Markets need rules

July 9, 2009

NEW YORK, July 9 (Reuters) – Why are free marketers so afraid of rules? As regulators take a fresh look at the commodity markets, Wall Street and its defenders are again panicked that regulators will overreach.

No doubt regulation, when excessive, can be problematic. But energy markets are so totally unfettered, they can benefit from tougher rules, especially when it comes to transparency and excessive speculation.

Free markets are great, don’t get me wrong. As a product of the University of Chicago economics department, I’m not exactly keen on central planning. But excessively free markets can be dangerous, as the financial crisis has taught us only too well.

With few rules to control how and where it could profit, Wall Street facilitated any and all transactions that could generate a fee, regardless of systemic risk. In energy markets, speculation is largely unchecked, and the spillover effects to the real economy last summer were very painful.

The problem with my free-market-loving brethren is their obeisance to the concept above all others. Few realize they’ve forsaken a far more fundamental aspect of successful capitalist economies: the division of labor.

In successful economies, trade is paramount. Free markets play an important role, but so does specialization. When individuals can devote themselves to particular tasks for which they are suited, everyone benefits.

If I trust my mortgage lender will sell me a suitable loan, then I can let him worry about its Byzantine structure while I focus on what I do best. My productivity increases and society benefits.

Anyone in business knows how much trust matters on both sides of any transaction. When trust disappears, transactions stop. The market breaks down and individuals are forced to rely on themselves. In a perfectly free market, where economic Darwinism means competition always trumps cooperation, trade quickly grinds to a halt.

No one wants this. As economist Russell Roberts has argued, “self-sufficiency is the road to poverty.”

Laws align incentives so that cooperation can be more profitable than competition. So that individuals in the free market don’t have to worry about the market eating them alive.

Energy is a major economic input, of course. With few, if any, rules to keep volatility in check, we risk drastic cuts in productivity when volatility is severe. And for what? So that anyone, anywhere can gamble on the direction of energy prices? I fail to see how society benefits.

Current rules are clearly inadequate, so the discussion to have isn’t whether we should have rules; it’s what are the right ones. Federally established position limits may not be helpful, or perhaps more stringent exchange limits are what’s needed. In any case, it’s not an easy discussion to have while Wall Street tries to fight off rules of any sort.

As for transparency, there’s no such thing as too much. CFTC’s current trading reports are completely inadequate. And early proposals to increase disclosure don’t go far enough.

Correcting the way traders are classified is a start, but it would also be helpful to have data regarding trader positions.

None of the above is an argument in favor of price controls. If supply and demand dictate higher energy prices, so be it. In the end, society will benefit as higher prices encourage investment in alternate means of production. But higher prices driven by pure speculation do not increase investment. No energy company made long-term capital spending plans assuming oil prices north of $100, much less $147.

Right now, trading in energy derivatives is among the most unfettered markets we have. Surely it can benefit from some rules to strengthen its integrity. And that is what the CFTC is looking into. The risk is that the free marketers take such an extreme position, against any rules, that we miss the opportunity to have a productive discussion about what are the right ones.

When it comes to energy trading, it’s time to increase disclosure and reduce gambling. Orthodox free marketers need to realize that to protect market freedom sometimes we need better rules to keep markets from breaking down.

Reader note: for more details about CFTC’s announcement earlier this week, I recommend John Kemp’s excellent analysis.

One comment

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Rolfe the reason why commodities went haywire wasn’t because of the free market. It was because of the the low interest rate international Bretton Woods 2 system. Lets have a thought experiment shall we. Lets say we have a truly free market. This includes no central bank or fractional reserve banking. That pretty much takes out most of the fuel that was used to speculate on commodities. What would drive prices higher in this new system? Increased demand for commodities from the rest of the world and speculation. In this new system speculation would be used to price things in. There wouldn’t be enough money in the speculation market to move it for any substantial amount of time. Also remember speculation in this bubble was an effect of the Federal Reserve’s devaluing of the dollar. The dollar went down and oil went up. Investors finally caught on and thats when the $100-$150 spike happened. If the Fed hadn’t devalued the dollar all these years then speculation in oil wouldn’t had happened.

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