Below is a research paper I wrote in college over a year ago about capitalism in the context of entropy and the sub-prime mortgage bubble:

Why Entropy Must Guide Free Market Policy

William Thomspon, or Lord Kelvin, on entropy and the second law of thermodynamics: “There is at present in the material world a universal tendency to the dissipation of mechanical energy… Within a finite period of time past, the earth must have been, and within a finite period of time to come the earth must again be, unfit for the habitation of man as at present constituted, unless operations have been, or are to be performed, which are impossible under the laws to which the known operations going on at present in the material world are subject.” “Everything in the material world is progressive.”

Thompson’s assertion underscores the notion that in nature, entropy rules—systems and life are fundamentally inclined towards decay, and thus in order to delay expiration man must actively seek to limit the effects of entropy. But can one apply this concept to economics? We have recently witnessed a plethora of apocalyptic financial crimes, from the Enron scandal to the Madoff Ponzi scheme, and, finally, and most important, to the near collapse of the global financial system brought about by the largest bubble in history, The Great Panic of 2008.

How can we comprehend, and what must we learn from these incidents? On the most fundamental level, the catastrophes in question emphasize how important it is for society to maintain a system of law and order. Just as any sane person recognizes that we need police officers to prevent people from mugging and killing us when we walk down the street, it is imperative that there exist regulators who seriously enforce the rule of law in the financial realm as well. Each of the three above mentioned crimes proves that, if left unmonitored, every market will shift towards collapse and breed collateral chaos with it: Enron illustrates how this occurs in the energy industry; Madoff offers evidence of how the phenomenon takes shape in the form of seemingly arcane investment strategies; and the shadow banking system (which by extension includes conventional banking as will be explained later) shows how it ultimately overtakes the entire financial system. The notion not only appeals to simple common sense, but it also applies the law of entropy, in that, as Thompson states, all things tend towards “dissipation.”

But ultimately, as Thompson also remarks, “everything in the material world is progressive:” this can be taken to mean that it is up to us to progress by mitigating the inevitable damages that arise in nature— the norm is chaos, and man’s great challenge is to bring about order and equilibrium. An obvious example is the following: prior to civilization, the primitive man (or, perhaps even more relevant, those currently living in lawless lands such as Darfur), having little practical incentive to aid his fellows in the hunt for life’s necessities, embodied all the horrors of survival of the fittest—mercilessly killing and brutalizing anyone who impeded his fight for food, shelter and females. The purported goal of civilization therefore is to limit and ideally eliminate that impulse in its citizens. Hence we have laws and regulators.

All this seems sensible and obvious enough in the abstract, but in practice these are controversial claims nowadays. Why is this so? Essentially, one can chalk it up to the ideological revolution of Ronald Reagan. His infamous claim that “government is not the solution to our problem, government is the problem” made an extremist application of deregulation a mainstream tenet. This radical agenda has many implications, but in particular, it made it not only possible but popular for leaders in finance to promote dismantling restraints on industry. But why were most policy makers guided by this outlook—an outlook that contradicts the second law of thermodynamics? The answer is that they chose to follow a different principle—the principle of general equilibrium theory, which promotes the perfection of laissez-faire, unfettered free markets, also known as Adam Smith’s “invisible hand.”

This analysis— which starts with the comparatively minor Enron and Madoff scandals, scandals that plagued thousands, and grows into a discussion of the subprime mortgage meltdown, the most apocalyptic of all fiscal crises, as it created a near depression, a painful and prolonged recession, and almost destroyed the global financial system— examines why it is imperative that policy makers perceive markets as processes of entropy rather than of laissez-faire: if those in charge accept the harsh reality and assume that systems are by nature inclined to decay they will maintain stronger vigilance in their attempts to prevent future financial mega-crises. The key players involved in the disasters of Enron, Madoff and the Great Panic illustrate that human behavior tends towards extreme selfishness, often at the expense of society, and these tragedies must be perceived as proof that markets cannot govern themselves.

Enron: Though it committed fraud in many different forms, I will focus on how Enron manipulated the electricity market in California, as that strikes me as the most damning and telling. In 1996, California’s officials implemented deregulatory policies that removed price caps and thus made it possible for electricity wholesale companies to generate unlimited profits. As such, in 2000 and 2001 Enron, which had acquired PG&E and thus consolidated much control, exploited the situation (together with two other wholesale companies) by creating an artificial energy crisis : they instructed people running plants to temporarily stop producing energy for hours at a time to cause rolling blackouts (tapes of Enron traders executing this strategy and greedily gloating over their victims’ misfortunes have been discovered); once the power went out, utility prices skyrocketed since there was increased demand, and Enron was able to profit tremendously to the tune of $2 billion (this served as one of the prime ways Enron boosted its stock value to maintain the illusion that it was a strong and solvent company). Consequently, California lost roughly $30 billion—adding to an already dangerous deficit— residents had to pay significantly more expensive electricity bills, small businesses suffered, retail utility companies had to lay off over 1,000 employees because they could not afford the raised rates, and, of course, for many periods there was no power! (Enron’s CEO, Jeffrey Skilling, joked that the difference between California and the Titanic is that when the Titanic sank “at least the lights were on.” )

All this, of course, could have been prevented. There was no real shortage of power in California during the crisis. As Loretta Lynch, California’s Public Utilities Commissioner explained, the state had access to more than enough energy. However, lack of price control and restrictions made it irresistibly tempting for Enron to gain at everyone else’s expense. Furthermore, FERC, the federal regulatory agency that had the authority to stop the madness, had no motive to do so, since Ken Lay, Enron’s CEO, who was mentioned as a candidate for America’s secretary of energy under Bush, recommended the chairman of FERC! Amazingly, Bush and Cheney refused to help California and maintained in front of cameras that price caps, which could have been imposed only by the federal government because California’s deregulatory system made it impossible for the state to implement any changes, would not solve the problem (Cheney said “there’s not a lot you can do, you can’t manufacture kilowatts in the West Wing of the White House”). The fact that the crisis abruptly ended when the democrat-controlled senate finally legislated price restrictions proves that the problem was caused by a lack of oversight. As such, if the policy makers in charge would have been guided by the entropy approach to markets they would have assumed that vicious manipulation for maximum personal profit and social havoc was bound to occur and would have put checks in place, such as price caps, to prevent such a calamity.

Madoff’s Ponzi Scheme: Essentially, Madoff’s scam consisted of a classic Ponzi scheme: he persuaded people to invest in his “split-strike conversion program,” which he pretended was a highly complex and ultra-profitable strategy that only he knew how to execute in a manner that would consistently generate impressive returns. In truth, there was no such program in place. Madoff simply took his investors’ money and passed it around to his other investors while pocketing much of it himself. As Andrew Kirtzman, the author of Betrayal, the Life and Lies of Bernie Madoff explains: “it was the simplest of crimes. There was no manipulation of the markets, no insider trading, nothing that required complex skills. The clerks who worked on seventeen [the secretive floor in Madoff’s building where the scheme was implemented] were simply writing fiction, duping investors into thinking they were making money when in reality the money didn’t exist.” What makes Ponzi schemes so corrosive is the fact that they can continue only as long as massive amounts of money keep pumping in. It was only when the Great Panic hit in 2007-08 that investors sought to retrieve their money, bringing about the collapse.

As with Enron, the misery Madoff caused could likewise have been averted with proper oversight. Harry Markopolis, a true split-strike conversion practitioner, notified the SEC about the Ponzi scheme as early as 1999, detailing how it is impossible for anyone to produce the profits Madoff professed. But there was simply inadequate regulation. The SEC was woefully understaffed and unschooled. As Harvey Pitt, former chairman of the commission explained on Frontline: “SEC’s examination program, put in place in the mid-90s, was fatally flawed. There are now 11,000 registered investment advisers subject to the SEC’s jurisdiction. There are about another 5,000 broker-dealers. If hedge funds become regulated, that will add another 7,000 or 8,000 entities. The entire staff of the SEC is 3,500 people, and not all of them do examinations.” In addition, much as with Enron, the regulators had little incentive to launch a serious investigation into Madoff’s affairs, since many who worked for the SEC perceived their job as a prelude to a lucrative career on Wall Street. If anything, they had a motive to please the likes of Madoff. Markopolis went so far as to claim before congress that the SEC ironically distrusted Ed Manyon, the only SEC employee who took Markopolis seriously, because he had industry experience as a financial analyst and because he worked for the Boston wing of the agency, which was in a Red Sox-Yankees like rivalry with the New York wing. As such, if those in charge of the SEC had assumed that markets, like nature, tend towards chaos and disorder they would have prioritized strong regulation. An entropy-guided approach would have compelled those in charge to hire an adequate amount of regulators and provide them with incentives to prefer to work for the SEC over Wall Street. However, because they followed the opposite presumption the SEC became laughably lax.

The Sub-Prime Mortgage Crisis: But all this is merely preliminary. Those scandals seem almost insignificant when one considers The Sub-Prime Mortgage Crisis. As mentioned above, Enron and Madoff devastated thousands and offered hints about how dangerous ungoverned finance could be; but the subprime mortgage fiasco, which is the root of the global economic crisis, likely would have destroyed our civilization (see footnote) if the government had not intervened. Because it touches everyone and because it is complicated and easy to misunderstand, I will devote the lengthiest stretch of my analysis to this issue.

So what actually happened?

Here’s how it worked (I will spell this out as clearly and precisely as possible by describing the process in four steps. As a layman myself I recognize how confusing this process can seem if not detailed carefully): Step 1, Mortgages: a mortgage lending company, such as Washington Mutual, Countrywide or Quick Loan Funding, utilized a strategy called “originate and sell” in which they’d sell houses to people and take the mortgages from those transactions and sell them to a Wall Street firm such as Goldman Sachs, Merrill Lynch, Bear Sterns, Lehman Brothers, etc.

Step 2, Bonds: the Wall Street firm would then take a bunch of these mortgages and pool them together in a package to create a bond that it would sell to either other Wall Street firms or to conventional banks, or to various institutions such as pension funds, student loan companies, or international banks and firms.

Step 3, CDOs, Collateralized Debt Obligations: When a Wall Street firm would receive one of these bonds (in other words, if Meryl Lynch were to sell a bond to Goldman Sachs, for example), it (Goldman Sachs) would package the paper yet again in what is called a CDO—a collateralized debt obligation— which was another type of bond, also known as a security, that would bundle together a new pool of collected mortgages and sell this in the same process as the bond transaction described in step 2. As will be explained later, AIG bought the bulk of these during 2004-05.

Step 4, CDS, Credit Default Swaps: Finally, Wall Street firms would profit further (in the short term) through fees related to these mortgage backed CDOs and bonds by selling a type of derivative (which simply means a transaction in which tangible money is not the item being sold) called CDS’s—credit default swaps—which was insurance, or a bet, on the underlying mortgages: in this case, a Wall Street firm (Goldman Sachs, say) would sell a CDS, i.e. insurance, on a mortgage backed asset such as a bond or a CDO to a hedge fund, such as Cornwall Capital; the idea was that Cornwall would pay Goldman a semi-annual insurance premium to retain that asset. However, if the mortgages underlying the credit default swap Goldman sold to Cornwall were to default, Goldman would have to pay Cornwall whatever amount the CDS was initially valued at. In other words, Cornwall was “shorting” Goldman’s CDS. So, in this transaction, Goldman was assuming that the mortgages upon which the credit default swaps were based were sound, while Cornwall was betting that the mortgages were flawed, doomed to mass default. To further clarify, I will cite an example of what such a transaction would look like as described in Michael Lewis’s book, The Big Short:

“For instance, you [who are in the position of Cornwall as described in my example] might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric Bonds [which represents Goldman in my example]. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General electric defaulted on its debt any time in the next ten years and bondholders recovered nothing. It was a zero-sum bet: if you made $100 million, the guy who had sold you the credit default swap lost $100 million.”

So there you have it. That, in sum, is the “doomsday machine,” as Michael Lewis calls it, which created the greatest bubble in history. Now, what’s so dangerous about this? Well, each step of the process involves subterfuge and recklessness. Let’s dissect how this occurs and how an entropy-guided fiscal policy would have enabled us to avoid these pitfalls, step by step.

Step 1, Mortgages: the “originate and sell” model was predicated on predatory lending. The mortgage companies were not selling traditional mortgages. Under normal circumstances, they would make sure their prospective homeowners could afford to repay their loans by demanding sizable down payments, conducting serious background checks, and issuing a fixed rate mortgage—i.e. a mortgage rate that stays the same from month to month. However, the subprime mortgage market (subprime meaning that the houses being sold were not prime, or particularly expensive, real estate) of the 2000’s (starting in 2002 till 2007) did not function at all like this. Rather, the mortgage companies took practically no measures to ensure that their loans would be repaid: this business model featured miniscule down payments, essentially no background checks, and, most important, adjustable rate mortgages, which were essentially “teaser rates” that changed over time—during the first year or so the rate would seem enticing to the customer; but after some time elapsed the rate would increase dramatically, rendering the homeowner unable to make his payments and thus forced into foreclosure.

Consequently, as Lewis explains, “a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.” First, why would the buyers agree to this? The answer is that they either did not understand what they were buying because of the deceptive sales pitches presented by the mortgage companies, or they didn’t care about the unfair rates because, as the salesmen explained to them, they could simply take out more money against their homes in the future, as real estate values were increasing every year and the Federal Reserve kept interest rates at historic lows between 9/11 and 2005. And why did the mortgage companies do this? To start, when homeowners would need to refinance to meet the new, raised rates, the lenders would collect more fees for executing the additional loans. But more important, they issued these bizarre mortgages because they faced no immediate risk. It made no difference to them whether or not the loans got paid back because they sold the mortgages to Wall Street firms, as described in step 2. This is a textbook example of “moral hazard”—the idea that financial institutions, which are traditionally expected to be conservative, have every incentive to take excessive risks, since they do not suffer the consequences, someone else does.

At the heart of this phenomenon is the fact that many of the mortgage lenders were merely wings of commercial banks (such as Citigroup and JPMorgan), which, unlike investment banks, have historically been instructed to avoid excessive risk. From the 1930’s till the 1980’s, FDR’s policies ensured that there wouldn’t be any risk of bank runs by forcing commercial banks to avoid uniting with other lending firms, specifically investment banks. As such, there were no wide-scale runs for over 40 years. In FDR’s bargain, known as the Glass-Steagal Act (which was brushed aside by the Reagan revolution and formally repealed by Clinton), the government would guarantee commercial banks security from bank runs in return for tight regulation and low risk money management, because if large banks fail, as the Great Depression proved, the whole economy goes with them. As such, in recent years, when commercial banks created mortgage units they entered the “shadow banking system,” and thus exposed themselves to tremendous risk. For example, the authors of 13 Bankers, the Wall Street Takeover explain that, “according to the head of Quick Loan Funding, a subprime lender, Citigroup provided the money for loans to borrowers with credit scores below 450… JPMorgan Chase aggressively marketed its ‘no doc’ and ‘stated income’ programs to mortgage brokers and used slogans such as ‘it’s like money falling from the sky!” Though, as stated above, the mortgage companies experienced moral hazard because they simply sold their mortgages to other firms and thus avoided short term risk, they also created severe long term risk because their actions led to a housing bubble that eventually burst, destroying their industry and nearly bringing down the conventional banking system with them.

Now, if policy makers had perceived markets as a form of entropy, they would never have allowed any of this to occur: with proper regulatory measures in place, mortgage companies would not have been permitted to sell houses to undeserving tenants, and they certainly would have been barred from engaging in predatory lending practices. At the same rate, prospective homeowners would have been penalized for falsifying information to qualify for loans they knew they could not afford. Furthermore, even if such actions had been carried out, the mortgage companies doubtless would not have been allowed to sell mortgages that were bound to default to Wall Street. Last, commercial banks would have been unable to enter the shadow banking system by creating mortgage lending units.

Step 2, Bonds: When Wall Street firms packaged the mortgages they bought as bonds, they needed to create the illusion that the assets were profitable so they could sell them to investors—i.e., other Wall Street firms, commercial banks, foreign firms, etc. How did they do this? Through the rating agencies, specifically Moody’s and S&P, who established that the bonds in question were safe by issuing AAA ratings for most mortgages. This had devastating consequences because the entire housing bubble was based on the assumption that the mortgage ratings were reliable. In fact, because the mortgages, bonds, and CDO’s were perceived to be as safe as U.S treasury bonds (which in fact are the safest assets anyone can hold), the firms and banks that held them were not required to include them on their balance sheets, and were hence free from regulation. There was therefore virtually no chance for any government agency to adequately analyze and stop what was happening.

The obvious question is, why did the rating agencies do this? Hard as it is to believe, it simply boils down to foolishness, corruption and a designed lack of information. In The Big Short, Lewis describes how Steve Eisman and Vincent Daniel of FrontPoint Partners, one of the only hedge funds to realize early on that the entire economy was built on a bubble, went to investigate Moody’s and S&P. They concluded that “the ratings agency people were all like government employees.’ Collectively, they had more power than anyone in the bond markets, but individually they were nobodies. ‘They’re underpaid,’ said Eisman. ‘The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for.” Equally alarming was the discovery that “the arbiter of the bonds [i.e. the rating agencies] lacked access to relevant information about the bonds… Eisman concluded that ‘S&P was worried that if they demanded the data from Wall Street, Wall Street would just go to Moody’s for their ratings.” In other words, the rating agencies made money by charging fees for issuing ratings. As such, if Goldman, for example, sought to obtain a AAA rating and didn’t get one from Moody’s, they could simply go to S&P instead. Just as with Enron and Madoff, the people who were responsible for assessing the assets in question were incentivized to evaluate them favorably.

Here we must once again consider how we could have avoided this with an entropy-guided system. Because authority figures in the entropy paradigm assume the worst, they would presume that Wall Street firms seek profit even at everyone else’s expense and would have therefore required each financial institution to include everything on its balance sheet, even assets that were considered as safe as U.S. Treasury Bills, such as AAA rated mortgage backed securities. In addition, policy makers would have abolished the system in which rating agencies receive fees from the very companies whose assets they are evaluating. Last, they would have seen the necessity to devise a plan to recruit talented employees at Moody’s and S&P who can provide accurate mortgage assessments.

Step 3, CDO, Collateralized Debt Obligations: Whoever bought these were obviously the suckers because they were deceived into thinking that the AAA ratings proved the assets were safe. From 2004 to 2005, in the thick of the bubble, AIG assumed virtually all of this risk. Essentially, Goldman Sachs and many Wall Street firms convinced a unit of AIG called AIG FP to buy their collateralized debt obligations by presenting AAA ratings. Lewis explains that, “as one AIG FP trader put it… ‘Something else came along that we thought was the same thing as what we’d been doing.” Eventually, AIG caught on and stopped buying the CDO’s, but this practice essentially ruined AIG when the mortgage holders defaulted en mass in 2007, forcing the infamous government bailout. In addition, once AIG left the CDO market, others took its place and further inflated the housing bubble.
In this case, if entropy had ruled policy thinking, AIG FP would have been forced to include these transactions on AIG’s balance sheet and thus subject to regulatory review. Such a procedure would have revealed that AIG was one of the only companies to purchase CDOs, which would have raised suspicion. Even further, once AIG ceased buying CDOs there would have been an inquiry into why this occurred, leading to an investigation of CDOs and, by extension, the mortgage backed securities of which they consisted.

Step 4, CDS, Credit Default Swaps: Initially, the keen hedge fund managers, such as Eisman, who perceived early on that the entire financial system was built on a housing bubble, purchased as many CDS’s as they could with the intent to cash in on the mass defaults. Their shrewdness however, kept the bubble afloat longer than it would have been otherwise, because many of the firms that created CDOs (collateralized debt obligations, to be clear) relied on the money they received from those who purchased credit default swaps to create additional, phony bonds. To quote Lewis,

“Eisman finally understood… why those firms [on Wall Street] were eager to accept them [Eisman’s credit default swap purchases]… the credit default swaps, filtered through the CDO’s, were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets [i.e. Eisman’s credit default swap purchases] in order to synthesize more of them. ‘They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,’ said Eisman. They were creating them out of whole cloth. One hundred times over. That’s why the losses in the financial system are so much greater than just the subprime loans.”

What this means is that, by agreeing to sell credit default swaps, and thus allowing guys like Eisman to bet against Wall Street that the housing bubble would burst, Wall Street was implying that it believed its own lie—that the bubble would never burst! They maintained this fiction by convincing themselves that, though many homeowners were bound to default, they wouldn’t all do so at the same time. They also led themselves to think that the enhanced technological innovations, represented by the fancy CDSs and CDOs previously described, would somehow render the economy impervious to failure. The irony is that those very “advances” caused the destruction in part because many involved, such as Howie Hubler of Morgan Stanley, who lost his bank $16 billion, simply didn’t understand what it was they were trading. However, towards the end, in 2007, Wall Street finally realized that it had deluded itself and decided to mitigate its losses by doing exactly what Eisman had been doing for some time, that is, buy credit default swaps to bet that the housing bubble would pop. This is where the SEC’s lawsuit against Goldman Sachs enters the picture: at this point Goldman started play both sides of the game—on the one hand they continued to sell collateralized debt obligations to investors, leading the latter to believe that the mortgages underlying those papers were valuable, while at the same time they also purchased credit default swaps to bet against those very mortgages in an attempt to profit in both ways from a bubble it had helped originate.

Yet again, an entropy inspired policy could have proved vastly beneficial. If this had been the leading philosophy, the Fed would have forced firms to trade credit default swaps in an open exchange market. This would have enabled policy makers to perceive that companies were fabricating the underlying CDOs, and they would have outlawed such a practice. Finally, officials would have done what the SEC is currently doing to Goldman Sachs (the only instance in which the government has illustrated an entropic type policy throughout the entire tragedy)—sue them for committing fraud.

Conclusion: But what role did the government play throughout all of this? Up until the bailouts, when it was too painfully obvious that the general equilibrium theory is false and that the market cannot regulate itself, it maintained the exact opposite position. The countless instances in which Greenspan denied the existence of a housing bubble are well known. He even went so far as to claim, perversely, that CDO’s are safe because they diversify portfolios and hence spread risk. Greenspan’s pathetic admission before congress that his entire outlook was wrong emphasizes the Fed’s failure.

But how did we get here? In retrospect, how could it be that the chairman of the Fed was so misguided?

In truth, the general equilibrium theory, which, as mentioned earlier, buttresses the argument for laissez-faire, has much to offer, if applied intelligently. It seems clear that capitalism is the best fiscal system the world has known: it has brought about unrivalled innovation and created tremendous opportunity. In a sense there is much truth to Thomas Paine’s exuberant assertion that “what Athens was in miniature, America will be in magnitude.” Our country, and our financial system, was built on Paine’s teachings and the metaphor of Adam Smith’s invisible hand:

“The woolen coat, for example, which covers the day-laborer… is the produce of the joint labour of a great multitude of workmen. The shepherd, the sorter of the wool, the wool-comber or carder, the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser, with many others, must all join their different arts in order to complete even this homely production.”

The benevolent perception of capitalism as a beautiful blend of disparate crafts has served us well as an ideal in many respects. But we must treat this understanding with realistic expectations. While it is true that, as Paine and Smith assert, all those who contribute to creating the woolen coat described above can coincide in good faith, it is clearly not the case that pursuing self interest usually produces results that are both beneficial to the individual and society. All too often the opposite occurs. A powerful example can be found in the housing bubble fiasco. As John Cassidy explains in his book How Markets Fail, the deregulated market placed many CEOs in the “prisoner’s dilemma:” as the housing bubble expanded, many must have known that it would inevitably pop at some point; but, as discussed above, they nonetheless convinced themselves that housing prices would never fall, and the prime reason they needed to persuade themselves of this is because all their competitors were earning massive short term profits by trading CDOs and CDSs; in order to remain competitive, each CEO had to surf the bubble rather than practice prudence and abstain because investors would have turned to other firms to reap the seemingly impressive, but ultimately artificial, gains. Thus, what was good for the individual CEO was ultimately devastating for the economy at large.

The United States government, from FDR till Reagan, recognized that capitalism can produce incredible innovation but must be regulated to limit abuse. Once Reagan took office, however, and especially once the Soviet Union disintegrated, American policy shifted dramatically. It finally became fashionable to promote deregulation because, in the short term, America’s economy experienced an impressive boom, and the collapse of communism signaled that capitalism is the only system that could conceivably offer stability. Furthermore, Reagan’s agenda received a critical boost from the popular economist Milton Friedman, who in his book Capitalism and Freedom identifies “detailed regulation of banking” as one of the “activities currently undertaken by government in the U.S. that cannot, so far as I can see, validly be justified.” As a result, capitalism was pushed to an extreme, and the trend continued with each subsequent presidency up until the system came as close as it has ever come to falling apart. Clearly, the fact that it was the Bush administration, which was perhaps the harshest proponent of deregulation, which implemented the bailouts proves that free markets cannot survive without proper oversight (see footnote).

As Christopher Hitchens has remarked, perhaps a lesson we can glean from the crisis is that “Marxism and capitalism are symbiotic, and that neither can expect to outlive the other.” Though Marx was misguided in his conviction that the ills of capitalism would invariably lead to a utopian society brought about by a workers’ revolution, his critique of capitalism offers valuable insight. An implicit appeal to entropy can be found in Marx’s most famous indictment: “in the history of capitalist production, the determination of what is a working day, presents itself as the result of a struggle, a struggle between collective capital, i.e., the class of capitalists, and collective labour, i.e., the working-class.” In this characterization we see the forces of entropy at work in the form of class struggle and the divergence between self-gain and the good of society at large.

Though, as this essay illustrates, regulation is imperative, too much regulation is equally dangerous. Orwell remarks in The Prevention of Literature that “in any totalitarian society that survives for more than a couple of generations, it is probable that prose literature, of the kind that has existed during the past four hundred years, must actually come to an end.” In other words, too much government control destroys innovation. Clearly, Communism of the Soviet variety proves the accuracy of this claim the same way the housing bubble of the 2000’s proves the failure of the opposite extreme.

Just as 9/11 forced the government to be proactive and assume that the world is fundamentally dangerous and chaotic, the financial terrorism orchestrated by Enron, Madoff and the mega banks that brought about the housing bubble likewise offers compelling evidence that absolute free markets cause chaos, and that policy makers must operate with the assumption that the worst case scenario is likely. What’s so strange about the Great Panic of 2008, though, is that because it’s so complex and difficult for the layman to comprehend, it’s hard to decipher what can be learned from this. Unlike 9/11, when it was clear for all to see the cause and effect relationship between extremist Islam and America, as symbolized by the planes striking the twin towers, the Great Panic is harder to pin down. The culprits are less easy to identify instantly here. But, as with 9/11, the Great Panic is one of those earth shattering intellectual events that must alter the way we think. The same way it’s fashionable for those on the right to (justifiably) say that many extreme liberals didn’t learn anything from 9/11, those on the left must now treat our economic crisis in the like manner—considering what occurred, it is absurd that conservatives still believe the government should not intervene (see footnote). .

Even if the argument put forth in this paper— that the second law of thermodynamics naturally applies to human interaction in the form of free markets— is not strictly true, since one cannot test and prove its validity in a conventional scientific sense, the real purpose of my analysis is to illustrate how acting as if this were indeed reality would have prevented the three crises discussed. The challenge we face is to strike a proper balance between adequate oversight and opportunity for innovation. With that in mind, I conclude by turning to the often misunderstood John Maynard Keynes:

“Confusion of thought and feeling leads people to confusion of speech. Many people, who are really objecting to capitalism as a way of life, argue as though they were objecting to it on the ground of its inefficiency in attaining its own objects. Contrariwise, devotees of capitalism are often unduly conservative, and reject reforms in its technique, which might really strengthen and preserve it, for fear that they may prove to be the first steps away from capitalism itself… I think that capitalism, wisely managed, can probably be made more efficient for attaining economic ends than any alternative system yet in sight, but that in itself it is in many ways extremely objectionable. Our problem is to work out a social organization which shall be as efficient as possible without offending our notions of a satisfactory way of life.”

Works Cited
Thompson. Art. LIX. On a Universal Tendency in Nature to the Dissipation of Mechanical Energy
William Thompson, preliminary draft for the ‘Dynamical theory of heat,’ PA 128, ULC. PP. 6
The Smartest Guys In the Room Film
Andrew Kirtzman. 2009. Betrayal: the Life and Lies of Bernie Madoff. New York, HarperCollins Publishers
http://www.pbs.org/wgbh/pages/frontline/madoff/interviews/pitt.html (Harvey Pitt interview regarding Madoff)
http://www.youtube.com/watch?v=uw_Tgu0txS0&feature=PlayList&p=345C9479BAEE28FF&playnext_from=PL&playnext=1&index=2 (Markopolis testimony about SEC regarding Madoff)

John Cassidy. 2009. How Markets Fail: The Logic of Economic Calamities. New York, FSG Books

Paul Krugman. 2009. The Return of Depression Economics. New York, Norton

Simon Johnson and James Kwak. 2010. 13 Bankers: The Wall Street Takeover and the Next Financial Crisis. U.S.A., Pantheon Books

Michael Lewis. 2010. The Big Short: Inside the Doomsday Machine. New York, Norton

Thomas Paine. 2003. Common Sense and Other Writings. U.S.A., Random House Inc

Adam Smith. 1999. The Wealth of Nations Books I-III. U.S.A., Penguin Books

Andrew Ross Sorkin. 2009. Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves. USA, the Penguin Group

George Orwell. 1984. The Orwell Reader: Fiction, Essays and Reportage. USA, Harcourt Inc

Marx, Engels. 1978. The Marx- Engels Reader, Second Edition, Edited by Robert C. Tucker. New York, Norton

John Maynard Keynes. 2010. Essays In Persuasion. USA, BNP

Milton Friedman. 2002. Capitalism and Freedom. USA, the University of Chicago Press

http://www.theatlantic.com/magazine/archive/2009/04/the-revenge-of-karl-marx/7317/ (Christopher Hitchens’ article)