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The Failure of State-Designed Markets / Artikel mises.org

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The Failure of State-Designed Markets
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By Casey Khan
[Posted September 3,
2003]

<img alt src="http://www.mises.org/images3/monopolyboard.gif" align="right" border="0" width="236" height="153">A
growing recognition of the superiority of markets over planning has created an
unviable hybrid: the planned market, one created not by property owners but
rather by the state and for the state. Planned markets bear a close enough
resemblance to the real thing to fool even astute observers who are otherwise
friends of genuine market forces. And yet the designed"market" is
responsible for a whole range of recent economic failures, such as electricity
shortages and blackouts, and will cause more if the idea is taken to areas
like predicting terrorism.

Let us begin by examining
real markets. Their appearance is as spontaneous as it is unpredictable. Back
in the summer of 1998, for example, I was working as an over-the-counter
broker dealing with forward electricity contracts in New York. Our office was
located on the 10th floor of 1 World Trade. One summer day when the
market was slow due to a credit meltdown in the Cinergy market, two brokers
started making some bets. They were betting on the temperature displayed on a
digital clock across Liberty Street. In similarity to an option contract where
the price is derived from an underlying commodity or index, they bet on the
clock temperature rising above or below a particular"strike" at a
particular time.

One could bet that the
clock"temp" would be above the 102 Fahrenheit strike by 10:15
expiration or below 99 by 11:30. Since the sun was shinning directly on the
clock causing volatile swings in the temp by the minute, and we were bored out
of our minds, interest began to grow in this market for clock temp bets. It
eventually sounded like just another busy day on the trading floor. It got so
complicated at one point that some were trying to make spread trades between
different temp strikes. Out of thin air, a market was created the speculative
market for clock temp bets. Kind of sounds crazy, but it was fun. Of course,
when the sun stopped shining on the clock, interest waned and the market was
over.

The above
represents an excellent example of a market economy. Just as in the more
formal case of the Buttonwood
Agreement, individuals freely
contracted to make mutual gains from exchange. Granted that the payouts in the
clock temp market are zero-sum in a monetary sense, and it only lasted for
three hours. Consumers in the market were able to trade some of their money
for the boredom of that slow summer day. And when the consumers were done, the
market for clock temps bets ceased to exist.

This is much like a
futures contract, an exchange traded forward agreement, that starts off hot
with growing open interest, but then interest wanes with the contract's
eventual delisting. Such a case happened when the New York Mercantile Exchange
(NYMEX) introduced electricity futures contracts. The forward market for
wholesale electric power of various hubs across the US developed when the FERC
(Federal Energy Regulatory Commission)"deregulated" the market. It
was the equivalent of a deregulated wholesale milk market with a corresponding
regulated retail market, in other words, totally insane.

Anyway, NYMEX saw an
opportunity to market electricity futures to members of the exchange, natural
hedgers (power marketers and utilities), and speculators. Open interest
started to grow steadily in the beginning but began to drop off when, in the
summer of 1998, massive price spikes hit the Midwest market for Cinergy. This
was primarily due to a power plant tripping in Chicago combined with
record heat causing Midwest wholesale power players to scramble for supply,
bidding up the market.

Prices became so volatile
for a market previously trading between $30 and $70 a megawatt hour, that it
was now trading between $200 and $500 a megawatt hour. At times it took a
hundred bucks just to cross a bid-ask spread. Locals on the floor like
volatility, but when it means they are already down a hundred dollars a
megawatt hour (which translates in the millions) after hitting a bid, they
begin to lose interest fast. Power producers also didn't like the small size
of the futures contract, 2 megawatt hours as opposed to the more conventional
25 to 50 megawatt hours in the over-the-counter market. Producers and locals
exercised their subjective preferences in avoidance of the NYMEX power
contracts, with the eventual delisting of the contracts from the exchange
after the California"power crisis."

In neither case of NYMEX
power or of clock temperatures, did the government design or create a market.
This is an important point. The market process exists independent of actions
by the state serving to satisfy the subjective preferences of consumers. As
Mises explains in Human
Action:<a id="_ednref1" title href="http://www.mises.org/fullstory.asp?control=1321#_edn1" name="_ednref1">[i]</a>

<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
The market economy is the social
system of the division of labor under private ownership of the means of
production. Everybody acts on his own behalf; but everybody's actions aim at
the satisfaction of other people's needs as well as at the satisfaction of
his own. Everybody in acting serves his fellow citizens. Everybody, on the
other hand, is served by his fellow citizens. Everybody is both a means and
an end in himself, an ultimate end for himself and a means to other people
in their endeavors to attain their own ends.

[/i]
This process exists
logically antecedent to the empirical examples shown. In praxeological study,
the data does not prove the theory correct. Rather, a logically correct theory
explains the data. In the case of NYMEX power futures, individual traders
exercised their own judgment by independently moving away from the futures to
the over-the-counter forward market.      

<h1>The Government's"Market"</h1>
Which leads us to the
case of the government's"market."  The two prior cases
consisted of naturally occurring markets, one totally unregulated by the state
(clock temperature bets) and the other which the state has allowed to operate
with restriction (wholesale electric power). The state does not limit itself
to restricting markets; often it attempts to create markets for its own
intents and purposes.

The most well known
example of state market creation is the primary market for government debt. A
government issues debt to expand its rule and power with the expectation of
taxing its subjects to pay back principle and interest. The state's means of
revenue are a use of force and coercion, a concept antithetical to the market.
"The market directs the individual's activities into those channels in
which he best serves the wants of his fellow men. There is in the operation of
the market no compulsion and coercion," explains Mises <a id="_ednref2" title href="http://www.mises.org/fullstory.asp?control=1321#_edn2" name="_ednref2">[ii]</a>.
Why is there no market coercion?  Coercion is absent because consumers
would naturally avoid threatening vendors. Knowing this, state organizations
have to use a hammer to keep consumers under their tutelage.

In the case of government
debt, taxation and monetary debasement are the hammers. Naturally this leads
us to ask, can the state create a market economy?  Not if we accept a
logical definition of the market process. Of course, state propaganda distorts
economic reasoning to justify its existence,"squaring the circle"
if you will. The statists can redefine"market" to mean whatever
they want it to mean, even if it defies all logical reasoning, primarily
because the state can force others to accept it.

The U.S. Treasury auction
on government debt is portrayed as a market, but in reality, it serves to help
only one consumer, the government itself. Even more so than voting, the
primary Treasury market is the ultimate auction on stolen goods. This makes it
quite amusing to hear financial practitioners call interest rates on the
Treasury yield curve,"risk free."  It doesn't seem logical to
consider an investment in an entity that uses coercion, theft, and force to
remain solvent, as one that is risk free. But such illogical propositions help
the state in its solvency. Granted, individuals do not have to buy primary
Treasury securities, but many do so, seduced by the"guaranteed"
rate of return at the expense of themselves and their fellow taxpayers.   

It is interesting to note
that rising from state market products, like the U.S. Treasury debt and
Federal Reserve notes, the secondary and derivative markets developed
reflecting market principles. Treasury bond futures on the Chicago Board of
Trade rose from those who were looking for a way to hedge interest-rate risk
in their portfolios. Currency swaps markets naturally occurred when
governments tried to impose foreign exchange controls on their currencies.
However, regardless of secondary market characteristics, there is no
justification for the primary market aberrations created by the state's use of
force.  

Moving beyond money and
credit, governmental organizations continue to design other markets, which
often claim to meet the needs of some nameless consumer. These consumers are
usually collective entities like the public at large, or a nonhuman element
like the environment. The EPA, in its perpetual quest to save the environment
from owners of private property, imposed sulfur dioxide emissions regulations
on companies with coal burning plants. In the regulatory process they came up
with a"free-market" solution of tradable emission allowances. The
EPA would distribute a certain amount of allowances a year for companies with
coal emitting plants.

This is another example
of a coercive attempt to change behavior, but not a real market. Of course,
this led to the push for power generation companies to move away from building
coal plants toward natural gas fired generation. After all, in the minds of
government regulators and even power companies, natural gas was a pretty cheap
substitute for coal and in some cases, more efficient. What was not seen as a
possible consequence of this regulation, was that the market price for natural
gas could increase as demand from gas fired power producers increased during
the traditional summer storage months for natural gas, and that they have.   

Which brings us back to
money. The EPA's particular regulatory framework is not the only reason
natural gas prices have been riding high. Another governmental"market"
contributing to distortions in the natural gas market, as well as just about
every other market process in the economy, has been the Federal Reserve's Open
Market Operations. A reasonable case could be made that distortions in the
structure of production resulting from the Fed's operations have caused
drastic fluctuations in the supply and price of natural gas. As both Mises and
Hayek have argued, all prices do not necessarily rise or become distorted at
the same time as a result of inflationary policy:

<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
The crucial point is
that so long as the flow of money expenditure continues to grow and prices
of commodities and services are driven up, the different prices must rise,
not at the same time but in succession, and that in consequence, so
long as this process continues, the prices which rise first must all the
time move ahead of the others. This distortion of the whole price structure
will disappear only sometime after the process of inflation has stopped.
This is a fundamental point which the master of all of us, Ludwig von Mises,
has never tired from emphasizing for the past sixty years. It seems
nevertheless necessary to dwell upon it at some length since, as I recently
discovered with some shock, it is not appreciated and even explicitly denied
by one of the most distinguished living economists.<a id="_ednref3" title href="http://www.mises.org/fullstory.asp?control=1321#_edn3" name="_ednref3">[iii]</a>

[/i]
Hayek's appreciation of
time and inflation is still ignored by a majority of economists and market
participants. Looking solely at the CPI and PPI indicators, one would never
see the inflation of money and credit created by the Fed's Open Market
Operations. In the opinion of this market observer, a deeper analysis will
show the true nature of inflation as described by Hayek. As unprecedented
amounts of money were created, exhibited by the M3 indicator, banks began
investing the newly created money and credit heavily into technology companies.
And with the depression of the Fed Funds rate, the corresponding broker call
rate was lowered for margin interest, giving incentive for the masses to bid
up technology companies in the heavily tech weighted Nasdaq Composite index.  

During the tech boom, the
newly created money allocated existing capital toward tech ventures away from
other ventures in the economy. Boring, stodgy natural gas companies were one
major economic player ignored in the tech boom. The Nasdaq reached its height
in the spring of 2000; not long after the Fed's Y2K emergency creation of
massive amounts of money and credit.

As Silicon Valley and the
rest of California boomed on these tech ventures, demand for power and natural
gas grew to an eventual boiling point, perpetuating what became the California
Power Crisis. Eventually, investors grew weary of tech companies; realizing
profitability in such ventures was unsustainable. With gas moving to the
stratosphere and tech collapsing almost a year after the Nasdaq's high, banks
with constantly increasing money and credit, courtesy of the Federal Reserve,
began pouring money into electric power and natural gas companies, like the
infamous Enron, and out of technology ventures.

Money and credit was
going toward new exploration and production with the increase in gas rigs as
well as electricity power plants. Eventually many of these ventures went bust
as well with natural gas prices plummeting on record storage levels and spark
spreads (electric power producer's margin) diminishing. This bust recorded
some of the largest bankruptcies in US history, including Enron. Of course,
mainstream analysis will fail to see the Fed's role in this process because
many hold a neutral view of money and credit. Further study will illustrate
the non-neutrality of money, combined with the component of time, have
volatile effects on the seemingly uncorrelated markets like natural gas and
power.    

Of course, culpability
politically lies with the now bankrupt Enron and the"free market,"
not with Federal Reserve policy or with any other statist market creations all
are forced to comply with.

Power Market Design

Since the failure
of the reregulation of the electric power market in California, the Federal
Energy Regulatory Commission has proposed"harmonizing" US wholesale
power markets. Their justification for potential standardization of the
wholesale power market is based on the same tired argument that markets just
don't work. According to a FERC white paper on the Wholesale
Power Market Platform <a id="_ednref4" title href="http://www.mises.org/fullstory.asp?control=1321#_edn4" name="_ednref4">[iv]</a>
issued this year:

<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
…short-term wholesale
markets with transparent prices and market structures that will reliably
produce just and reasonable prices are not likely to develop without strong
Commission action. Wholesale electricity markets do not automatically
structure themselves with fair behavior rules, provide a level playing field
for market participants, effectively monitor themselves, check the influence
of market power, mitigate prices that are unlawful, or fix themselves when
broken.

[/i]
We have heard this type
of argument before. It goes something like this. Government"deregulates"
market. Market fails under"deregulation." Government must place
stronger restrictions on a process to correct its failures and shortcomings.
Of course what is lost in this whole argument is that the government's
original regulations caused the initial problems. Also, it is never mentioned
that after"deregulation," the government is still regulating the
market.

In the case of electric
power, there is still massive Federal regulation of the transmission system
and massive state regulation of retail markets despite the deregulation of
wholesale. To the one-dimensional economic thinker, a"deregulated"
wholesale market can exist or be expected to exist independently and
effectively from the transmission (electricity transportation) and retail
markets. Therefore, according to FERC, since"deregulated,""unhampered"
markets for wholesale power are failing, FERC needs to step in and make it
function"properly." 

However, the astute
multidimensional economic thinker knows better, understanding that all markets
are interrelated. Deregulated wholesale power markets are not free markets
when transmission and retail markets are restrained by government power. It is
not the free market that has failed, rather it is the restrictions on the
market participant's ability to deal with scarce resources. Since this ability
is restricted, people are unable to creatively deal with shortages and
surpluses in an effective manner. Economic calculation becomes impossible due
to the centralized control of the market's resources, and in this case the
controlled resources are transmission and retail supply. Taking the analysis
to the next dimension, socialized money and credit compound the impossibility
of effective economic management, distorting the medium of exchange and unit
of account used in transacting in the power market.         

To fix the perceived
market problems, FERC proposes to impose a Wholesale Market Platform
consisting of components like"fair cost allocations for transmission,"
"market power mitigation," and"transparency in congestion
management."  FERC is under the impression that its market design is
superior to failed models like California because it is more effective in
curbing unwanted market behaviors while at the same time effectively serving
the consumer. But how can FERC, with the use of compulsion and coercion, serve
the consumer?  It cannot, and its market design will fail because its
plan could never be a market. Consumers will have no choice in abstaining from
it. If power companies find that the FERC's wholesale market isn't exactly
what they want out of a market, they will have no choice but to accept it.
Unlike the case of NYMEX Futures versus over-the-counter forwards, there will
be no alternative.

The only way to get
innovation and change is to beg FERC or payoff some politicians. While they
wait and beg, transmission lines will decay, blackouts will ensue, and the
consumers will be asked to conserve. In other words demand will not be met,
because supply will have to beg the government to serve demand. Such a"middle
road" is always doomed to failure, because the middle road is not the
market.

<h1>Terror Futures</h1>
Looking at US Treasuries, Federal
Reserve Notes, EPA emission credits, or power market designs, it should be no
surprise that DARPA (Defense Advanced Research Projects Agency) under the
Information Awareness Office has tried to mold such a monstrosity as the
market for terror futures. In essence, the market would be purely speculative
unlike most futures markets which have large hedging interests. Profits in the
market would also be restrained to $100 a trade thus keeping would-be
terrorists from having massive windfall profits on an event's occurrence. <a id="_ednref5" title href="http://www.mises.org/fullstory.asp?control=1321#_edn5" name="_ednref5">[v]</a> 

Proponents of the initiative argue
that it would be an effective way to gather intelligence and combat terrorism.
According to Hal
Varian in the New York Times, markets
can be great"predictors" of future events. <a id="_ednref6" title href="http://www.mises.org/fullstory.asp?control=1321#_edn6" name="_ednref6">[vi]</a> 
He cites evidence of online betting markets, like tradesports.com, which is
similar to the DARPA proposition and the earlier example of clock temperature
bets. Pat
Buchanan argues that a bettors' market might
have predicted some of the greatest strategic disasters in the last century. <a id="_ednref7" title href="http://www.mises.org/fullstory.asp?control=1321#_edn7" name="_ednref7">[vii]</a> 
In a Wired news article, Noah
Shachtman quotes proponent David Pennock, who
has done extensive surveys on the reliability of such markets:

<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
"'The very fact of the
terrorist doing that (investing money in an attack) would reveal his hand,'
he said. Prices would rise as the terrorist invested his cash, and that
would tip leaders off to the potential for strike. 'The market would know
something is going to happen that people never would have known otherwise,"
Pennock added." <a id="_ednref8" title href="http://www.mises.org/fullstory.asp?control=1321#_edn8" name="_ednref8">[viii]</a>  

[/i]
It is important to note that
futures markets are not necessarily good predictors of future events, rather
they are the best estimate of a future market price now. It is a market's
effectiveness in dealing with events as they arise due to their roots in
property rights that make them desirable. With this ability to freely exercise
private property rights comes the potentially rewarding prospect of increased
profitability.

Where all of these proponents fail
in their analysis is that markets are effective means of information
dissemination because they are decentralized institutions rooted in property
rights. Even with their own examples of sports betting or the Hollywood stock
exchange, they fail to see the fundamental difference between freely
functioning markets and a creation of the state.

The state's idea of terror futures
is so bad, that only the use of force could sustain it. The prospect of
earning a whopping hundred dollars on a futures trade is not very lucrative.
It is highly doubtful that traders would expend large amounts of capital
towards better systems and information gathering to reap a hundred bucks.
Since there are few restrictions on profitability in a normal futures markets,
futures players are willing to expend their private capital toward all sorts
of detailed information in the hopes of future profit maximization. For
instance a monthly subscription to a Bloomberg or Reuters news service can run
in the thousands. Some companies have paid meteorologists six figure salaries
to help with their weather risk management.

With the potential profitability
on a terror futures trade of a hundred bucks, the prospect of any relevant
intelligence arising in such a market is highly unlikely, since information is
an expensive commodity, particularly on military intelligence and political
instability. For an annual subscription to an Economist
Intelligence Unit's (a major sponsor of the
DARPA market) country report it would cost $470 a country.

<img alt src="http://www.mises.org/images3/jordan.jpg" align="right" border="0" width="380" height="142">If
one went long the potential overthrow of the Jordanian monarchy, and decided
to use an EIU annual subscription to track it, one would hope the monarchy was
overthrown at least five times before meeting information costs.   Just
to get a good two to one risk reward on such a trade, the poor Hashemite king
would have to be overthrown at least ten times. I guess one could hire some
disgruntled policy analysts from DARPA for $20 bucks a month, but even that
would put a big dent into profit margins. What DARPA, EIU, and the state fail
to see, is that you can't have the benefits of robust market information,
while limiting the profitability of a trade.   

The one positive aspect of the
terror futures market proposal is the implicit admission by DARPA that the
state's current means of intelligence gathering is as ineffective as every
other means it uses in protection of its tutelage. To further justify the
state's roll in intelligence gathering and protection, DARPA developed a
scheme under the auspices of"market" economics. Unfortunately, such
a measure will fail to meet the demands of consumers because it is not market
economics. Fortunately, this means the state's ineptitude is becoming more
obvious.     

Conclusion

While things like terrorism
futures are overtly grotesque, economic thinkers need to be disciplined in
understanding the fundamental differences between the market and the state. In
more subtle examples like EPA emission credits, US Treasuries, or Federal
Reserve Open Market Operations, economists need to realize the roots of these
creations and how they affect the market economy. It cannot be stressed enough
that the state cannot create its antithesis, the market. Markets are rooted in
private property; states are rooted in theft. Don't be fooled by squared
circles.  

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<hr align="left" width="33%" SIZE="1">
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Casey Khan [send
him mail] works as a risk analyst in the
energy industry in Phoenix, AZ, where he lives with his wife.


<hr align="left" width="33%" SIZE="1">


 

<div class="MsoBodyText">
<div class="MsoBodyText" id="edn1">
<a id="_edn1" title href="http://www.mises.org/fullstory.asp?control=1321#_ednref1" name="_edn1"></a>
Mises, Ludwig von, [i]Human
Action. Chapter 15, Section 1, fully interactive addition.

</div>
<div class="MsoBodyText" id="edn2">
<a id="_edn2" title href="http://www.mises.org/fullstory.asp?control=1321#_ednref2" name="_edn2">[ii]</a>
Ibid. Chapter 15, Section 1.

</div>
<div class="MsoBodyText" id="edn3">
<a id="_edn3" title href="http://www.mises.org/fullstory.asp?control=1321#_ednref3" name="_edn3">[iii]</a>
Hayek, F.A. "Can
We Still Avoid Inflation?" The
Austrian Theory of the Trade Cycle. Edited
by Richard Ebeling. The Mises Institute, 1996.

</div>
<div class="MsoBodyText" id="edn4">
<a id="_edn4" title href="http://www.mises.org/fullstory.asp?control=1321#_ednref4" name="_edn4">[iv]</a>
Federal Energy Regulatory Commission, White Paper, Wholesale
Power Market Platform.
Issued April 28, 2003.

</div>
<div class="MsoBodyText" id="edn5">
<a id="_edn5" title href="http://www.mises.org/fullstory.asp?control=1321#_ednref5" name="_edn5">[v]</a>
Varian, Hal R." A
Good Idea With Bad Press." New
York Times. July 31, 2003.

</div>
<div class="MsoBodyText" id="edn6">
<a id="_edn6" title href="http://www.mises.org/fullstory.asp?control=1321#_ednref6" name="_edn6">[vi]</a>
Ibid.

</div>
<div class="MsoBodyText" id="edn7">
<a id="_edn7" title href="http://www.mises.org/fullstory.asp?control=1321#_ednref7" name="_edn7">[vii]</a>
Pat Buchanan." A
City of big ideas and tiny minds." 
Townhall.com, August 6, 2003.

</div>
<div class="MsoBodyText" id="edn8">
<a id="_edn8" title href="http://www.mises.org/fullstory.asp?control=1321#_ednref8" name="_edn8">[viii]</a>
Shachtman, Noah." The
Case for Terrorism Futures."  Wired,
July 30, 2003.


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