This guest post was contributed by Dan Geldon, a fellow at the Roosevelt Institute. He is a former counsel at the Congressional Oversight Panel and a graduate of Harvard Law School.
Over the past year, there has been much discussion about how the financial crisis exposed weaknesses in free-market theory. What has attracted less discussion is the extent to which the high priests of free-market theory themselves destroyed meaningful contracts and other bedrocks of functioning markets and, in the process, created the conditions for the theory’s weaknesses to emerge.
The story begins before Wall Street’s capture of Washington in the 1980s and 1990s and the deregulatory push that began around the same time. In many ways, it started in 1944.
In that year, Frederich von Hayek published The Road to Serfdom, putting forward many of the ideas behind the pro-market, anti-regulatory economic view that swept through America and the rest of the world in the decades that followed. Von Hayek’s basic argument was that freedom to contract and to conduct business without government meddling allowed for free choice, allocated resources efficiently, facilitated economic growth, and made us all a little richer. Milton Friedman built on Hayek, creating an ideology that resonated with conservatives and ultimately became the prevailing economic view in Washington.
While many have noted how information asymmetry, moral hazard, and agency costs reveal glaring holes in free-market theory and contributed to the current crisis, few have focused on the extent to which the supposed heirs to von Hayek and Friedman directly and purposefully created market distortions and, in the process, destroyed the assumptions of free-market theory.
In other words, the same interests that claim the mantle of von Hayek and Friedman pulled the threads from the free-market system and exposed the theory’s greatest weaknesses.
In the years leading up to the crisis, the proliferation of fine print, complex products, and hidden costs and dangers – and the push against government regulations over them – exemplified the larger pattern. While touting complexity as a form of innovation and railing against every attempt at government interference, supposedly pro-market forces used that complexity to clog the gears of free market machinery and to reduce competition and maximize profit.
When consumer credit contracts are buried in so much legalese that even experts can’t understand all the terms – I heard one former CEO of a top financial company admit privately that his lawyers couldn’t explain various mortgage terms and conditions — how can anyone believe the mortgage contract represents meaningful free choice? What consumer is able to weigh the benefits and costs of individual financial product features buried in the fine print and decide what to take and what to leave?
The corporate assault on comprehensible contracts is important because contract law has been the bedrock of capitalism for a long as there has been capitalism. By enabling free choice, meaningful contracts maximize economic efficiency. The assumption behind von Hayek and other theorists is that robust contract law facilitates a vibrant economic system and minimizes the need for government intervention in the economy. But that went out the window when von Hayek’s theory itself was used to manipulate contracts. Now that products and fine print have become so perverted and incomprehensible, how can anyone expect contracts to steer the market in economically efficient ways?
We now know that the problem of complex contracts did not just harm consumers. Municipalities across the country were lured into buying toxic derivatives and institutional investors were routinely abused at the hands of complex products. Stories about Wall Street’s math wizards purposefully cramming dangerous and confusing products down the throats of the unsuspecting are commonplace and legendary.
The world has changed in fundamental ways thanks to computers and complexity can have value, but the world as we now know it has made traditional economic assumptions that assume real choice and real contracts irrelevant. All that’s left is the hollow façade of choice when your broker shows you where to sign or when you click “accept” after quickly scrolling through incoherent legalese. And we all are forced to accept this even though we know that the large majority of these products – and the actual deals around them — just aren’t that complicated. The only thing that’s complicated are the fine print and the economically valueless tricks and traps hidden in the legalese.
Some conservatives are quick to blame the fine print on litigation and trial lawyers. But that just doesn’t explain all the complexity that has come to define Wall Street. Talk to a CEO of a major credit card issuer privately, and they will admit that “stealth pricing” was purposefully innovated to maximize profit by making contracts difficult to understand and compare. The proliferation of opacity and the lack of competition in the industry are not an accident.
The industry has not only manipulated contract language to prevent real agreement (or what contract lawyers call “meetings of the mind”), but it also massively increased its negotiating leverage with counterparties by making it so onerous to walk away from boilerplate and incomprehensible terms and conditions. It’s not easy to negotiate with the other side of a 1-800 number, nor is it easy to go toe-to-toe with an industry that can and does get away with tricking and trapping even supposedly sophisticated investors.
And if you think all that were enough, many of the same conservative economists and lobbyists have fought tooth and nail behind the scenes to preserve implicit government guarantees created by the bailouts – guarantees that allow large banks to access capital more cheaply than the smaller banks left struggling to compete. While touting pro-market values and railing against “big government” attempts to break up the big banks, they are directly and purposefully allowing for market distortions. And those distortions help explain the massive consolidation we’re seeing in the industry, the dwindling of real competition, and the proliferation of faceless conglomerates with infinite leverage over the drafting of terms and conditions.
What’s really galling though isn’t that supposed free-market advocates are so hell-bent on distorting the market wherever necessary to inflate profit. What’s worse is the extent to which the same interests successfully advocated the rules that allowed this to happen under the well-worn guise of–you guessed it–freedom to contract and freedom to choose. That is, through their well-financed and well-oiled lobbyist teams, they facilitated the destruction of the freedom to contract and free choice while pretending to do the opposite. They killed the free market in the name of saving it.
The greatest lesson from the crisis that we haven’t yet learned is that “industry interests” and “free-market interests” are not the same. In fact, they are more like oil and water, as the industry profits most in the absence of true market competition. And so it should be no surprise that Wall Street has devoted itself to making contracts indecipherable, building boundless negotiating leverage and fighting for favorable breaks and regulation at every turn. What should be a surprise is that the same scoundrels that killed our markets (and also, mind you, wrecked the global economy and demanded taxpayer bailouts) have so ably sold themselves as natural heirs to von Hayek and Friedman — and that so many of us have let them.
By Dan geldon