulation, there was initially concern that airplane safety would suffer when corporate profitability was allowed to run loose. Miraculously, and happily, that has proved not to be true at all (although the recent case of the Boeing 737 MAX gives rise for concern).
But that does not mean that customer safety will be protected when any industry is deregulated. Though it may be debatable, deregulation of the financial industry increased customer risk and reduced benefits. For example in the 2007-2009 financial crisis, customers lost billions investing in collateralized debt obligations and other shaky instruments.
The economists’ hour
Applebaum’s interesting book traces the ascendancy of the economics profession over the last 50 years, from a profession that was largely looked down upon by the lawyers who held office and set policy, to one that is arguably thought of as one of the most exalted. Until the 1970s even the secretary of the Treasury and the chair of the Federal Reserve were not economists. Now, economists are not only almost always in those positions but are omnipresent in the setting of most private and public policies.
Applebaum plainly doesn’t believe this is necessarily a good thing. He lets that feeling show not so much in flat statements but in comparisons he makes. For example, in Chile (where the “Chicago boys” Milton Friedman and colleagues and their disciples, mostly from the University of Chicago, convinced the Chilean dictator Augusto Pinochet to adopt the economic policies they recommended – which he did but at the cost of executing thousands of dissenters) Applebaum notes that, “Wealthy Chileans are born in private rooms in private clinics…On the other side of town, at the city’s best public hospital, twelve mothers share a room on the maternity ward,” and, “In Lo Espejo, an inner-city neighborhood of dense housing projects, infant mortality was four times higher in 2000 than in Lo Barnechea, where the wealthy live in mansions on the lower slopes of the Andes.”
Applebaum inserts many quotes from Alan Greenspan, Larry Summers, Phil Gramm, and others that clearly show how blind they were to financial industry risk – presumably because of their conviction of the eternal verities of the economic theories that had so gripped not only their own profession, but beyond it.
And then, finally, toward the end of the book, Applebaum makes his moral crystal clear. It can be elucidated in a few direct quotes:
The idea of a marketplace regulated by its participants is fundamentally flawed. A half-century of experience with ‘self-policing’ has amply demonstrated that even the most sophisticated customers are frequently victimized by financial industry professionals. Markets run on information, and the insiders usually have more information.
…The absence of regulation is a license to steal. The average adult obtains a few mortgage loans in a lifetime, from bankers who make more loans before lunchtime. The paperwork is overwhelming; the language is impenetrable. And the most vulnerable borrowers often are least equipped to parse the details.
…Ben S. Bernanke, the Fed chairman during the crisis years, wrote in his memoirs that he finally reached a conclusion at odds with his intellectual upbringing. ‘We found it was almost impossible to write sufficiently clear disclosures for some financial products,’ he wrote. ‘Like flammable pajamas, some products should just be kept out of the marketplace.’ But that was after the crisis.
…Milton Friedman said of John Maynard Keynes that if he had lived long enough, he would have been at the forefront of the free-market counterrevolution. Perhaps if Friedman had lived a few years longer, even he would have recognized that the counterrevolution had gone too far.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, chief investment strategist of Compendium Finance, adviser to mobile financial planning software company Plynty, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.
1 It was realized by a few, and by many more later, that they did not have to do all those brokered trades because they could trade much less and still achieve the same investment return. That realization led to the rise of passive index funds.
2 Applebaum cites Kaldor-Hicks efficiency in which, under the “aggregate goods” criterion, as Kaldor wrote, “it is possible to make everybody better off than before, or at any rate to make some people better off without making anybody worse off” by redistributing the excess “goods” from those who are much better off to those who are worse off. However, Applebaum notes, “It is important to recognize that Kaldor did not care whether everybody was left unharmed. It was sufficient, in his view, that everybody could be left unharmed… As the economic philosopher Amartya Sen has noted, the sole purpose of this standard…is to justify policies that hurt people.”
More Fixed Income Topics >
