Economics

Appelbaum.

Binyamin Appelbaum's powerful new book The Economists' Hour: False Prophets, Free Markets, and the Fracture of Society is a lively, colorful, and highly insightful contemporary economic history. The arc of the book follows the seemingly unstoppable emergence of the free market theories of Milton Friedman all the way through to the discrediting of those theories in the wake of the global crisis of 2008. The full panorama of personalities are here, from Kahn, Burns, Volcker and Greenspan to Carter, Reagan, Bush, Clinton and Obama, with a smattering of personalities such as George Schultz, Wendy and Phil Gramm, and Marty Feldstein along the way. The following is a brief excerpt on financial derivatives from the book. The economic establishment had protected derivatives from regulation in the late 1990s, but that came back to haunt the global economy in the crisis when a form of derivatives called credit default swaps added billions in losses:  "Shortly after Brooksley Born became the head of the Commodity Futures Trading Corporation (responsible for regulating commodities, futures, and other derivatives) in August 1996, taking the job once held by Wendy Gramm, Born was invited to lunch by Alan Greenspan, who explained his view that markets would police fraud. Born was bemused: as a lawyer, she often had represented the victims of financial frauds. Her clients had included victims of the legendary effort by the Hunt brothers, a pair of Texas oil heirs, to corner the market in silver in the late 1970s. She knew the Hunts had not been stopped by the market; they had been stopped by the CFTC. "The market in credit derivatives soon caught Born's attention. She was struck by the industry's adamant opposition to the most basics forms of regulation, like record keeping and reporting. 'That puzzled me,' she said. 'What was it that was in this market that had to be hidden? Why did it have to be a completely dark market? So it made me very suspicious and troubled.' In early 1998, her staff began to prepare a tentative first step toward regulation, a request for public comment. Before the industry even had a chance to object, however, the Clinton administration tried to shut down Born's plan. According to the Washington Post, Larry Summers, then a deputy to Treasury Secretary Robert Rubin, called Born and told her, 'I have thirteen bankers in my office and they say if you go forward with this you will cause the worst financial crisis since World War II.' That April, Born was summoned to a meeting with Rubin, Greenspan, and Arthur Levitt, the chairman of the Securities and Exchange Commission. The men took turns telling her to drop the issue. "The aversion to regulation had reached such a pitch in Washington that a proposal to talk about proposing rules had caused a firestorm. "Born released the proposal, which did not cause the predicted crisis. "It did, however, prompt her opponents in other parts of the government to issue an extraordinary public statement expressing 'grave concerns,' questioning the CFTC's authority and urging Congress to intervene. At a hearing in July, Summers told Congress that Born had 'cast the shadow of regulatory uncertainty over an otherwise thriving market.' He had a sympathetic audience: Phil Gramm. 'I see no evidence whatsoever to sug­gest that this is a troubled market,' Gramm said.

Brooksley Born, the Commodity Futures Trading Commission chairman under President Clinton testifying on Capitol Hill in 1998. (Washington Post photo by Ray Lustig.)

"Less than two months later, a fresh batch of evidence landed with a thud. Long-Term Capital Management, a massive hedge fund led by some of the very Chicago professors whose theories underpinned the case for deregulation, collapsed in spectacular fashion. The lack of regulation, rather than its prospect, had once again caused a crisis. Born described it as a 'wake-up call,' but no one else stirred. Summers and Greenspan already knew markets were prone to breakdowns. Neither believed that markets were perfectly efficient. Summers was the author of an immortal five-word rebuttal: 'There are idiots. Look around.' Greenspan, contrary to some caricatures, had a healthy fear of financial crises. But both men regarded market discipline as the better of two imperfect options. When Congress summoned the wise men again in late 1998, following the collapse of Long-Term Capital, Greenspan testified, 'I know of no set of supervisory actions we can take that will prevent people from making dumb mistakes.' "The Clinton administration asked Congress to suspend Born's rule­-writing authority. Phil Gramm decided to go further. He had become chairman of the Senate Banking Committee in 1995, a role in which he was more successful in reducing regulation than he had been in reducing government spending. He wrote a provision, quietly inserted into a broader bill in December 2000, that prohibited the government from reg­ulating large portions of the market in derivatives. Brickell, the industry lobbyist, rejoiced that the law 'nailed the door shut.' "Support for deregulation was heightened by the fear of foreign competi­tion. Senator Charles Schumer, Democrat of New York, told colleagues that 'the future of America's dominance as the financial center of the world' was at stake in a 1999 vote to let large banks become financial supermarkets. Similar words were spoken against derivatives regulation."