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Even if global

regulation can't do much good, at least, it is argued, it cannot do any harm.

But in fact it can. Regulation, by its nature, inhibits freedom of market action,

and that freedom to act expeditiously is what rebalances markets.

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Undermine this freedom and the whole market-balancing process is put at

risk. We never, of course, know all the many millions of transactions that

occur every day. Neither does a U.S. Air Force B-2 pilot know, or need to

know, the millions of automatic split-second computer-based adjustments

that keep his aircraft in the air.

In today's world, I fail to see how adding more government regulation

can help. Collecting data on hedge fund balance sheets, for example, would

be futile, since the data would probably be obsolete before the ink dried.

Should we set up a global reporting system of the positions of hedge and

private equity funds to see if there are any dangerous concentrations that

could indicate potential financial implosions? I have been dealing with financial

market reports for almost six decades. I would not be able to judge

from such reports whether concentrations of positions reflected markets

in the process of doing what they are supposed to do—remove imbalances

from the system—or whether some dangerous trading was emerging. I

would truly be surprised if anyone could.

To be sure, the "invisible hand" presupposes that market participants

act in their self-interest, and there are occasions when they do take demonstrably

stupid risks. For example, I was shaken by the recent revelation that

dealers in credit default swaps were being dangerously lax in keeping detailed

records of the legal commitments that stemmed from their over-thecounter

transactions. In the event of a significant price change, disputes

over contract language could produce a real but unnecessary crisis.* This

episode was a problem not of market price risk but of operational risk—

that is, the risks associated with a breakdown in the infrastructure that enables

markets to function.

Superimposed on the longer-term forces I've discussed, it is important

to remember, is the business cycle. It is not dead, even though it has been

muted for the past two decades. There is little doubt that the emergence of

just-in-time inventory programs and increasing service output has markedly

diminished the amplitude of fluctuations in GDP. But human nature

does not change. History is replete with waves of self-reinforcing enthusi

*Fortunately, with the assistance of the Federal Reserve Bank of New York, this particular

problem is on its way to being solved.

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asm and despair, innate human characteristics not subject to a learning

curve. Those waves are mirrored in the business cycle.

Taken together, the financial problems confronting the next quarter

century do not make a pretty picture. Yet we have lived through far worse.

None of them will permanently undermine our institutions, or even likely

topple the U.S. economy from its place of world leadership. Indeed there

are currently a number of feared financial imbalances that are likely to be

resolved with far less impact on U.S. economic activity than is generally

supposed. I indicated in chapter 18 that the unwinding of our current account

deficit is not likely to have a major impact on economic activity or

employment. The fear that a liquidation of much of China's and Japan's

huge foreign-exchange reserves will drive U.S. interest rates sharply higher

and dollar exchange rates lower is also exaggerated.

There is little we can do to avoid the easing of global disinflationary

forces. I view that as a return to fiat-money normalcy not a new aberration.

What is more, we have it within our power to sharply mitigate some of the

more dire features of the scenario I have outlined above. First, the president

and Congress must not interfere with the Federal Open Market Committee's

efforts to contain the inevitable inflationary pressures that will eventually

emerge (the members will need no encouragement). Monetary policy

can simulate the gold standard's stable prices. Episodes of higher interest

rates will be required. But the Volcker Fed demonstrated that it can be done.

Second, the president and Congress must make certain that the economic

and financial flexibility that enabled the U.S. economy to absorb the

shock of 9/11 is not impaired. Markets should remain free to function

without the administrative constraints—particularly those on wages, prices,

and interest rates—that have disabled them in the past. This is especially

important in a world of massive movements of funds, huge trading volumes,

and markets rendered inevitably opaque by their increasing complexity.

Economic and financial shocks will occur: human nature, with its

fears and its foibles, remains a wild card. The resulting shocks will, as always,

be difficult to anticipate, so the ability to absorb them is a paramount

requirement for stability of output and employment.

Hands-on supervision and regulation—the twentieth-century financial

model—is being swamped by the volume and complexity of twenty-first

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century finance. Only in areas of operational risk and business and consumer

fraud do the principles of twentieth-century regulation remain intact. Much

regulation will continue to be aimed at ensuring that rapid-fire; risk-laden

dealings are financed by wealthy professional investors, not by the general

public. Efforts to monitor and influence market behavior that is proceeding

at Mach speeds will fail. Public-sector surveillance is no longer up to the

task. The armies of examiners that would be needed to maintain surveillance

on today's global transactions would by their actions undermine the

financial flexibility so essential to our future. We have no sensible choice

other than to let markets work. Market failure is the rare exception, and its

consequences can be assuaged by a flexible economic and financial system.

H

H

owever we get to 2030, the U.S. economy should end up much larger,

absent unexpectedly long crises—three-fourths larger in real terms

than that in which we operate today. What's more, its output will be far

more conceptual in nature. The long-standing trend away from value produced

by manual labor and natural resources and toward the intangible

value-added we associate with the digital economy can be expected to continue.

Today it takes a lot less physical material to produce a unit of output

than it did in generations past. Indeed, the physical amount of materials

and fuels either consumed in the production of output or embodied in the

output has increased very modestly over the past half century. The output

of our economy is not quite literally lighter, but it is close.

Thin fiber-optic cable, for instance, has replaced huge tonnages of copper

wire. New architectural, engineering, and materials technologies have

enabled the construction of buildings enclosing the same space with far less

physical material than was required fifty or one hundred years ago. Mobile

phones have not only downsized but also morphed into multipurpose communication

devices. The movement over the decades toward production of

services that require little physical input has also been a major contributor

to the marked rise in the ratio of constant dollars of GDP to tons of input.

If you compare the dollar value of the gross domestic product—that is,

the market value of all goods and services produced—of 2006 with the

GDP of 1946, after adjusting for inflation, the GDP of the country over

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which George W. Bush presides is seven times larger than Harry Truman's.

The weight of the inputs of materials required to produce the 2006 output,

however, is only modestly greater than was required to produce the 1946

output. This means that almost all of the real-value-added increases in our

output reflect the embodiment of ideas.

The dramatic shift during the past half century toward the less tangible

and more conceptual—the amount of weight the economy has lost, as it

were—stems from several causes. The challenge of accumulating physical

goods in an ever more crowded geographical environment has clearly resulted

in pressures to economize on size and space. Similarly, the prospect

of increasing costs of discovering, developing, and processing ever-larger

quantities of physical resources in less amenable terrain has raised marginal

costs and shifted producers toward downsized alternatives. Moreover, as

the technological frontier has moved forward and pressed for information

processing to speed up, the laws of physics have required microchips to become

ever more compact.

The new downsized economy operates differently from its predecessors.

In the typical case of a manufactured good, the incremental cost of increasing

output by one unit ultimately rises as production expands. In the

realm of conceptual output, however, production is often characterized by

constant, and often negligible, marginal cost. Though the setup cost of creating

an online medical dictionary, for instance, may be huge, the cost of reproduction

and distribution may be near zero if the means of distribution is

the Internet. The emergence of an electronic platform for the transmission

of ideas at negligible marginal cost is doubtless an important factor explaining

the most recent increased conceptualization of the GDP. The demand

for conceptual products is clearly impeded to a much lesser degree by rising

marginal cost and, hence, price, than is the demand for physical products.

The high cost of developing software and the negligible production and,

if online, distribution costs tend to suggest a natural monopoly—a good

or service that is supplied most efficiently by one firm. A stock exchange is

an obvious example. It is most efficient to have all the trading of a stock

concentrated in one market. Bid-asked spreads narrow and transaction

costs decline. In the 1930s, Alcoa was the sole U.S. producer of raw aluminum.

It kept its monopoly by passing on, in ever-lower prices, almost all its

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increases in efficiency. Potential competitors could not envision an acceptable

rate of return if they had to match Alcoa's low prices.*

Today's version of that aspiring natural monopoly is Microsoft, with its

remarkable dominance in personal computer operating systems. Getting

into a market early with the capability to define a new industry's template

fends off potential competitors. Creating and cultivating this lock-in effect

is thus a prime business strategy in our new digital world. Despite this advantage,

Microsoft's natural monopoly has proved far from absolute. The

dominance of its Windows operating system has been eroded by competition

from Apple and open-source Linux. Natural monopolies, in the end,

are displaced by technological breakthroughs and new paradigms.

Strategies come and go, but the ultimate competitive goal remains:

gaining the maximum rate of return, adjusted for risk. Competition effectively

works, whatever the strategy, provided free and open markets prevail.

Antitrust policy, never in my judgment an effective procompetition tool, is

going to find its twentieth-century standards far out of date for the new

digital age, in which an innovation can turn an eight-hundred-pound gorilla

into a baby chimpanzee overnight.1

The trend toward conceptual products is irreversibly increasing the

emphasis on intellectual property and its protection—a second area of

the law that is likely to be challenged. The president's Council of Economic

Advisors in early 2006 cited output by industries "highly dependent on

patent.. . and copyright protection," such as pharmaceuticals, informa

nt is often said that many companies do lower prices in an attempt to drive competitors out

of business. But unless their costs are persistently lower than competitors', this is a losing strategy.

To raise prices after potential competitors retire from the market is decidedly short-sighted.

Despite claims that it is a common practice, I have seen very little of it in my six decades observing

business. It is an effective way to lose customers.

tAntitrust policy in the United States was born in the nineteenth century and evolved in

twentieth-century law in reaction to allegations of price fixing and other transgressions contrary

to then current views of how markets should work. I have always thought the competitive

model employed by the courts to judge infractions was not one that maximized economic efficiency.

I fear that applying that twentieth-century model to markets of the twenty-first century

will be even more counterproductive. Freeing up markets by withdrawing subsidies and anti-

competition regulation, in my judgment, has always been the most effective antimonopoly

policy

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tion technology, software, and communications, as accounting for almost a

fifth of U.S. economic activity in 2003. The council also estimated that a

third of market value of publicly traded U.S. corporations in September

2005 ($15 trillion) was attributable to intellectual property; of that third,

software and other copyright-protected materials represented nearly two-

fifths, patents a third, and trade secrets the remainder. It is almost certainly

the case that intellectual property's share of stock-market value is much

larger than its share of economic activity. Industries with disproportionately

large shares of intellectual property are also the most rapidly growing

industries in the U.S. economy. I see no obstacle to intellectual property's

share of GDP rising into 2030.*

Before World War I, markets in the United States were essentially

uninhibited by government regulations, but were supported by rights to

property, which in those years largely meant physical property. Intellectual

property—patents, copyrights, and trademarks—represented a far less important

aspect of the economy. One of the most significant inventions of

the nineteenth century was the cotton gin: perhaps it was a sign of the

times that the cotton gin design was never effectively protected.

Only in recent decades, as the economic product of the United States

has become so predominantly conceptual, have issues related to the protection

of intellectual property rights come to be seen as significant sources

of legal and business uncertainty. In part, this uncertainty derives from the

fact that intellectual property is importantly different from physical property.

Because physical assets have a material existence, they are more capable

of being defended by police or private security forces. By contrast,

intellectual property can be stolen by an act as simple as publishing an idea

without the permission of the originator. Significantly, one individual's use

of an idea does not make that idea unavailable to others for their own simultaneous

use.

Even more to the point, new ideas—the building blocks of intellectual

Th e major loser of GDP share by 2030 is likely to be U.S. manufacturing (excluding high

tech). Moreover, continued productivity growth will further shrink the number of jobs in

manufacturing

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property—almost invariably build on old ideas in ways that are difficult or

impossible to trace. From an economic perspective, this provides a rationale

for making calculus, developed initially by Newton and Leibniz, freely

available, despite the fact that the insights of calculus have immeasurably

increased wealth over the generations. Should the law have protected

Newton's and Leibniz's claims in the same way that we do those of owners

of land?