A Visible Hand Is Needed

Invisible hand is the term used by Adam Smith to describe the natural force that guides free market capitalism through competition for scarce resources. According to Adam Smith, in a free market each participant will try to maximize self-interest, and the interaction of market participants, leading to exchange of goods and services, enables each participant to be better off than when simply producing for himself/herself. He further said that in a free market, no regulation of any type would be needed to ensure that the mutually beneficial exchange of goods and services took place, since this "invisible hand" would guide market participants to trade in the most mutually beneficial manner.

Adam Smith (baptized June 16, 1723 – July 17, 1790 [OS: June 5, 1723 – July 17, 1790]) was a Scottish moral philosopher and a pioneering political economist. One of the key figures of the intellectual movement known as the Scottish Enlightenment, he is known primarily as the author of two treatises: The Theory of Moral Sentiments (1759), and An Inquiry into the Nature and Causes of the Wealth of Nations, commonly known as The Wealth of Nations (1776). Smith is also known for his explanation of how rational self-interest and competition, operating in a social framework which ultimately depends on adherence to moral obligations, can lead to economic well-being and prosperity. His work helped to create the modern academic discipline of economics and provided one of the best-known rationales for free trade. He is widely acknowledged as the "father of economics".

The above two paragraphs I borrowed to make a point. Adam Smith was a Scottish moral philosopher who lived in the 18th century and never saw the likes of Wall Street. Had Adam Smith lived to see what technology has permitted markets to do today, I seriously doubt that he would have insisted that no regulation was necessary because an “invisible hand” would guide market players to trade in the most mutually beneficial manner. (And this was before Adam Smith knew that some day there would be a Senator Phil Gramm who would sponsor legislation, that would be known as the Enron Bill, that would negate that assumption.)

I am happy that President Bush signed the new housing bill and did not veto it. While it probably is not perfect, at this late hour, perfect is out of the question, let us keep as many families in their homes as possible. But, unless Congress tackles the harder questions of regulation, oversight and auditing, we will have eventually more of the same.

There is a joke about people that do the same thing over and over again expecting different results being idiots. Well, unless Congress puts some teeth into regulation as it pertains to our capital markets and how they operate, we are going to have the same crisis again and again until we learn our lesson.

The housing bubble and the mortgage meltdown would never have got off the ground, I repeat, would never have got off the ground, without the triple-A ratings handed out by the rating companies. Without the AAA rating, pension portfolio managers and everyone else managing million dollar and billion dollar funds would never have purchased those mortgage bonds for their portfolios in the first place. Without the billions of dollars in mortgage bonds being rated triple-A, the mortgage bond market does not get off the ground, and, the housing bubble never gets started.

Yes, there is a high-yield bond market sometimes referred to as the “Junk Bond Market”, but the percentage of junk bonds found in the average pension fund portfolio under the fixed-income portion of the pension fund portfolio is easily less than ten percent. No major corporate or state pension fund would invest a significant portion of their fixed-income assets in unrated mortgage bonds. Without buyers for the mortgage bonds, the mortgage bond underwriting business does not get off the ground. The whole mess is predicated on the mortgage bonds receiving the triple-A rating. Again, without the triple-A rating, this train does not leave the station.

Unless something is done about the companies that rate mortgage bonds, the United States is looking at another meltdown in the future. It is my opinion, that if Adam Smith could come back and see how the capital markets operate today, and given the size of the markets today, that he would say it is time for the “invisible hand” to become visible.

Stay tuned.