July/August 2009 Vol. XXXI No. 4

GEORGESELGINThe powerof privatecurrency

PAGE 11

FREEMANDYSONClimate disaster,safe nukes, andother myths

PAGE 5

Did Deregulation Cause the Financial Crisis?

The growing narrative in Wash-ington is that a decades-longunraveling of the regulatorysystem allowed and encour-aged Wall Street to excess,

resulting in the current financial crisis. Leftunchallenged, this narrative will likely formthe basis of any financial reform measures.Having such measures built on a flawed foun-dation will only ensure that future finan-cial crises are more frequent and severe.

ROLLING BACK THE REGULATORY STATE?

Although it is the quality and substanceof regulation that has to be the center of anydebate regarding regulation’s role in the finan-cial crisis, a direct measure of regulation isthe budgetary dollars and staffing levels ofthe financial regulatory agencies. In a Mer-catus Center study, Veronique de Rugy andMelinda Warren found that outlays for bank-ing and financial regulation increased fromonly $190 million in 1960 to $1.9 billion in2000 and to more than $2.3 billion in 2008(in constant 2000 dollars).

Focusing specifically on the Securities andExchange Commission—the agency at thecenter of Wall Street regulation—budget out-lays under President George W. Bush increasedin real terms by more than 76 percent, from

$357 million to $629 million (2000 dollars).However, budget dollars alone do not

always translate into more cops on the beat—all those extra dollars could have been spenton the SEC’s extravagant new headquartersbuilding. In fact most of the SEC’s expand-ed budget went into additional staff, from2,841 full-time equivalent employees in 2000to 3,568 in 2008, an increase of 26 percent.The SEC’s 2008 staffing levels are more than

eight times that of the Consumer ProductSafety Commission, for example, which reviewsthousands of consumer products annually.

Comparable figures for bank regulatoryagencies show a slight decline from 13,310in 2000 to 12,190 in 2008, although this is driven completely by reductions in staff at the regional Federal Reserve Banks, result-ing from changes in their check-clearing

BY MARK A. CALABRIA

Venezuela’s government did not want its citizens hearing the Cato Institute’s message of freedom. Officialsunder Hugo Chávez sought to shut down a recent session of Cato University in the country, but failed to keepyoung Venezuelans from learning about the benefits of capitalism and individual liberty. Here, VenezuelanChavistas protest Cato’s activities in the country. PAGE 12

After eight years as a senior economist at the Senate Com-mittee on Banking, Housing, and Urban Affairs, MARKCALABRIA joined the Cato Institute in April as direc-tor of financial regulation studies.

Continued on page 6

JAMESTOOLEYHow the pooreducate themselves

PAGE 17

2 • Cato Policy Report July/August 2009

”

resident Obama is keeping the wrong promises.He’s working very hard to keep his promises totax more, spend more, and regulate more.

But he also promised to end the war in Iraqand to cut federal spending on net, and those promis-es were left behind when they closed the campaignheadquarters.

Hundreds of thousands of Americans turned outon April 15 to protest the bailouts, the $787 billionstimulus package, and Obama’s budget. Maybe someday soon antiwar activists will realize that the war isstill going on and will hold some rallies too.

Obama’s broken promises give libertarians achance to get out in front with a “Stop the War, Stopthe Spending” movement.

Take the war in Iraq. Barack Obama rose to promi-nence as a vigorous opponent of the war. His antiwarspeech in Chicago in October 2002 was the keystoneof his campaign. With most of his Democratic oppo-nents having voted for the war as senators, Obamacampaigned as the only true antiwar candidate. In thethick of the primaries, he declared, “I opposed this warin 2002. I will bring this war to an end in 2009. It istime to bring our troops home.” That’s how he drewthe support of the Democratic left and then a broad-er audience of Americans who had turned against thefloundering war.

But later in the campaign, after the primaries, hebacked away from his commitment to end the war in his first year. He said he would “redeploy our com-bat brigades at a pace that would remove them in 16 months.”

Soon after taking office, he essentially reaffirmedthat plan. But it turned out that after about 18 moremonths of combat, until the end of summer 2010, the president intends to keep some 50,000 troops in Iraq until at least 2012. That’s a far cry from “I willbring this war to an end in 2009. It is time to bring ourtroops home.”

As for spending, during the campaign Obama pan-dered to interest groups with promises of taxpayerdollars—money for college loans, “green energy,”national health insurance, higher teacher pay, moreMedicaid, subsidies for homeowners, and so on.During the campaign Hillary Clinton said, “I have amillion ideas. The country can’t afford them all.” Sodid Obama, and it’s not clear that he understood thatlatter point.

But he also promised to crack down on earmarksand pork-barrel spending. He promised that he would“reinstate pay-as-you-go (PAYGO) budget rules, sothat new spending or tax cuts are paid for by spendingcuts or new revenue elsewhere.” And most significant-

ly, in the third presidential debate, when those last fewundecided voters were watching intently, Obamadeclared, “We’ve been living beyond our means andwe’re going to have to make some adjustments. Now,what I’ve done throughout this campaign is to pro-pose a net spending cut.”

That’s right. He promised a net spending cut. And what did taxpayers get? Right out of the box,

a $787 billion kitchen-sink “stimulus” spending bill—on top of a federal budget that had increased by a trillion dollars under George W. Bush even before the bailout bonanzas of late 2008. A $1.8 trilliondeficit in 2009, larger than the entire budget inPresident Clinton’s last year. The national debt sky-rocketing to 67 percent of GDP. A permanent 25 per-cent increase in the size of nondefense spending as apercentage of GDP. And all of these figures are basedon the dubious assumptions that “temporary” spend-ing programs will actually expire, that discretionaryspending growth will be much lower after 2012 than it is now, that national health care won’t costmore than expected, and so on. No wonder taxpayersturned out on April 15.

Now some critics say, “Where were these spendingopponents during the spendthrift years?” And theyhave a point. Too many conservatives and Republi-cans went along with the Bush-Lott-Hastert-DeLayspendathon. Not the Cato Institute, of course, whichproduced a steady stream of books, reports, seminars,and op-eds deploring the GOP spending record andcalling for cuts. But the fact is that while Bush was the biggest spender since Lyndon Johnson, Obama isleaving him in the dust. Bush almost doubled thenational debt, to $10 trillion. Obama’s budget pro-poses a national debt of $17 trillion by 2013 and $23trillion in 10 years.

We should also note that as bad as our currentspending is, the real budget problem is the loomingcost of entitlements programs. As the Social Securitytrustees reported in May, the total unfunded indebt-edness of Social Security and Medicare comes to$106.4 trillion. Paying that off would require an 81percent increase in everyone’s income taxes in perpe-tuity. Until we’re willing to confront those long-termpromises that we can’t keep, we’re not really dealingwith the spending problem.

Millions of Americans are tired of the war and worried about soaring federal spending. Somebodyshould give them a rallying point: Stop the War, Stopthe Spending.

PEditorial

BY DAVID BOAZ

“

Stop the War, Stop the Spending

President Obama

promised to end the war in Iraq and

to cut federalspending on net.

July/August 2009 Cato Policy Report • 3

Cato News NotesCato research fellow BENJAMIN

FRIEDMAN is coeditor with HarveySapolsky and Brendan Rittenhouse Greenof US Military Innovation since the ColdWar: Creation without Destruction, just

published byRoutledge. Thebook explains howthe U.S. militaryreacted to the“Revolution inMilitary Affairs”and failed to inno-vate its organiza-

tion or doctrine to match the technolo-gical breakthroughs it brought about.Friedman wrote or coauthored four chap-ters for the book, which is available fromthe publisher or from online book servic-es. Friedman’s Cato paper, “Learning theRight Lessons from Iraq” (coauthoredwith Sapolsky and Christopher Preble),has been included in the 7th edition of the classic textbook Use of Force:Military Power and International Politics,edited by Robert J. Art and Kenneth Waltz.

Roll Call, a newspaper widely read onCapitol Hill, reviewed a Shakespeare par-ody performed by members of Congressin a benefit for the Shakespeare TheatreCompany. The reviewer wrote that one ofthe best lines “came from Sen. RogerWicker (R-Miss.), who put in an enthusi-astic turn on the boards as a reflexivelyconservative Sen. Right. ‘My PDA has adirect line to the CATO INSTITUTE,’ hedeclared, as he searched for talkingpoints on a bill.”

Reviewingnews coverage ofPresident Obama’sfirst 100 days,New York maga-zine awarded thetitle “Most Dis-dainful AmericanCoverage” to

Cato vice president GENE HEALY’SWashington Examiner column “Obama’s100-day Power Grab.”

Miron, Calabria Strengthen Financial StudiesCato welcomes new scholars

Author and Soviet-era political dissident VLADIMIR BUKOVSKY has joined the CatoInstitute as a senior fellow. He will continue to write and speak on his experiences fight-ing Soviet tyranny and the dangers of repressive regimes.

Bukovsky spent 12 years in Soviet prisons, labor camps, and forced-treatment psychiatrichospitals as punishment for his anti-communist activities. He latersmuggled documents out of Russia and has worked to preservearchives on Soviet brutality. He has written several books about hisexperiences, including To Build a Castle: My Life as a Dissenter (1978),Soul of Man under Socialism (1979), and Soviet Hypocrisy and WesternGullibility (1987).

Though he settled in Cambridge, England, in 1976, Bukovsky vis-ited Moscow after the fall of communism in 1991 and has remainedan outspoken voice for democracy there. His more recent writingshave criticized former President Vladimir Putin for trampling the

Russian constitution and aggressively expanding his own political power.Bukovsky was a founder of Committee 2008, whose mission was to ensure a free and fair

Russian presidential election. He gained widespread support as a presidential aspirant him-self, though his candidacy ultimately was not certified by the pro-Kremlin Central ElectionCommission.

JEFFREY MIRON, director of undergraduate studies at Har-vard’s Department of Economics, has joined the Cato Institute as asenior fellow.

Miron will help Cato’s economic team promote dynamic marketcapitalism and economic freedom through media appearances, pol-icy analyses, and outreach to the academic community. He is theauthor of Drug War Crimes: The Consequences of Prohibition and TheEconomics of Seasonal Cycles, in addition to numerous journal articles.

Miron will remain at Harvard’s economics department. Prior tojoining Harvard, he served as chairman of the Department of Eco-

nomics at Boston University. Miron received his Ph.D. in economics from the MassachusettsInstitute of Technology.

MARK CALABRIA, a veteran staff member of the Senate Committee on Banking, Hou-sing and Urban Affairs, has joined the Cato Institute as director of financial regulation studies.

“I join Cato with a great sense of excitement and urgency,”Calabria said. “Cato has long been a strong, and sometimes the only,voice for expanding and protecting individual choice. We are confronted with stark choices regarding the regulation of our finan-cial markets: whether to expand the role of politics in deciding who will get credit and which institutions will fail. In a time whenmarkets and freedom are being questioned and attacked, Cato’s mis-sion of understanding the impact of government proposals is all themore necessary.”

In addition to his work on Capitol Hill, Calabria served as deputyassistant secretary for consumer and regulatory affairs, U.S. Department of Housing andUrban Development, and was also senior economist at the National Association of Realtorsand a fellow at Harvard’s Joint Center for Housing Studies. Calabria earned his Ph.D. in eco-nomics from George Mason University.

4 • Cato Policy Report July/August 2009

C A T O E V E N T S

P ATRI FRIEDMAN, executive director of the Seasteading Institute, tells a Cato PolicyForum audience on April 7 that libertarian efforts to improve government have beenunsuccessful and that “exiting” from governments—such as with self-sufficient deep-

sea platforms free of national governments—would better enable individuals to live inthe free societies they want. Above left, he argues that economic growth has been steadilydeclining, demonstrating the impracticality of central governments. At right he talkswith syndicated columnist JAMES PINKERTON, a former aide to Presidents Ronald Reaganand George H. W. Bush.

JAMES BARTHOLEMEW,columnist for theDaily Telegraph and

the Daily Mail, dis-cussed his book TheWelfare State We’re In—which Milton Fried-man called “a devastat-ing critique”—at a CatoBook Forum on May18. Bartholemew ar-gues that the welfarestate in Britain has re-sulted in a generationof badly educated anddependent citizens,and has done moreharm than good.

July/August 2009 Cato Policy Report • 5

PROFESSOR MEIR KOHN of DartmouthCollege speaks at a Cato luncheon onApril 29 about his theory of econom-

ic progress and development in history,using examples from Europe and Chinaover the last few centuries. Kohn findsthat a centuries-long conflict between com-merce and predation explains the econom-ic history of both regions.

A t an April 30 Cato seminar in New York, an overflow crowd of more than 300 peopleheard from an all-star lineup of speakers. Top right, investment adviser PETER SCHIFFwarned that the Federal Reserve’s actions would result in surging inflation. Below,

noted civil libertarian and Cato senior fellow NAT HENTOFF discussed current threats tofreedom of speech. FREEMAN DYSON, best known for his work in quantum electrodynam-ics and “applied elegant mathematics,” offered some “heretical” thoughts on globalwarming and the dangers of nuclear weapons. Cato senior fellow Pat Michaels alsospoke on the topic of his new book, Climate of Extremes: Global Warming Science They Don’tWant You to Know.

activities (mostly now done electronically)and at the FDIC, as its resolution staff deal-ing with the bank failures of the 1990s waswound down. Other banking regulatory agen-cies, such as the Comptroller of the Curren-cy —which oversees national banks likeCitibank—saw significant increases in staffinglevels between 2000 and 2008.

Another measure of regulation is theabsolute number of rules issued by a depart-ment or agency. The primary financial reg-ulator, the Department of the Treasury, whichincludes both the Office of the Comptrollerof the Currency and the Office of Thrift Super-vision, saw its annual average of new rulesproposed increase from around 400 in the1990s to more than 500 in the 2000s. Dur-ing the 1990s and 2000s, the SEC issued about74 rules per year.

Setting aside whether bank and securitiesregulators were doing their jobs aggressive-ly or not, one thing is clear—recent years havewitnessed an increasing number of regula-tors on the beat and an increasing numberof regulations.

GRAMM-LEACH-BLILEYCentral to any claim that deregulation

caused the crisis is the Gramm-Leach-BlileyAct. The core of Gramm-Leach-Bliley is arepeal of the New Deal-era Glass-Steagall Act’sprohibition on the mixing of investment andcommercial banking. Investment banks assistcorporations and governments by under-writing, marketing, and advising on debt andequity issued. They often also have large trad-ing operations where they buy and sell finan-cial securities both on behalf of their clientsand on their own account. Commercial banksaccept insured deposits and make loans tohouseholds and businesses. The deregula-tion critique posits that once Congress clearedthe way for investment and commercial banksto merge, the investment banks were giventhe incentive to take greater risks, while reduc-ing the amount of equity they are requiredto hold against any given dollar of assets.

But there are questions about how muchimpact the law had on the financial marketsand whether it had any influence on the cur-rent financial crisis. Even before its passage,investment banks were already allowed to trade

and hold the very financial assets at the cen-ter of the financial crisis: mortgage-backedsecurities, derivatives, credit-default swaps, col-lateralized debt obligations. The shift of invest-ment banks into holding substantial trad-ing portfolios resulted from their increasedcapital base as a result of most investmentbanks becoming publicly held companies, a structure allowed under Glass-Steagall.

Second, very few financial holding com-panies decided to combine investment andcommercial banking activities. The two invest-ment banks whose failures have come to sym-bolize the financial crisis, Bear Stearns andLehman Brothers, were not affiliated withany depository institutions. Rather, had eitherBear or Lehman possessed a large source ofinsured deposits, they would likely havesurvived their short-term liquidity problems.As former president Bill Clinton told Busi-nessWeek in 2008, “I don’t see that signing thatbill had anything to do with the current cri-sis. Indeed, one of the things that has helpedstabilize the current situation as much as ithas is the purchase of Merrill Lynch by Bankof America, which was much smoother thanit would have been if I hadn’t signed that bill.”

Gramm-Leach-Bliley has been presentedby both its supporters and detractors as a rev-olution in financial services. However, the actitself had little impact on the trading activi-ties of investment banks. The off-balance-sheet activities of Bear and Lehman were allow-able prior to the act’s passage. Nor did thesetrading activities undermine any affiliatedcommercial banks, as Bear and Lehman didnot have affiliated commercial banks. Addi-tionally, those large banks that did combineinvestment and commercial banking have

survived the crisis in better shape than thosethat did not.

DID THE SEC DEREGULATE INVESTMENT BANKS?

One of the claimed “deregulations” result-ing from the mixing of investment and com-mercial banking was the increase in leverageby investment banks allowed by the SEC. Aftermany investment banks became financialholding companies, European regulatorsmoved to subject European branches of thesecompanies to the capital regulations dictat-ed by Basel II, a set of recommendations for bank capital regulation developed by theBasel Committee on Banking Supervision,an organization of international bank regu-lators. In order to protect its turf from Euro-pean regulators, the SEC implemented a sim-ilar plan in 2004.

However the SEC’s reduction in invest-ment bank capital ratios was not simply ashift in existing rules. The SEC saw the ruleas a movement beyond its traditional investorprotection mandates to one overseeing theentire operations of an investment bank. Thevoluntary alternative use of Basel capital ruleswas viewed as only a small part of a greatlyincreased system of regulation, as expressedby SEC spokesman John Heine: “The Com-mission’s 2004 rule strengthened oversightof the securities markets, because prior totheir adoption there was no formal regula-tory oversight, no liquidity requirements, andno capital requirements for investment bankholding companies.”

The enhanced requirements gave the SECbroader responsibilities in terms of the pru-dential supervision of investment banks andtheir holding companies.

DERIVATIVES AS FINANCIAL MISCHIEF

After Gramm-Leach-Bliley, the most com-mon claim made in support of blaming dereg-ulation is that both Congress and regulatorsignored various warnings about the risks ofderivatives, particularly credit default swaps,and chose not to impose needed regulation.In 2003, Warren Buffett called derivatives“weapons of mass financial destruction,” andwarned that the concentration of derivativesrisk in a few dealers posed “serious systemic

6 • Cato Policy Report July/August 2009

“Recent years have witnessed an increasing

number of regulators on the beat and an increasing

number of regulations.”

Continued from page 1

problems.” Buffett was not alone in callingfor increased derivatives regulation.

But would additional derivatives regula-tion have prevented the financial crisis?

During her chairmanship of the Com-modity Futures Trading Commission Brook-sley Born published a concept paper outlin-ing how the CFTC should approach the reg-ulation of derivatives. Her suggestions wereroundly attacked both by members of theClinton administration, including RobertRubin and Larry Summers, and by the lead-ing members of the CFTC oversight com-mittees on Capitol Hill.

Foremost among Born’s suggestion wasthe requirement that derivatives be traded overa regulated exchange by a central counter-party, a proposal currently being pushed byTreasury secretary Timothy Geithner. Cur-rently most derivatives are traded as individ-ual contracts between two parties, each beinga counterparty to the other, with each partybearing the risk that the other might be unableto fulfill its obligations under the contract.A central counterparty would stand betweenthe two sides of the derivatives contract, guar-anteeing the performance of each side to theother. Proponents of this approach claim acentral counterparty would have preventedthe concentration of derivatives risk into a fewentities, such as AIG, and would have pre-vented the systemic risk arising from AIG link-ages with its various counterparties.

The most basic flaw in having a central-ized counterparty is that it does not reducerisk at all, it simply aggregates it. It also increas-es the odds of a taxpayer bailout, as the gov-ernment is more likely to step in and back acentralized clearinghouse than to rescue pri-vate firms. In the case of AIG, Federal Reservevice chairman Donald Kohn told the SenateBanking Committee that the risk to AIG’sderivatives counterparties had nothing to dowith the Fed’s decision to bail out AIG andthat all its counterparties could have with-stood a default by AIG. The purpose of a cen-tralized clearinghouse is to allow users ofderivatives to separate the risk of the deriva-tive contract from the default risk of the issuerof that contract in instances where the issueris unable to meet its obligations. Such anarrangement would actually increase thedemand and usage of derivatives.

Proponents of increased regulation ofderivatives also overlook the fact that muchof the use of derivatives by banks is the directresult of regulation, rather than the lack ofit. To the extent that derivatives such as cred-it default swaps reduce the risk of loans orsecurities held by banks, Basel capital rulesallow banks to reduce the capital held againstsuch loans.

One of Born’s proposals was to imposecapital requirements on the users of deriva-tives. That ignores the reality that counter-parties already require the posting of collat-eral when using derivatives. In fact, it was notthe failure of its derivatives position that ledto AIG’s collapse but an increase in calls forgreater collateral by its counterparties.

Derivatives do not create losses, they sim-ply transfer them; for every loss on a deriva-tive position there is a corresponding gain onthe other side; losses and gains always sumto zero. The value of derivatives is that theyallow the separation of various risks andthe transfer of those risks to the parties bestable to bear them. Transferring that risk toa centralized counterparty with capital require-ments would have likely been no more effec-tive than was aggregating the bulk of risk inour mortgages markets onto the balancesheets of Fannie Mae and Freddie Mac. Reg-ulation will never be a substitute for one ofthe basic tenets of finance: diversification.

CREDIT RATING AGENCIESWhen supposed examples of deregula-

tion cannot be found, advocates for increasedregulation often fall back on arguing that aregulator’s failure to impose new regulationsis proof of the harm of deregulation. The sta-

tus of credit rating agencies in our finan-cial markets is often presented as an exam-ple of such.

Credit rating agencies can potentially serveas an independent monitor of corporate behav-ior. That they have often failed in that roleis generally agreed upon; why they’ve failedis the real debate. Advocates of increased reg-ulation claim that since the rating agenciesare paid by the issuers of securities, theirreal interest is in making their clients happyby providing the highest ratings possible. Inaddition they claim that the rating agencieshave used their “free speech” protections toavoid any legal liability or regulatory scruti-ny for the content of their ratings.

The modern regulation of credit ratingagencies began with the SEC’s revision ofits capital rules for broker-dealers in 1973.Under the SEC’s capital rules, a broker-deal-er must write down the value of risky or spec-ulative securities on its balance sheet to reflectthe level of risk. In defining the risk of heldsecurities, the SEC tied the measure of riskto the credit rating of the held security, withunrated securities considered the highest risk.Bank regulators later extended this practiceof outsourcing their supervision of com-mercial bank risk to credit rating agenciesunder the implementation of the Basel cap-ital standards.

The SEC, in designing its capital rules, wasconcerned that, in allowing outside credit rat-ing agencies to define risk, some rating agen-cies would be tempted to simply sell favor-able ratings, regardless of the true risk. Tosolve this perceived risk, the SEC decided thatonly Nationally Recognized Statistical Rat-ing Organizations would have their ratingsrecognized by the SEC and used for com-plying with regulatory capital requirements.In defining the qualifications of an NRSRO,the SEC deliberately excluded new entrantsand grandfathered existing firms, such asMoody’s and Standard and Poor’s.

In trying to address one imagined prob-lem, a supposed race to the bottom, the SECsucceeded in creating a real problem, anentrenched oligopoly in the credit ratingsindustry. One result of this oligopoly is thatbeginning in the 1970s, rating agencies movedaway from their historical practice of mar-keting and selling ratings largely to investors,

July/August 2009 Cato Policy Report • 7

”

“The value of derivatives is that

they allow the separation of

various risks and the transfer of

those risks to the parties best able

to bear them.

8 • Cato Policy Report July/August 2009

toward selling the ratings to issuers of debt.Now that they had a captive clientele, debtissuers, the rating agencies quickly adaptedtheir business model to this new reality.

The damage would have been large enoughhad the SEC stopped there. During the 1980sand 1990s, the SEC further entrenched themarket control of the recognized rating agen-cies. For instance, in the 1980s the SEC limit-ed money market funds to holding securitiesthat were investment grade, as defined by theNRSROs. That requirement was later extend-ed to money market fund holdings of com-mercial paper. Bank regulators and state insur-ance commissioners followed suit in basingtheir safety and soundness regulations on theuse of NRSRO-approved securities.

The conflict of interest between raters andissuers is not the result of the absence of regulation, it is the direct and predictableresult of regulation. The solution to this prob-lem is to remove the NRSROs’ monopolyprivileges and make them compete in the marketplace.

PREDATORY LENDING OR PREDATORY BORROWING?

As much of the losses in the financial crisishave been concentrated in the mortgage mar-ket, and in particularly subprime mortgage-backed securities, proponents of increased reg-ulation have argued that the financial crisiscould have been avoided had federal regula-tors eliminated predatory mortgage practices.Such a claim ignores that the vast majority ofdefaulted mortgages were either held by spec-ulators or driven by the same reasons thatalways drive mortgage default: job loss, health

care expenses, and divorce. The mortgage characteristic most closely

associated with default is the amount of bor-rower equity. Rather than helping to strength-en underwriting standards, the federal gov-ernment has led the charge in reducing them.Over the years, the Federal Housing Adminis-tration reduced its down-payment require-ments, from requiring 20 percent in the 1930sto the point today that one can get an FHAloan with only 3.5 percent down.

The predatory lending argument claimsthat borrowers were lured into unsustainableloans, often due to low teaser rates, whichthen defaulted en masse, causing declines inhome values, which led to an overall declinein the housing market. For this argument tohold, the increase in the rate of foreclosurewould have to precede the decline in homeprices. In fact, the opposite occurred, withthe national rate of home price appreciationpeaking in the second quarter of 2005 andthe absolute price level peaking in the secondquarter of 2007; the dramatic increase in newforeclosures was not reached until the sec-ond quarter of 2007. While some feedbackbetween prices and foreclosures is to be expect-ed, the evidence supports the view that ini-tial declines in price appreciation and laterabsolute declines in price led to increases inforeclosures rather than unsustainable loansleading to price declines.

Normally one would expect the ultimateinvestors in mortgage-related securities toimpose market discipline on lenders, ensur-ing that losses stayed within expectations.Market discipline began to breakdown in2005 as Fannie Mae and Freddie Mac became

the largest single purchasers of subprimemortgage-backed securities. At the height ofthe market, Fannie and Freddie purchasedover 40 percent of subprime mortgage-backedsecurities. These were also the same vintagesthat performed the worst; subprime loansoriginated before 2005 have performed large-ly within expectations. Fannie and Freddieentering this market in strength greatlyincreased the demand for subprime securi-ties, and as they would ultimately be able topass their losses onto the taxpayer, they hadlittle incentive to effectively monitor the qual-ity of underwriting.

CONCLUSIONThe past few decades have witnessed a sig-

nificant expansion in the number of finan-cial regulators and regulations, contrary tothe widely held belief that our financial market regulations were “rolled back.” Whilemany regulators may have been short-sighted and over-confident in their own abil-ity to spare our financial markets from collapse, this failing is one of regulation, not deregulation. When one scratches belowthe surface of the “deregulation” argument,it becomes apparent that the usual suspects,like the Gramm-Leach-Bliley Act, did notcause the current crisis and that the sup-posed refusal of regulators to deal with derivatives and “predatory” mortgages wouldhave had little impact on the actual courseof events, as these issues were not central to the crisis. To explain the financial crisis,and avoid the next one, we should look at the failure of regulation, not at a mythi-cal deregulation. ■

H A R D B A C K : $ 2 9 . 9 5 ● E - B O O K : $ 1 4 . 0 0Buy your copy at bookstores nationwide, call 800-767-1241 or visit Cato.org.

“N E W B O O K F R O M T H E C A T O I N S T I T U T E

Written from his perspective as scholar, journalist, and activist, Tom Palmer’s incisive articles range in subject from the theory of justice, multiculturalism, and democracy, to limited government,

globalization, property rights, censorship, individual liberty, and more.

Drawing on his extraordinary interdisciplinary learning, Palmer offers asociologically, institutionally, and historically informed libertarianism—

one that is true to the rich legacy and tradition of classical liberalism.—JACOB T. LEVY, McGill University

“

July/August 2009 Cato Policy Report • 9

BENN STEIL: How do we account for the factthat every five years or so there’s a major cur-rency crisis and we’re unable to develop anycoherent response to it? In our book, wepoint out that globalization today is excep-tionally unusual. If you look at earlier peri-ods of globalization, particularly the late19th century, what you see is that ideas offree trade went side by side with the idea ofa universal monetary standard. So it’s notcoincidental that in the late 19th century, ascountries started to coalesce around theidea that free trade might be mutually ben-eficial, they also coalesced around the ideathat we needed a universal monetary stan-dard to facilitate this—which was the classi-cal gold standard.

On the other hand, if you look backthrough history and examine periods of pro-tectionism—such as the 18th century, whenideas of mercantilism were at the forefront—those always went side by side with the ideaof monetary nationalism, that it was theruler’s prerogative to determine what moneyshould be, how it should be valued, andwhat could and could not be consideredmoney within the borders. Of course, youdid have money moving back and forthacross borders, but you had floatingexchange rates because rulers were continu-ally debasing their money. Money fluctuated

radically in value as it crossed borders. But here we are in the early 21st century,

when you have on the one hand the mostliberal global trade and investment regimewe’ve ever seen, and on the other, the mostextreme doctrine of monetary nationalismthat governments have ever contrived. We’venever seen a period of history like the onewe’ve been in since 1971, where all the cur-rencies around the world are tied to nothingof intrinsic value. They are simply conjuredby governments as a manifestation of mon-etary sovereignty.

That we’re having trouble accommodat-ing this situation wouldn’t have been sur-prising to an economist in the 1930s—of theright or the left, of the free market variety orthe anti-market variety. We talk in the bookabout the views of Friedrich Hayek on theone hand and Karl Polanyi on the other,both of whom considered it absolutely obvi-ous that in order to have free trade and safeglobal capital flows, you needed to have auniversal monetary standard. Both of themagreed this was gold. Of course, Hayek hadsympathy with the liberal internationaltrade order and Polanyi had a lot less sym-pathy with it, but they both agreed that goldwas absolutely necessary to free trade.

Many economists believed that once welost this idea of a universal monetary stan-

dard, and national currencies routinely fluc-tuated against each other, capital flows—which in the late 19th century had beenextremely stabilizing and acted as an equili-brating mechanism to bring about thequick end of crises—would actually be mas-sively destabilizing. Every time you had anysort of banking crisis, the reaction ofinvestors, both foreign and domestic, wouldbe to sell the currency en masse because theywouldn’t believe that the old parities wouldbe restored. They would naturally assumethat things were going to get worse.

What we are experiencing today I wouldargue is not actually surprising at all. It issomething that was anticipated by econo-mists of the right and left in the 1930s. It’snot a fundamental flaw with the idea ofglobalization or the idea that we should havea liberal international trade and investmentregime. It’s a flaw in the system of monetarynationalism that we’re currently pursuing.

MANUEL HINDS: The world faces the prob-lem of not having a true international cur-rency where the supply of money is notdependent on political conditions withinany one country. Because there is no globalcurrency, countries are forced to use moneyissued by a single country—in our case, theUnited States. But within the UnitedStates, the Federal Reserve isn’t as con-cerned with what is going on in the globalmarket for its currency as it is with internalU.S. politics. The world uses fiat money—and it could be anybody’s criteria employedto determine how much of it is going to becreated.

This is one way of doing things. A secondwould be to have a true international cur-rency, but then who is going to determinethis? Will we have a politician saying whetherwe have to increase the supply of money?

A third way would be to have a com-modity currency like gold. We had this cur-rency for several centuries, but it was per-fected in the 19th century. The real goldstandard existed between the 1880s and1914. It has been maligned because it is a

P O L I C Y F O R U M

Do our current financial troubles result from badmonetary policy and an abandonment of the goldstandard? Benn Steil, director of international eco-

nomics at the Council on Foreign Relations, and ManuelHinds, former finance minister of El Salvador, discussed thisquestion at a Cato Book Forum for their book, Money, Mar-kets, and Sovereignty,on May 19, 2009. At a Cato Book foruma month earlier, on April 17, George Selgin, professor of eco-nomics at West Virginia University and author of Good Mon-ey, offered his thoughts on the roots of modern monetarypolicy and the power of private currency.

Money, Markets, and the State

system in which the supply of money is notsomething we can manage. It is unthink-able in the current time to have a currencywithout discretion over how much is print-ed. But this was the big advantage of thegold standard: it remained outside the con-trol of any one person, it was really some-thing that was determined by the marketand the price of gold.

There are many people who are now dis-covering the gold standard and findingthat it functioned rather well. First, it wasan international system. It was acceptedeverywhere. It was determined by the mar-ket and had very clear rules. The centralbanks participated in the gold standardnot because their governments decidedthat it was the best way of organizing inter-national trade, but because internationaltrade was organized in that way.

Something I would like to mention, how-ever, is deflation. Bernanke and many otherpeople say we need to avoid deflation, whichhappened with the gold standard. In thelong term, the gold standard kept the pricelevel the same, but in the very short term,there were fluctuations. The gold standardhas certain mechanisms through whichprices have to go down again. There was a lit-tle inflation, a little deflation, and in the verylong term you had almost zero inflation.But then, for example, between 1870 and1890, and almost reaching to 1910, therewas a long world deflation in which priceswent down by 25 percent. You will probablysay this was the most horrible depression in the world and actually people called it a great depression, but they were talkingabout the great depression of prices, not of production. This was the period in whichGermany and the United States becameindustrialized. It was one of the most pro-gressive periods in history—and prices weregoing down.

When you look at the gold standard, yourealize many claims about it are myths. Forinstance, it is a myth that it stopped growthbecause of inelasticity of supply. Or that itcreated deflation and thus led to a reductionin production. It was not like that. The prob-lem was that the system had constrained thepoliticians, and so there came a momentwhen they decided they didn’t want to fol-

low it anymore. They wanted to have theirown monetary policy. They didn’t want tobe part of a global system. They launchedthe gold exchange system, in which theystarted creating currency outside the strictrules of the gold standard—and the contra-

diction began there. This contradiction—between a system

that was not discretionary and politiciansusing discretionary monetary policies—cre-ated conflicts and several crises, and eventu-ally lead to the Great Depression. After that,the Bretton Woods system was created,which was still based on gold but gave thecountries certain discretion to create money.

Now we reach our current system, whichstarted when Nixon demonetized gold in1971. Because we have free-floating curren-cies, each country can decide how to trade itsmoney. If they are creating too much money,their currency will depreciate. But then again,we hit the same problem that we had. Wedon’t have an international currency, we usethe dollar, and the dollar has a big privilege

because people around the world think indollars. If the Fed decides to reduce interestrates, others tend to reduce interest rates—and if the Federal Reserve decides to increaseinterest rates, interest rates will increase.

That was the case until very recently.Now you see the Federal Reserve lower inter-est rates and interest rates in the market goup. It is because people are starting to doubtthe dollar. They are starting to buy goldagain and to stop passing dollars throughthe financial system. In three months, theFed more than doubled the creation ofmoney in the U.S. and it still didn’t gothrough to the people—to Main Street, asthey say. The ability of the Federal Reserve tocreate monetary policy is starting to skid. Itis no longer what it used to be.

If the Federal Reserve abuses its power,people will stop believing in the dollar, andthey will find something else. They willfind a new currency, which will be gold, orthe Euro, or whatever, and that is going tobe a real problem for the United States.

GEORGE SELGIN: Mismanagement of mon-ey—and mismanagement of money seriousenough to cause serious economic crises—has been the rule rather than the exceptionso long as central banks have been in chargeof managing money.

The Federal Reserve was established in1914 ostensibly to end financial panics likethe one that had broken out seven yearsbefore. Within four years of the Fed’s cre-ation, starting from what was then a verylow rate of inflation, the inflation rate pas-sed 20 percent. It was the worst inflation inU.S. history, except for that during the CivilWar. Then 1920 brought the most severedeflation in U.S. history. Fortunately, therewas no New Deal or stimulus package inresponse to that crisis, so the economyrecovered within a year. But then the Fedwas at it again, fueling what became thegreat bull market of the late 1920s. I don’thave to tell you what the Fed did after that;you all presumably know the story of thegreat monetary contraction that started theGreat Depression. Then, just as the econo-my was beginning to struggle to its feet inthe mid 1930s, the Fed decided to doublebank reserve requirements, plunging it into

10 • Cato Policy Report July/August 2009

P O L I C Y F O R U M

Benn Steil

“All the currencies around the

world are tied to nothing of intrinsic

value. ”

depression yet again. Then came World WarII with serious inflation—disguised by pricecontrols, of course—and then . . . well, you getthe general idea.

The Fed’s record has been lousy through-out its existence. The same can be said forother central banks around the world. Infact, the Fed has been one of the best: the typ-ical central bank’s record has been farworse—somewhere between the Fed’s andthat of, say, the Reserve Bank of Zimbabwe.That’s why the dollar is, relatively speaking,so popular even now.

Why do we put up with it? Why do we letgovernments manage money in the firstplace, when they routinely make such a botchjob of it? The answer the central bankers giveis twofold. First, and more fundamentally,they argue that only governments are trust-worthy enough to issue money or that onlygovernment authorities can issue trustwor-thy money. They also claim that financialpanics in the absence of central banks wouldbe even more serious than they’ve been withcentral banks in charge.

That second argument is false on twogrounds. First of all, it’s empirically false, inthat pre-central banking panics were not assevere, certainly not in this country, as post-central banking panics have been. The worstof the pre-Fed panics was in 1907, and allthree of the panics that broke out within thefirst 20 years of the Fed’s existence were farmore serious than it. Also, the pre-Fed panicswere not the result of unhindered markets,but were products of unwise and misguidedgovernment intervention in the U.S. finan-cial system, much of it dating to the CivilWar period. Canada, during the 19th centu-ry and right up to the thirties, avoided majorfinancial crises without a central bank. Itrelied instead on a completely decentralizedand private commercial currency systemwith notes issued by various large nation-wide banks. It was a famously stable finan-cial system. Regarding Great Britain, wecould tell a similar story. England sufferedrepeated financial crises in the 19th century.Scotland managed to avoid them. Englandhad a central bank. Scotland had a decen-tralized, free banking system.

The more fundamental argument givenfor government control of money and for

the existence of central banks is the claimthat only governments can be trusted tosupply money. That claim dates back toancient times. Its roots lie not in papermoney, to which it’s mainly applied thesedays, but to coinage. Ancient governments—

kings and princes—insisted that only theycould be trusted to coin money. This claim,which soon became a dogma, was the basisof the so-called “sovereign right of coinage”or the “coinage prerogative” of government.This ancient coinage prerogative is the ulti-mate foundation for the entire modernapparatus of government management ofnational money supplies, including centralbanking. The Federal Reserve’s legal author-ity, for example, rests solely on Congress’sconstitutional power to coin money, whichis just the old ancient and medieval preroga-tive of coinage being continued into moderntimes. Of course, ancient and medieval gov-ernments enjoyed many prerogatives ofwhich modern governments have beenthankfully deprived.

How is it, then, that the coinage preroga-tive has managed to survive intact into mod-ern times? The answer is that people, includ-ing economists—and despite economists’general opposition to monopoly and despitetheir knowledge of how governmentsthroughout history abuse their monetarypowers—believe in the ancient claim that ifyou let the private sector coin money, youwill end up with bad money. But what if thisancient claim on which all modern govern-ment regulation of money rests is wrong?What if it can be shown that the private sec-tor, if ever given a chance to coin money,would do a better job than government? Ifthat could be proven, it would mean that theentire legal foundation for government con-trol of money is basically rotten.

So has there ever been a case where,somehow, despite ancient and medievaldogmas condemning the practice, coinagewas left to private enterprise? If there hasbeen, what was the outcome? Was it thecase, as so many economists predict, thatGresham’s Law led to bad money drivinggood money out of circulation?

My book tells the story of one suchepisode, and its title answers the question. Inthe 18th century, the British economy founditself without any decent coins for retailtrade and wage payments. The royal mintwas producing few silver coins because silverwas legally undervalued. The governmentgave up coining copper partly because ofcomplaints about distribution—too much insome places and none at all elsewhere—but itdid so mostly because its copper coins wereeasy to counterfeit, and were being counter-feited aggressively. No copper and no silver,hence no money for most payments.

It’s then that the private market steppedin. When the government refused, despiteentreaties from entrepreneurs, to supplydecent coins, the entrepreneurs themselves,beginning with major industrialists, startedto strike their own coins. By the early 1790s,there were no fewer than 20 distinct privatemints striking custom coins that were issuedall over England and other parts of GreatBritain. These supplied the bulk of themoney used for wage payments and retailexchange during those crucial decades. In

July/August 2009 Cato Policy Report • 11

George Selgin

“The Fed’s record has been lousy

throughout its exis-tence. The same can besaid for other central

banks around the world.”

Continued on page 12

12 • Cato Policy Report July/August 2009

In May, the Cato Institute conductedanother session of its successful CatoUniversity in Caucagua, Venezuela. This

time, however, the government of HugoChávez took exception to Cato’s teachingof individual liberty and free-market, limit-ed government principles and sent theNational Guard to disrupt the event.

Prior to Cato’s arrival in Venezuela, statetelevision and online media told Venezue-lans that Cato was coming to set up a train-ing camp for young subversives, a camp atwhich they would be taught techniques foroverthrowing Chávez.

Once the event started, the Chávez gov-ernment claimed that Cato University, con-ducted with the help of the Venezuelan-based, classical liberal think tank, CEDICE,lacked the proper permits to operate as auniversity. While Cato was teaching youngVenezuelans about the benefits of individ-ual choice in a free society, a state represen-tative of the ministry of higher educationarrived, accompanied by reporters fromstate television and the National Guard,and harassed the conference organizers.Even after being told that Cato Universitywas not, in fact, a university, the Chávez gov-ernment did not back down. Instead, itchanged its tactics, accusing Cato Universi-ty of engaging in false advertising.

The government then took the step ofdetaining Alvaro Vargas Llosa, a Peruvianintellectual and speaker at the event. He was released after three hours by airport

authorities, but only on the condition that he not speak about the political situa-tion in Venezuela, a condition he did notadhere to.

Later, Chavistas, not officially sanc-tioned by the Chávez government, picketedin front of the Caracas hotel in whichCEDICE was holding its 25th AnniversaryConference, waving signs denouncing theCato Institute and accusing it of workingwith the Central Intelligence Agency and

Washington military interests to create sub-versive dissent among Venezuelans. Theseprotests were carried on state television.

The reaction of the Chávez regime totwo gatherings of market-liberal intellectu-als demonstrates how tense the situationhas become in Venezuela. But it alsodemonstrates how necessary Cato’s mis-sion of promoting liberty is—and how fear-ful the ideas of liberty are for those whowould wield excessive state power.

Regime attempts to shut down Cato University

Chávez Fails to Silence Cato’s Message of Liberty

Cato University attendees gather in Caucagua, Venez-uela, in May to discuss classical liberal ideas. TheNational Guard was sent to disrupt the event. State

television stations and Internet sites spread propagandacharging Cato and local cosponsor CEDICE with settingup a training camp in subversive tactics to overthrow thegovernment. The government’s tactics ultimately failedand Cato’s message of liberty remained loud and clear.

towns where either local, private coins orofficial coins could be used in exchange,private coins commanded a 100 percentpremium over the other coins—which is tosay you had to pay twice as much if youused the legal tender money! That’s themarket’s verdict, the one that really counts.

Eventually private coinage was, ofcourse, snuffed out. But in case you sup-pose that it was snuffed out because pri-vate coins were harming the public, it’s easyto prove that that wasn’t the case. When it

decided to outlaw private tokens, the gov-ernment still hadn’t put its own coinageact together. Consequently people were literally left begging for cash of any sort. A government that was truly concernedabout people having better money would-n’t have forced them to settle for havingnone at all!

To conclude: it’s admittedly a long wayfrom Great Britain in 1789 to the UnitedStates in 2009, but even the relatively dis-tant past can harbor important clues toanswering today’s pressing public policy

questions. One of those question is, mustwe forever remain at the mercy of the error-prone central banks? Must we forever suf-fer from the financial crises they causeagain and again and again? Ancient dogmatells us that we have no choice. History, onthe other hand, suggests that govern-ment’s ancient monetary prerogative be-longs in the same scrapheap into whichmost other medieval princely powers weretossed long ago. Perhaps central banks,which owe their existence to that preroga-tive, ought to be scrapped as well.

Continued from page 11

July/August 2009 Cato Policy Report • 13

With the debate over health care reformheating up in Washington and aroundthe country, the Cato Institute has tak-

en the lead in providing principled free-market critiques and solutions. To bring itsunique perspective to a wider audience, Catolaunched a new website (healthcare.cato.org)to provide in-depth analysis of health careissues. The site is a perfect resource for every-one interested in becoming better informedon this crucial area of public policy.

Cato has also published two recent and important books on the health care. In Healthty Competition: What’s Holding BackHealth Care and How to Free It, Michael F. Can-non, director of health policy studies, andMichael Tanner, director of health and wel-fare studies, examine the best and worst ideason health care reform from the left and theright—and provide their own, market-basedsolutions. And in Crisis of Abundance: Rethink-ing How We Pay for Health Care, adjunct schol-ar Arnold Kling argues against our currentmethods of financing health care, while advo-cating a return to individual responsibility.

Michael Cannon took the fight againstbig government in health care to Congresswhen, over the course of four days in April, hedelivered four lectures on Capitol Hill as partof “Health Care University: Which ReformsAre Better—or Worse—than Doing Nothing?”There he laid out three “lines in the sand”regarding health care policy—no public plan,no mandates, and no price controls—as wellas free-market solutions. Cannon continuedto promote these principles in his debut as a

columnist for Kaiser Health News, where, inMay, he published a column, “Is UniversalCoverage Comparatively Effective?” Can-non called on Congress to “start practicingevidence-based health policy.” That samemonth, Cannon took Cato’s message to thepages of National Review, as part of a specialhealth care issue.

Cato has stood firm in its opposition to government-mandated health cover-age, even as many others embrace Mitt Romney’s “Massachusetts model.” In June,Michael Tanner published “MassachusettsMiracle or Massachusetts Miserable: Whatthe Failure of the ‘Massachusetts Model’Tells Us about Health Care Reform.” Tan-ner demonstrates the need to maintain free market principles in health care byexposing the awful outcome of what is nowseen as the model for federal policy. He also addressed the potential federal plandirectly with his latest Policy Analysis, “Oba-macare to Come: Seven Bad Ideas for Health Care Reform.”

But more than just showing what’swrong with our current health care systemand the plans the Obama administration

has for changing it, Cato analysts are of-fering a comprehensive set of solutions for America’s health. Cato continues, forinstance, to be a leading proponent of healthsavings accounts as an alternative or supple-ment to traditional health insurance.

On June 17, the Cato Institute took theopportunity to present both its critique ofcurrent and proposed interventionist healthcare and its vision for a better, free marketfuture by hosting the Cato Institute Confer-ence on Health Care Reform. This full dayevent featured a wide array of policy expertsincluding U.S. Rep Paul Ryan (R-WI), Dou-glas Holtz-Eakin, former director of the Congressional Budget Office, and SusanDentzer, editor-in-chief of Health Affairs, andRick Scott, founder of Conservatives forPatients’ Rights. Panels discussed healthinsurance mandates, health delivery-systemreform, ideas for a new public plan, and freemarket alternatives for providing health care.

By providing a clear and coherent voicein opposition to the bad policies being proposed in Washington, as well as princi-pled solutions, Cato is leading the way tobetter health.

New website, conference, Capitol Hill briefings

Cato Scholars Take on Obama’s Health Care Program

The Cato Institute’s new website (healthcare.cato.org) brings together the best analysis of health care poli-cy from a market-liberal perspective. By making this information easily available in a single resource, Catoprovides a powerful means to learn about this important area of public policy.

Director of health policy studies Michael F. Cannonspeaks on Capitol Hill as part of Cato’s Health CareUniversity. Cannon taught members of Congress,their staff, and the media about the benefits of afree market health care system and the perils ofincreased government control.

14 • Cato Policy Report July/August 2009

C A T O E V E N T S

CHRISTOPHER A. PREBLE, director of foreign poli-cy studies, is interviewed following a May 11Capitol Hill Briefing on the dangers of U.S.

military dominance. Preble argued that a reduc-tion in military power will make America “richer,freer, and safer.”

NEAL MCCLUSKEY, associate director of Cato’s Center for EducationalFreedom, argued at a Capitol Hill

Briefing on April 7 that PresidentObama’s goal of dramatically increasingthe number of college graduates in theUnited States may not lead to exactly the results hoped for.

T ED GALENCARPENTER,vice president

for defense andforeign policystudies, and IANVÁSQUEZ, directorof the Center forGlobal Liberty andProsperity, discussthe benefits ofending the inter-national war ondrugs at a CapitolHill Briefing on May 15.

July/August 2009 Cato Policy Report • 15

APRIL 3: NATO at 60: A HollowAlliance

APRIL 3: Drug Decriminalization in Portugal

APRIL 3: Dead Aid: Why Aid Is NotWorking and How There Is a Better Way for Africa

APRIL 6: Securing Land Rights forChinese Farmers: The Progress SoFar

APRIL 7: What the Administration’sCollege Proposals Would Do forAmerica

APRIL 7: Seasteading: Homesteadingthe High Seas for Liberty

APRIL 14-17: Health Care University:Which Reforms Are Better—orWorse—than Doing Nothing?

APRIL 15: The Beautiful Tree: APersonal Journey Into How the World’sPoorest People Are Educating Themselves

APRIL 16: Left Turn? South Africaafter the Election

APRIL 17: Can Government BeTrusted with the Money Supply?

APRIL 20: Can the Pentagon Be Fixed?

APRIL 23: The Power of Freedom:Uniting Human Rights and Development

APRIL 24: Shadow Open MarketCommittee

APRIL 28: Restoring the Pro-TradeConsensus

APRIL 30: Cato Institute PolicyPerspectives 2009, New York

MAY 1: The Dangers of U.S. MilitaryDominance

MAY 11: How Overreaction andMisdirection Play into the Strategyof Terrorism

MAY 15: Is It Time to End theInternational War on Drugs?

MAY 18: The Welfare State We’re In

MAY 19: Money, Markets, andSovereignty

Audio and video for all Cato events dating back to1999, and many events before that, can be found onthe Cato Institute website at www.cato.org/events.You can also find write-ups of Cato events in EdCrane’s bimonthly memo for Cato Sponsors.

CatoCalendar

The Cato Institute continues to be aforum for scholars and policymakersfrom around the world actively in-

volved in expanding freedom. On April 6Chinese attorney KELIANG ZHU of the RuralDevelopment Institute spoke at a policyforum about the status of land rights inChina based on RDI’s recent survey ofChinese farmers and about Beijing’s tenta-tive moves to strengthen those rights. OnMay 14 JANOS KOKA, former Hungarianminister of economics and former leader ofHungary’s Free Democrats, discussed thecauses of, and solutions to, the current eco-nomic crisis in Hungary. Koka, who is alsothe head of the special parliamentary com-mittee on the Nabucco gas pipeline project,reported on the state of the pipeline.

CONSTITUTION DAYWashington ● Cato InstituteSeptember 17, 2009

CATO CLUB 200 RETREATSanta Barbara, CaliforniaFour Seasons ● October 8-11, 2009

RESTORING GLOBALFINANCIAL STABILITY27th Annual Monetary ConferenceWashington ● Cato InstituteNovember 19, 2009Speakers include William Poole, George Selgin,Judy Shelton, Lawrence H. White, and KevinMurphy.

MILTON FRIEDMAN PRIZEPRESENTATION DINNERWashington ● Hilton WashingtonMay 13, 2010

16 • Cato Policy Report July/August 2009

C A T O P U B L I C A T I O N S

In 2001, Portugal took the dramatic stepof decriminalizing all drugs, includingheroin and cocaine. Although it did not

receive a lot of attention at the time, TimLynch, who directs Cato’s Project on Crimi-nal Justice, decided it would be a good ideato commission a study on the Portuguesepolicy experiment after it had been given afair chance to work over several years. In2007, when Lynch met best-selling authorand lawyer Glenn Greenwald and discov-ered that Greenwald was fluent in Por-tuguese, Lynch’s search for the right authorwas finally over. Greenwald readily agreedto the idea of traveling to Portugal to inter-view key lawmakers and health officials.Upon his return, Greenwald began to pre-pare the most exhaustive study on the Por-tuguese experiment.

On April 2, Cato released Drug Decrimi-nalization in Portugal: Lessons for Creating Fairand Successful Drug Policies. The study notesthat while other states in the EuropeanUnion have developed various forms of defacto decriminalization—whereby sub-stances perceived to be less serious (such ascannabis) rarely lead to criminal prosecu-tion—Portugal remains the only EU mem-ber state with a law explicitly declaringdrugs to be “decriminalized.” (Portugal hasstopped short of “legalization” becausedrug dealing remains a criminal offense.)The shift in policy was controversial. Con-servatives in Portugal argued that the moveto decriminalize would only worsen thatcountry’s drug problems.

With more than seven years of experi-ence under the decriminalization regime,Greenwald reports that the policy has beenquite successful. One of the key findings ofthe study is that none of the nightmare sce-narios predicted by decriminalizationopponents—from rampant increases indrug usage among the young to the trans-formation of Lisbon into a haven for “drugtourists”—has occurred. As a result, Green-wald reports that the political climate inPortugal has changed: there is no longerany serious debate about whether drugsshould once again be criminalized.

Drug policy experts have seven years ofrelevant empirical information to examine.Those data indicate that decriminalizationhas had no adverse effect on drug usagerates in Portugal, which, in numerous categories, are now among the lowest in the EU, particularly when compared withstates with stringent criminalizationregimes. Although post-decriminalizationusage rates have remained roughly the sameor even decreased slightly when comparedwith other EU states, drug-related patholo-gies—such as sexually transmitted diseasesand deaths due to drug usage—have de-

creased dramatically. Greenwald says drugpolicy experts in Portugal attribute thosepositive trends to the enhanced ability ofthe government to offer treatment pro-grams to its citizens—enhancements madepossible, for numerous reasons, by decrimi-nalization.

Greenwald’s study has garnered plentyof media attention since it was released in April. Time Magazine, the Wall Street Jour-nal, the Financial Times, and the ScientificAmerican are among the numerous publica-tions that have cited the findings of thisCato report.

Study one of first to look at little-known success story

Report: Drug Decriminalization Works in Portugal

At an April 3 Cato Policy Forum,Glenn Greenwald demonstratesthat since decriminalizationPortugal has the lowest rate ofmarijuana use in the EuropeanUnion. His study (right) can bepurchased or downloaded atwww.catostore.org. The study drew attention in Time, the WallStreet Journal, the FinancialTimes, and Scientific American.

Private schooling is often thought ofas being exclusively for the privileged.But that is not the case in the devel-oping world. A thriving, virtually

unknown, private education sector hasemerged there, allowing many of theworld’s poorest people to rescue their chil-dren from failed government schools for aslittle as $10 a year. In The Beautiful Tree: APersonal Journey into How the World’s PoorestPeople Are Educating Themselves, JamesTooley documents this phenomenon,explaining how hundreds of millions ofpeople, from the slums of India to the shan-ty towns of Africa, are reaching into theiralmost-empty pockets to give their childrena fighting chance.

Conducting the research wasn’t easy. InZimbabwe, Tooley reports he was interro-gated in a basement by Robert Mugabe’sgoons. Meanwhile, in virtually every loca-tion Tooley visited he was told by govern-ment officials that no private schools for thepoor existed at all. In Gansu, China, seniorofficials denied Tooley’s request to researchprivate for-profit schools because it was a“logical impossibility”—universal publiceducation had been achieved there and pri-vate schools were against government poli-cy. But whenever Tooley struck out on hisown to visit the slums and villages, a differ-ent story emerged. In the slums ofHyderabad, India, Tooley found that 53 per-cent of the 918 schools there were private.Of the private schools, the majority of thosewere not even recognized by governmentstatistics. In Gansu, Tooley was ultimatelyable to bypass the officials and found 586private schools for the poor there.

While such schools are typically lessequipped than their public counterparts,with teachers lacking comparable creden-tials, they have one important advantage:they serve their customers. In Gansu, theprivate schools were not necessarily betterthan their public peers, but they weremuch closer to the farms and villageswhere people lived. And while the far-awayChinese public schools were “free,” theyused more expensive books than did the

private schools, making them more expen-sive for the parents.

Meanwhile, teacher absenteeism is ram-pant in government-run schools in thedeveloping world. When Tooley and hisresearch team called unannounced on theclassrooms in Hyderabad, 98 percent of theteachers were actually teaching in the pri-vate recognized schools, compared with 91percent in the unrecognized schools and75 percent in the government schools. InGa, Ghana, only 57 percent of teacherswere actually teaching in the governmentschools when randomly called.

Even if underpublicized, private school-ing is definitely a large and significant phe-nomenon in the developing world. But howeffective are the private schools comparedto their public peers? In order to test thatquestion, Tooley set about on a massiveresearch project, documenting the IQ andtest scores in math and English of morethan 3,000 students in India, Kenya,Ghana, and Nigeria. What Tooley discov-ered was remarkable. In Hyderabad, stu-dents attending recognized and unrecog-nized private schools outperformed theirpeers in government schools by a full stan-dard deviation in both English and math(after accounting for differences in theirobservable characteristics). In Ghana, theprivate-school advantage was between 0.2and 0.3 standard deviations in both sub-jects. And in Kenya, he found that privateschools, though serving a generally lessadvantaged population, were 0.1 standarddeviations above their public counterpartsin English and 0.2 deviations above publicschools in math. All of these results werehighly statistically significant. In a word,private schools were doing better than pub-lic schools for a fraction of the cost.

If the free education marketplace canmore effectively serve families in some ofthe most disadvantaged corners of theglobe, imagine what it could do in farwealthier nations such as our own.

Visit www.catostore.org or dial 800-767-1241 toget your copy of The Beautiful Tree today; $19.95hardcover.

Private schools in the midst of poverty

Surprising...engaging...a moving account of how poor parents struggle against greatodds to provide a richeducational experience to their children.PUBLISHERS WEEKLY—

““

Bootstrapping Education

July/August 2009 Cato Policy Report • 17

This is a great book—iconoclastic, refreshing,well-written, and careful.Tooley’s detective workreveals a major undis-covered planet: privateschools for the poor.WILLIAM EASTERLY,New York University; Author, White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good

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18 • Cato Policy Report July/August 2009

C A T O S T U D I E S

Financial institution bailout policy inthe United States is implementedthrough three agencies: the FederalDeposit Insurance Corporation, the

Federal Reserve, and the Treasury Depart-ment. The need for orderly financial dealings,particularly in times of crisis, would dictate aconsistent approach by these agencies basedon cumulative experience, ensuring that offi-cials devote public resources only where thereis a well-defined, transparent, and verifiablepolicy justification for a bailout. Yet thebailouts over the past year do not reflect awell-defined, transparent, and verifiable poli-cy justification. Even in the cases where astandard has been articulated, the agencieshave not demonstrated that they can success-fully implement that standard in practice.Vern McKinley, formerly of the FDIC andcurrently a central bank consultant, and GaryGegenheimer, a senior legal adviser with BearingPoint, argue in “Bright Lines andBailouts: To Bail or Not to Bail, That Is theQuestion” (Policy Analysis no. 637) thatfinancial-institution bailout policy has beenunwieldy, inequitable, extremely costly, dis-

ruptive, and lacking in transparency andoversight. The policy response of bailouts andmaintenance of the status quo has been precisely the wrong response, as it has led to retaining many of the mega-financial institutions that pose systemic risk, thusplanting the seeds for future crises. The ulti-mate answer is to place troubled institutionsinto receivership or the relevant form ofbankruptcy—including many of the institu-tions that have already been bailed out.

Making Free Trade Popular AgainFor more than 40 years the United Stateshas benefited from a level of pro-trade senti-

ment, among boththe public and itsgovernment. Recent-ly, however, this sen-timent is in decline.Daniel Ikenson, as-sociate director ofthe Center for TradePolicy Studies at the

Cato Institute, and Scott Lincicome, aninternational trade attorney, debunk several

myths of the anti-trade movement in“Audaciously Hopeful: How PresidentObama Can Help Restore the Pro-TradeConsensus” (Trade Policy Analysis no. 39).America’s manufacturing sector is not flee-ing across international borders. Prior to thecurrent recession, U.S. manufacturing wasthriving and recorded record output in2007. The current obsession over tradedeficits is unwarranted, the authors argue.The deficit is not a function of trade policybut rather of varying patterns of consump-tion and saving. The focus on trade agree-ment violations is also troubling, as theseagreements have only a small impact on theU.S. trade account and economy.

Dangerous PakistanAlong the border between Pakistan andAfghanistan, U.S. and NATO troops andlocal tribes are threatened by a spreadingIslamic insurgency. Maintaining security inthe region is essential. Cato foreign policyanalyst Malou Innocent, who recently spentseveral weeks in Pakistan, explains how it canbe accomplished in “Pakistan and the

Unwieldy, Inequitable, Costly, and Disruptive

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CATO POLICY REPORTDavid Boaz.............................................................................EditorDavid Lampo.......................................................Managing EditorJon Meyers..................................................................Art DirectorKelly Anne Creazzo.................................................PhotographerClaudia Ringel..............................................................CopyeditorJustin Higginbottom, Aaron Ross Powell, Zachary David Skaggs .............................................Contributors

CATO INSTITUTEEdward H. Crane .............................................President and CEORobert A. Levy.................................................................ChairmanDavid Boaz..............................................Executive Vice PresidentLesley Albanese.....................................................Vice PresidentKhristine Brookes.......................................V.P., CommunicationsTed Galen Carpenter ......V.P., Defense & Foreign Policy StudiesJames A. Dorn ...........................................V.P., Academic AffairsWilliam Erickson......................V.P., Finance and AdministrationGene Healy..............................................................Vice PresidentBrink Lindsey ...........................................................V.P., ResearchWilliam A. Niskanen.....................................Chairman EmeritusRoger Pilon .........................................................V.P., Legal Affairs

Swaminathan Aiyar...........................................Research FellowVirginia Anderson ................................Chief Information OfficerBrandon Arnold................................Director,Government AffairsDoug Bandow...........................................................Senior FellowMark Calabria...................Director,Financial Regulation Studies

Michael F. Cannon........................Director, Health Policy StudiesAndrew Coulson.........Director,Center for Educational FreedomTad DeHaven .........................................................Budget AnalystChris Edwards...............................Director, Fiscal Policy StudiesBenjamin H. Friedman......................................Research Fellow Robert Garber.................................................Director, MarketingKaren Garvin.................................................................CopyeditorJagadeesh Gokhale...............................................Senior FellowDaniel T. Griswold........................Director, Trade Policy StudiesJim Harper............................Director, Information Policy StudiesNat Hentoff...............................................................Senior FellowLinda Hertzog..............................................Director, ConferencesJuan Carlos Hidalgo........Project Coordinator for Latin AmericaDaniel J. Ikenson........ Associate Director, Trade Policy StudiesAndrei Illarionov.....................................................Senior FellowMalou Innocent.........................................Foreign Policy AnalystSallie James.................................................Trade Policy AnalystJason Kuznicki...................................................Research FellowDavid Lampo.................................................Publications DirectorTrisha Line.......................................................................ControllerJustin Logan...................Assoc. Director, Foreign Policy StudiesTimothy Lynch.......................................Director, Criminal JusticeAshley March...............................Director, Foundation RelationsNeal McCluskey...Assoc. Director, Center for Educational FreedomJon Meyers..................................................................Art DirectorDaniel J. Mitchell...................................................Senior FellowJohan Norberg........................................................Senior FellowRandal O’Toole........................................................Senior FellowTom G. Palmer.........................................................Senior FellowAlan Peterson.......................................................Director of MISChristopher Preble.....................Director, Foreign Policy StudiesAlan Reynolds..........................................................Senior FellowClaudia Ringel...................................Manager, Editorial ServicesDavid Rittgers ...............................................Legal Policy Analyst

John Samples....................Director, Ctr. for Representative Govt.Adam B. Schaeffer................................Education Policy AnalystIlya Shapiro............................................................. ..Senior FellowMichael Tanner.........................................................Senior FellowJerry Taylor................................................................Senior FellowMarian Tupy.......................................Development Policy AnalystPeter Van Doren.................................................Editor, RegulationIan Vásquez.......Director, Ctr. for Global Liberty and ProsperityWill Wilkinson.........................................................Policy Analyst

James M. Buchanan.......................Distinguished Senior FellowJosé Piñera.......................................Distinguished Senior FellowEarl C. Ravenal.................................Distinguished Senior Fellow

Randy E. Barnett.......................................................Senior FellowVladmir Bukovsky....................................................Senior FellowTucker Carlson..........................................................Senior FellowLawrence Gasman..............Senior Fellow in TelecommunicationsRonald Hamowy.....................................Fellow in Social ThoughtSteve H. Hanke.........................................................Senior FellowJohn Hasnas............................................................. Senior FellowPenn Jillette.........................................Mencken Research FellowDavid B. Kopel........................................Associate Policy AnalystChristopher Layne..............Visiting Fellow, Foreign Policy StudiesPatrick J. Michaels......Senior Fellow in Environmental StudiesJeffrey Miron.............................................................Senior FellowP. J. O’Rourke ......................................Mencken Research FellowWilliam Poole...........................................................Senior FellowGerald P. O’Driscoll Jr.............................................Senior FellowJim Powell.................................................................Senior FellowRichard W. Rahn.......................................................Senior FellowRonald Rotunda.................Senior Fellow, Constitutional StudiesTeller......................................................Mencken Research FellowCathy Young.....................................................Research Associate

Future of U.S. Policy” (Policy Analysis no.636). Learning from experiences in Iraq—while recognizing the uniqueness ofAfghanistan—the United States should sup-port counterinsurgency actions through asmall number of Special Forces personnel.To improve the ability of the Pakistani forcesto conduct this battle themselves, training ofPakistani troops at American military insti-tutions must be made a greater priority. Yetany aid to Pakistan should come with strongoversight, something absent from the $20billion already spent on aid in the region.Support must be conducted without en-dorsing particular leaders, however, as thecurrent methods injure their credibilitywhile fostering resentment of U.S. involve-ment in Pakistani politics.

Trade Not Aid for AfricaForeign aid has done Africa more harm thangood, encouraging waste and corruptionwhile failing to stimulate economic growth.Major industrial countries, meeting in Gle-neagles, Scotland, in 2005, agreed to give thecontinent more of the same. In “The FalsePromise of Gleneagles: Misguided Prioritiesat the Heart of the New Push for AfricanDevelopment” (Development Policy Analy-sis no. 9), Marian L. Tupy, policy analyst at theCato Institute’s Center for Global Liberty andProsperity, argues that trade liberalization hasthe greatest potential to bring Africa out ofpoverty. History shows that sustained eco-nomic growth is necessary for moving a coun-try toward wealth—and that free trade is thebest path to economic growth. Removingrestrictions on African exports and endingWestern farm subsides that hurt the marketfor Africans crops should be a priority.

Drug Decriminalization in PortugalFaced with rampant drug use, fewAmerican policymakers would seek solu-tions in more liberal drug laws. But that’swhat Portugal did in 2001—and theEuropean country has since quietly enjoyedthe benefits of drug decriminalization. In“Drug Decriminalization in Portugal:Lessons for Creating Fair and SuccessfulDrug Policies,” Glenn Greenwald, a consti-

tutional lawyer and contributing writer atSalon, explains why Portugal should be amodel for United States drug policy. After nosuccess with traditional drug war methods, anonpolitical commission in Portugal decid-ed to decriminalize all drugs, making posses-sion a civil, rather than criminal, offense.Opponents believed that once decriminal-ized, drug use rates would explode. Green-wald’s study shows, however, that, sevenyears after decriminalization, those grave predictions were false. First-time prevalencerates for every drug have decreased and highschool drug use has fallen significantly.

Exploding Federal SubsidyProgramsThe budget has doubled in eight years to $3.9trillion. In 2008 there were 1,804 differentsubsidy programs in the federal budget—upfrom 1,019 in 1970—and the recent stimulusbill added even more. Chris Edwards, director

of tax policy studiesat the Cato Institute, discusses the “largestfederal gold rushsince the 1960s” in“Number of Feder-al Subsidy ProgramsTops 1,800”(Tax andBudget Bulletin no.

56). This drastic increase in federal pro-grams violates ideals of federalism. Edwardssuggests that people use new internet tools,such as www.usaspending.gov, to researchsubsidy spending and, armed with thisknowledge, petition Congress about theabuse of tax dollars.

Sneaking the Fairness DoctrineBack InIn “Broadcast Localism and the Lessons ofthe Fairness Doctrine” (Policy Analysis no.639), John Samples, director of the Center forRepresentative Government at the Cato Insti-tute, looks to history to provide a warningagainst embracing government interventionin First Amendment territory. From 1949 to1987, the Fairness Doctrine imposed politi-cians’ ideas of fairness upon broadcasters—along with considerable compliance costs.Four decades of government regulation of the

press resulted not only in a chilling effect onspeech but, in many cases, the use of legisla-tion to silence political dissent. New propos-als justified in the name of “serving local com-munities,” including content requirementsand advisory boards to oversee managing sta-tions, would risk the same chilling effect onspeech that the Fairness Doctrine had.

Obamacare’s Seven Deadly SinsAlthough Obama’s health care plan presentsa wealth of problems, Michael Tanner, seniorfellow at the Cato Institute, boils them downto a handful of issues in “Obamacare toCome: Seven Bad Ideas for Health CareReform” (Policy Analysis no. 638). First, laborcosts would rise as employers would have toprovide insurance to their workers. Second,individual choice in insurance would bereplaced by a pool of providers deemed ac-ceptable by government. Third, the govern-ment itself would compete against privateproviders. Fourth, comparative-effectivenessguidelines would limit the ability of providersto meet patient needs. It would force privateinsurers to accept all applicants and wouldprohibit them from employing risk-basedpremiums. Sixth, the plan would expandMedicare and Medicaid, as well as subsidizeprivate insurance purchases. Finally, anexpensive system of national electronic med-ical records would be mandated. So many badideas spell trouble for America’s future health.

Zimbabwe’s Harmful Farm PolicyZimbabwean president Robert Mugabe’scostly and unjust land reforms are discussedin “The Cost of Zimbabwe’s ContinuingFarm Invasions”(Economic DevelopmentBulletin no. 12) by Eddie Cross, an econo-mist and opposition member of Parliament.Claiming to redress historical injustices andracial imbalances in land ownership, Zim-babwe enacted the Fast Track Land Reform.Farmers who wish to sell their land mustfirst offer it to the government at a marketprice. In theory, farmers have full rights totheir land. But in practice, Zimbabwe hasbeen taking farms without paying marketprice. The effects are staggering. Zimbabwehas lost 69 percent of its agricultural outputand 70 percent of the value of its crops.

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NO MEDIA BIAS HEREThe G-20 economic summit reached afinal agreement to restore the world’seconomy Thursday only after PresidentBarack Obama personally intervened.—McClatchy Newspapers, April 2, 2009

After getting blasted last week for pre-senting a budget plan light on details,House Republicans yesterday unveiled amore complete proposal that would cuttaxes for businesses and the wealthy,freeze most government spending for fiveyears, halt spending approved in the eco-nomic stimulus package and slash federalhealth programs for the poor and elderly. —Washington Post, April 2, 2009

YET SOMEHOW THEY GET AN “F”EVERY YEAR FROM THE NATIONAL TAXPAYERS UNIONThe respective heads of the House andSenate Budget Committees, John Spratt,Jr., of South Carolina, and Kent Conrad,of North Dakota, have spent years tryingto control the deficit . . .

Kent Conrad, the chairman of theSenate Budget Committee, has madeeradicating the federal budget deficit hislife’s work.—New Yorker, May 4, 2009

A STAUNCH DEFENDER OF ALL OF HIS MARRIAGESD.C. Councilman Marion Barry toldchurch leaders and other opponents ofgay marriage Tuesday that he opposed

the city council’s decision to recognizesame-sex marriages performed outsidethe District.

Calling himself “a politician who ismoral,” Barry said he would have votedagainst the measure if he had been presentat the April 6 session.—Washington Examiner, April 28, 2009

1-800-[GET OTHER PEOPLE’S MONEY]Dear Nonprofit Professional,

Billions of dollars from the Obamastimulus plan are becoming availabledaily for funding thousands of newstate, local and nonprofit programs!

And while it’s extremely time con-suming and difficult to keep up with theever-changing opportunities and thecomplex requirements to apply for them,we can help make that task easier thanyou’d imagine . . . —Email received April 29, 2009

INSIDE EACH BAILOUT, ANOTHER BAILOUTMatryoshki, the wooden nesting dollsthat are synonymous with Russian folkart—those gourd-shaped figures that canbe pulled apart to reveal ever-smallerdolls—are in trouble. . . .

With the country enduring its worsteconomic downturn in a decade, mat-ryoshka manufacturers are pleading withthe government for aid, and warning that their survival could depend on itbecause sales have already fallen by at least a third.

The Kremlin has agreed to add the

matryoshka to its bailout budget, pledg-ing to buy nearly $30 million worth of thedolls and other souvenirs for officials togive away as gifts. —Washington Post, May 31, 2009

BAILOUT NATION• More Homeowners Getting Aid,

but Demand Keeps Rising• AIG Could Repay U.S. in 3 to 5

Years, Chief Tells Congress• Treasury Clarifying Rules for

Bailed-Out Firms• Small Auto Suppliers Seek Help in

Wake of Giants’ Woes—Headlines in the Washington Post, May 14, 2009

OBAMA’S REPUBLICAN LAYS IT ON THE LINEQuestion: Some in the highway support-ers and motorists groups have been con-cerned by your livability initiative. Is thisan effort to make driving more tortuousand to coerce people out of their cars?

LaHood: It is a way to coerce peopleout of their cars, yeah. . . .

Question: Some conservative groupsare wary of the livable communities pro-gram, saying it’s an example of govern-ment intrusion into people’s lives. Howdo you respond?

LaHood: About everything we doaround here is government intrusion inpeople’s lives.—Transportation Secretary Ray LaHood atthe National Press Club, May 21, 2009

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