Reason Magazine - Contributors

In Defense of Derivatives

gcallah@erols.com (Gene Callahan) info@reason.com (Greg Kaza) — Sun, 01 Feb 2004 00:00:00 EST

Three of the six largest bankruptcies in American history -- WorldCom, Enron, and Global Crossing -- occurred between December 2001 and July 2002, shattering investor confidence and helping to knock 22 percent off the Dow Jones Industrial Average. The failures had more in common than just timing and size: All to varying extents involved the use of the controversial and poorly understood financial instruments known as derivatives.

In the season of finger pointing that followed, derivatives trading was singled out for abuse. "If you dig deep enough into any financial scandal," BBC business reporter Emma Clark claimed in February 2002, "you can usually find a derivative or two to take the blame." Howard Davies, chairman of the U.K. Financial Services Authority, told a conference the month before that an investment banker described to him one popular type of derivative (collateralized debt obligations) as "the most toxic element of the financial markets today." Even famed investor Warren Buffett warned that derivatives posed a grave threat to the global financial system. "We view them as time bombs, both for the parties that deal in them and the economic system," Buffett wrote in his 2002 annual report for Berkshire Hathaway. "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

What are these Wall Street WMDs, and what should be done about them? Technically, derivatives are financial products whose value is "derived" from that of an "underlying" asset. For example, stock options, perhaps the best-known derivatives, are based on the underlying value of the stock that the option enables the purchaser to buy at a later date. Futures contracts -- used extensively by farmers to protect themselves from poor crop yields and fluctuating prices -- are derived from the root value of the good to be bought or sold in the future.

Derivative products are not just a sophisticated way for investors to gamble. They also give producers a crucial tool for hedging against risk and uncertainty. And they have played a central role in the flowering of innovation that the financial markets have enjoyed during the last two decades. There are derivatives betting on the likelihood of a natural catastrophe; consumer credit card debt has been converted into bonds; futures markets have been established for such things as barge rates; and options allow investors to speculate on the temperature, wind chill, and amount of rainfall in many cities.

The common denominator in all these products is that they allow companies and private investors to trade away risk with which they are ill equipped to deal and focus instead on taking risks in areas in which they specialize. Many international corporations, for example, use currency derivatives to swap out their exposure to exchange rate fluctuations. This allows them to focus on their core business while allowing professional currency traders to worry about international valuations.

This wave of financial innovation has washed into unlikely places. Glam rock pioneer David Bowie, long famous for his innovative music and embrace of the new, became the first songwriter in history to use derivatives to securitize future royalties from his own song catalog when he created "Bowie Bonds" in 1997. Bowie and his business manager, the Rascoff/Zysblat Organization, sold the royalty rights to his 25 pre-1990 albums to the Prudential Insurance Company. The singer/songwriter was able to pocket $55 million immediately, while Prudential received a 7.9 percent return on bonds that were backed by Bowie's future royalty payments. Bowie's groundbreaking move was quickly emulated by James Brown, the Isley Brothers, Ashford and Simpson, Joan Jett, and other artists, as well as the estate of Marvin Gaye. Bowie Bonds even inspired a thriller novel, Something Wild (2002), by Linda Davies.

But all has not been hunky dory for derivatives. Besides the massive bankruptcies, critics point to a number of other derivatives-related mishaps. In 1995 Nick Leeson used derivatives to establish positions for his employer, the British bank Barings, with exposure of more than $60 billion, compared to the bank's capital of $615 million. When the positions turned against Barings, the 233-year-old institution was forced to fold. The Long-Term Capital Management (LTCM) hedge fund and the government of Orange County, California, were also involved in derivatives-related meltdowns in the 1990s.

The Men Who Sold the World

Although sometimes viewed as a recent innovation, derivatives actually predate Christ. Thomas F. Siems, a senior economist at the Federal Reserve Bank of Dallas, claims that the Greek philosopher Thales created the first known derivative contract roughly 2,500 years ago. Thales, apparently an excellent prognosticator, suspected that the olive harvest would be exceptionally good one year, so he bought options securing him the exclusive use of olive presses in his area. When the harvest turned out to be much as Thales had expected, he made a tidy profit renting out his monopolized presses for high fees.

A regular market for such sophisticated financial instruments existed in Europe as early as the 1600s, when short sales, options, and forward contracts all were exchanged on the Amsterdam bourse. The Dutch government was so skeptical of these mysterious goings-on that it passed laws making derivative contracts unenforceable in government courts. Economist Edward Stringham of San Jose State University has demonstrated that despite such official disapproval, the Amsterdam derivatives market worked in an orderly fashion, relying on privately created law and ostracism of those who didn't fulfill their contracts.

Still, derivatives played a relatively minor role in global financial markets until fairly recently. It was not until 1973 that the Chicago Board Options Exchange began trading listed options in the United States. From 1982 to 2000, trading in listed equity options increased roughly tenfold, spurred on in part by the pioneering work on options modeling by economists Fischer Black, Robert Merton, and Myron Scholes. As sophisticated mathematical models for valuing derivatives gained currency, computers came to play an increasingly important role in trading them. The fall in the price of computing power consequently enhanced the popularity of derivatives.

While trading in stock options was increasing, both the volume and variety of other types of derivatives were growing explosively. Between 1987 and 2002, the amount of outstanding currency and interest rate swaps and options increased from $865 billion to nearly $100 trillion, according to the International Swaps and Derivatives Association. (Swaps are agreements where two parties agree to exchange some features of two assets without trading the assets themselves. For example, a bank that holds many fixed-rate loans but wishes to obtain more floating-rate cash flows might swap the cash flows on some loans with another bank that holds many floating-rate loans but desires more fixed-rate cash flows. Each bank would continue to hold and service the loans it originated, but each would achieve a more preferable cash flow structure.)

Diamond Dogs

As the above description indicates, derivatives can be tricky to explain. Although they have been around for decades, are widely used, and have many valid commercial applications, they have an undeniable image problem. In the wake of the Enron debacle, The Washington Post described derivatives as "complex, risky and largely unregulated financial contracts." The Baltimore Sun quoted Michael Greenberger, formerly an official at the Commodity Futures Trading Commission, as declaring: "Derivatives, when used speculatively, amount to nothing more than gambling." Even Linda Davies, author of the Bowie Bonds novel, argues that "derivatives are financial instruments that have no intrinsic value."

The first problem with Davies' complaint is that no goods have "intrinsic" value. The value of economic goods arises from the desire human beings have for them; it does not somehow reside in the goods themselves. Perhaps the novelist means that while stocks and bonds, for instance, are truly valuable to their owners, the value ascribed to derivatives is somehow less real. But such a complaint will not stand scrutiny.

Consider a simple derivative, such as a stock option. Let's assume you could buy a share of IBM stock today at $100. Alternatively, you could buy an option granting you the right to buy a share of IBM stock at $100 at any time during the next six months. It should be clear that if you are interested in owning IBM you probably would consider such an option valuable. After all, should the share price of IBM plunge in the next half a year, you need not exercise your option, saving you from taking a bath. On the other hand, if IBM rises above $100, you can exercise your option and immediately make a profit.

The essence of derivatives is that they allow investors to separate out various aspects of an asset, and trade those aspects separately, rather than in a bundle. For example, when purchasing a share of common stock outright, the buyer gets both the upside and the downside potential of the stock. But by purchasing a "call" option, the buyer acquires only the upside potential.

Or consider David Bowie's sale of his royalty income, which separated the income stream from his song rights from the rights to the songs themselves. While the singer still controlled the use of his own songs, all of the royalty income from them flowed to those who bought the Bowie Bonds. From Bowie's point of view, his financial future was too dependent on the vagaries of his popularity. By selling some of his royalty income to others, Bowie was able to diversify his investments. (We assume that he did not spend the entire $55 million on a huge shopping spree for his supermodel wife Iman.) He reduced the risk that a major shift in the public's musical taste would leave him a pauper. Meanwhile, investors who had not previously had any stake in the sales of Ziggy Stardust could diversify into that area and earn a decent interest rate while doing so.

Similarly, a farmer who does not wish to concern herself with the dynamics of the wheat market can sell her crop "forward" (i.e., sell it at a specified future date for a price determined today). She can gain even more flexibility by purchasing a "put" option on the wheat -- buying the right, but not the obligation, to sell her crop at a certain price (the option's "strike price") over a specified period of time. If the spot wheat price falls below the strike, she can exercise her option and protect herself from losses. If the price rises above the strike, she can let the option expire and sell her crop at the higher price. Naturally, such flexibility has value to the farmer, and she must pay a price to others to persuade them to take on some of her risk.

"It is widely recognized that OTC ["over-the-counter," i.e., not traded on an exchange] derivative instruments are important financial management tools that, in many respects, reflect the unique strength and innovation of American capital markets," said Arthur Levitt, then chairman of the Security and Exchange Commission, in 1998 testimony to Congress. "OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to manage risks associated with their business activities or their financial assets. These instruments, for example, can be used by corporations and local governments to lower funding costs, or by multinational corporations to reduce exposure to fluctuating exchange rates."

How important are derivatives to multinationals? Consider this passage from IBM's 2002 annual report: "The company operates in approximately 35 functional currencies and is a significant lender and borrower in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity price changes. The company limits these risks by following established risk management policies and procedures including the use of derivatives and, where cost-effective, financing with debt in the currencies in which assets are denominated."

For the economy as a whole, the benefit of such activities is a simple extension of Adam Smith's 227-year-old insight that the division of labor increases overall productivity. By employing derivatives, David Bowie can focus on making music, the farmer can concentrate on farming, IBM can specialize in computer manufacturing, and financial market traders can worry about pricing assets and evaluating their risk.

Scary Monsters

Still, derivatives are newfangled enough that traders, CFOs, accountants, and investors remain on the learning curve for properly using and analyzing these instruments. We can expect these specialists to make miscalculations, occasionally serious ones. The media and general public, meanwhile, are a few steps further behind in understanding.

Take Enron. Derivatives did play a role in what was the second-largest bankruptcy in U.S. history (behind only WorldCom), but not in the way most people think. The Houston energy company did not go bankrupt because it lost money in derivatives trading. In fact, Enron was tremendously successful in its trading operations, racking up billions of dollars in profits. As documented by economic historian Frank Partnoy, the company went under not because it was losing money but because it tried to use these profits to disguise heavy losses in its consulting and technology businesses. When the accounting shenanigans were exposed, the company's credibility evaporated, as did its sources of credit and cash. The company was killed by a lack of cash flow, not a lack of profits.

But there are other troubling aspects of derivatives. For one thing, they may be used in what is called "regulatory arbitrage." Partnoy notes, in his financial history Infectious Greed (2003), that "bank regulators, by tightening their focus on banks to reduce their risks and prevent a banking crisis...pushed credit risks onto other, less regulated institutions."In other words, while it may have made sense in other ways for banks to retain more of their own credit risks, the regulatory environment prompted them to trade that risk away. Similar types of regulatory arbitrage have motivated other economic actors, such as insurance companies, to enter into derivative contracts that otherwise would have been unattractive to them.

It's clear that the legal system has a role to play in preventing financial scams. It is also clear that if a particular regulation is desirable, the use of derivatives to dodge it is not. If the regulation is not desirable, it is simply generating transactions that serve no purpose other than evasion, thus creating superfluous costs and transferring risk from specialists (such as banks and insurance companies) to the less experienced.

Another problematic aspect of derivatives is their often unmonitored use by government agencies. While there has been increased legal and social pressure on private corporations to be transparent in their use of derivatives, politicians have shown little interest in similar standards for government derivatives trading.

Some of the biggest users of derivatives are government-sponsored enterprises (GSEs) such as the mortgage-lending institutions Fannie Mae, Ginnie Mae, and Freddie Mac. Doug Noland of PrudentBear.com, a site that advises investors from a bearish perspective, notes, "We have Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system with total holdings [of derivatives] approaching $2.2 trillion and guarantees for another $1.5 trillion of securities."

This year, FM Watch, a coalition of financial service and housing-related organizations dedicated to monitoring GSEs, reported: "One of the GSEs was able to make its RBC [risk-based capital] virtually disappear through use of derivatives and other risk-hedging devices." FM Watch recommends that GSEs' "disclosures should be at least as complete as those provided by other publicly-traded companies and issuers."

The lack of transparency in governmental derivatives trading has resulted in the loss of billions of tax dollars in a string of mishaps spanning a decade. The largest municipal bankruptcy in U.S. history ($1.6 billion) occurred in Orange County, California, in December 1994, when the county treasurer used derivatives to bet that interest rates would stay low. A significant portion of the county's funds were invested in interest-rate-sensitive two-to-five-year notes and structured notes issued by GSEs such as Fannie Mae and Freddie Mac, in addition to other derivatives.
Through such instruments, the county's $7.6 billion general fund was leveraged to control more than $20 billion in assets.

The Orange County treasurer was managing a pool of money from nearly 200 California municipalities and government bodies, according to congressional testimony. The treasurer's services were in great demand by other governmental units, because he delivered returns nearly 2 percentage points higher than a similar pool run by the state of California. Local officials increased their leverage by issuing bonds to invest in the pool.

But in 1994 the Federal Reserve raised short-term rates, causing the treasurer's strategy to backfire, with disastrous results for Orange County taxpayers. An effective internal controls system would have made clear what the treasurer was up to. The structured notes involved were government securities subject to government regulators, who also missed the treasurer's misuse of leverage.

Arkansas taxpayers also suffered after the state lost an estimated $30 million from derivatives trading despite repeated warnings from auditors. A 1997 independent audit by the private accounting firm Deloitte & Touche LLP made the following observation about the Arkansas Teachers Retirement System (ATRS): "Alternative investments are becoming an increasing segment of the ATRS portfolio and, currently, ATRS does not have procedures in place to
obtain or monitor the market values of these instruments and consequently cannot monitor related investment returns." The "alternative investments" described in this prophetic warning included many derivatives. Deloitte & Touche recommended that Arkansas "develop procedures to ensure that market values are periodically determined for their investments and that these market values are supported by verifiable data." A 2000 audit made similar recommendations.

ATRS officials clearly did not understand the derivatives they were trading, and ATRS became the only state pension system in the U.S. to lose money in the offshore limited partnerships at the center of the Enron bankruptcy. As of mid-2001, more than 5 percent of ATRS' investments were considered "alternative," a high proportion.

In 1995 the Wisconsin Investment Board, which oversees the state's investment fund, lost more than $95 million through positions in leveraged derivative instruments linked to Mexican interest rates and currency. When the Mexican peso plummeted in value in 1994, the Investment Board incurred $35 million in losses. That same year, Independence Township in Michigan lost $2 million through its misuse of domestic swaps.

Legislatures in two Midwestern states re-sponded to these government failures. Wisconsin has become one of three states (along with Kansas and Missouri) that restrict derivatives holdings by government units, prohibiting the instruments except when used "for the purpose of reducing risk of price changes or of interest rate or currency exchange rate fluctuations with respect to investments held" by the Investment Board. The state of Michigan, meanwhile, passed a law requiring government derivatives to be reported in audits, subject to the Michigan Freedom of Information Act.

But politicians usually have been far more interested in passing laws that regulate corporate use of derivatives than in examining governmental use. Forty states have legal definitions or other acts regulating the percentage of portfolios that insurance companies and other firms may invest in derivatives, while only Michigan has mandated transparency for government units dealing in them.

Ch-ch-ch-ch-changes

In response to the various derivatives disasters, many have suggested that the government should become more active in regulating these new markets. Sen. Dianne Feinstein (D-Calif.), following the Enron bankruptcy, proposed giving the Commodity Futures Trading Commission regulatory oversight over all derivative transactions. (Her proposal was defeated in roll-call votes in 2001 and 2002.) State agencies should certainly pay more attention to their own derivatives trading. But there are a number of pitfalls in increasing the regulation of private derivatives trading.

For one thing, as pointed out above, many of the current uses of derivatives are ways to dodge existing regulations. It seems probable that a new round of regulation will spur the development of new derivatives designed to bypass its restrictions. As the Securities and Exchange Commission's Paul Atkins said at a Cato Institute policy forum in March 2003, "every decade sees some sort of financial crisis, followed by new cries for regulators to 'do something.' Yet the new regulations invariably fail to prevent the next crisis."

Partnoy notes that many of Enron's dubious maneuvers involving derivatives were designed to enhance the company's "accounting reality" at the expense of its true economic condition. But the divergence between accounting and economic reality is itself chiefly a product of the regulatory environment in which publicly traded companies exist. The existence of legal "safeguards" to protect the investing public encourages companies to focus on the safeguards at the expense of the actual financial health of the company. That does not excuse the behavior of executives who violated their responsibility to shareholders, but the motivation to do so would not have existed without regulations that create a divergence between economic reality and accounting reality.

Then there is the question of how to clean up after a derivatives meltdown. When, after some gamble has gone horribly wrong, the government intervenes to soften the blow to investors, it creates a moral hazard. Once people expect that someone else will pick up some of the cost of their speculative failures, they are more likely to undertake risky actions than they would if they had to bear the cost themselves. The amateur mountaineers who venture into places they would never go if there were no park rescue services are a case in point -- the existence of a free rescue service prompts people to take risks they wouldn't otherwise, necessitating even more rescues.

Government bailouts of failing investments create a similar moral hazard. The stronger the expectation of a government safety net, the less investors will concern themselves with the risks inherent in the investment. When the average private corporation makes a mistake with derivatives, it suffers a loss. After a few mistakes, it either goes out of business or learns its lesson and changes its practices. But large private hedge funds and money-center banks know that they are "too big to fail," at least in the government's eyes. In the event of a financial catastrophe, they expect to be bailed out by government deposit insurance and the Fed. Such bailouts came to be commonplace under Federal Reserve Chairman Alan Greenspan, especially when he was teamed with Treasury Secretary Robert Rubin.

After the October 1987 market crash, after the savings and loan collapse of the early '90s, and during the crises in Mexico, Russia, and East Asia, the U.S. government rode to the rescue of investors. In September 1998, when the large Long-Term Capital Management (LTCM) hedge fund faced a severe financial crunch, the government stepped in again. The Fed cut rates three times, and the New York Federal Reserve brokered a controversial de-leveraging of LTCM's derivative trades, which had gone south when the Asian and Russian financial crises unfolded. Large money-center banks were on the other side of many of these trades. "If Long-Term defaulted...the banks...would be left holding one side of a contract for which the other side no longer existed," Roger Lowenstein explained in his book, When Genius Failed: The Rise and Fall of Long-Term Capital Management (2000). "In other words, they would be exposed to tremendous...risks."

The Fed's actions sent a clear signal to markets -- and the European central banks that had invested in LTCM -- that large, politically connected banks with exposure to losing derivatives trades would be protected. There is some evidence that this action contributed to the Enron debacle. For instance, a U.S. district judge in New York ruled that some Enron derivative trades were actually "disguised loans" from a bank previously involved in the LTCM affair.

"In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained," economist Kevin Dowd has commented. "It implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking."

As Auburn economist Roger Garrison has put it, the Federal Reserve under Greenspan attempted to build a "firewall" protecting the "real" economy from financial shocks. But firewalls work both ways: To the extent that the rest of the economy is protected from financial shocks, the financial markets are also disconnected from the rest of the economy. With apparent protection against falling asset prices, investing on Wall Street began to look better and better compared to investing on Main Street, where one might lose one's money and not be bailed out. Wall Street trader James Canevari told us that the attitude on the street in the late '90s became: "With Easy Al and Trader Bob at the helm, you can take the risk factor out of your models."

It is unsurprising that investors would pay less attention to the exact nature of the risks they undertook as they came to believe they were protected on the downside when making risky, high-yield investments. Unsophisticated investors bought stock in a complex company like Enron, whose business they did not understand. If they tried to learn more from Enron's financial reports, they probably found the documents too abstruse to grasp, partly as a result of the very regulations designed to protect those ordinary investors. The government seemed to be offering a dual assurance -- that since it was keeping tabs on the markets, everything must be on the up and up; and that should any real disasters occur, it would step in to save the day.

It is telling that when the Enron scandal finally surfaced, the first reaction of many involved was to look to the government for help. Enron founder Ken Lay "called Treasury Secretary Paul O'Neill, Commerce Secretary Don Evans, Federal Reserve Chairman Alan Greenspan, and Robert McTeer, president of the Dallas Federal Reserve," according to Partnoy. Even Robert Rubin, now back in the private sector, attempted to intervene on Enron's behalf. Given the string of government bailouts in the wake of other financial collapses, it is not surprising that Enron's executives assumed their company would also be rescued.

Sound Vision

Derivatives meet important needs in the global economy. Like all financial instruments, they carry risk, and there can never be a guarantee that such risk will not have adverse consequences on a large scale.

But government regulators are not, generally speaking, in a better position than private investors to evaluate such risks. When regulations prevent or hinder transactions for which there is a genuine demand, they encourage the creation of securities designed simply for the purpose of dodging those regulations, in order to fulfill that demand.

In addition, when the government attempts to encourage the belief that financial markets are "safe" places to invest, it ends up attracting investors who are not prepared to properly evaluate the risks. This creates an interest group that will demand government redress when the investments don't work out. If fulfilled, those demands will encourage a new wave of risky speculation based on the seeming existence of government insurance on the downside. It is as though the government were granting investors free put options!

As in any innovative venture, there are significant risks involved with the fantastic voyage finance has undertaken in the last 20 years. But increased government intervention is likely only to heighten that risk.

The Roots of Racial Profiling

anderwl@prodigy.net (William Anderson) gcallah@erols.com (Gene Callahan) — Wed, 01 Aug 2001 00:00:00 EDT

It is early in the morning, and the well-dressed young African-American man driving his Ford Explorer on I-75 sees the blue lights of the Georgia State Patrol car behind him. The officer pulls behind the sport utility vehicle and the young man's heart begins to sink.

He is on his way to Atlanta for a job interview. The stop, ostensibly for speeding, should not take long, he reasons, as the highway patrol officer walks cautiously toward the Explorer. But instead of simply asking for a driver's license and writing a speeding ticket, the trooper calls for backup. Another trooper soon arrives, his blue lights flashing as well.

The young man is told to leave his vehicle, as the troopers announce their intention to search it. "Hey, where did you get the money for something like this?" one trooper asks mockingly while he starts the process of going through every inch of the Explorer. Soon, an officer pulls off an inside door panel. More dismantling of the vehicle follows. They say they are looking for drugs, but in the end find nothing. After ticketing the driver for speeding, the two officers casually drive off. Sitting in his now-trashed SUV, the young man weeps in his anger and humiliation.

Unmotivated searches like this are daily occurrences on our nation's highways, and blacks and white liberals have been decrying the situation for several years. Many conservatives, on the other hand, dismiss such complaints as the exaggerations of hypersensitive minorities. Or they say that if traffic cops do in fact pull over and search the vehicles of African Americans disproportionately, then such "racial profiling" is an unfortunate but necessary component of modern crime fighting.

The incident described above should give pause to those who think that racial profiling is simply a bogus issue cooked up by black leaders such as Al Sharpton and Jesse Jackson to use as another publicity tool. One of us teaches in an MBA program that enrolls a fairly large number of African Americans, and the story comes from one of our students. Indeed, during class discussions, all of the black men and many of the black women told stories of having their late-model cars pulled over and searched for drugs.

While incidents of racial profiling are widely deplored today, there is little said about the actual root cause of the phenomenon. The standard explanations for racial profiling focus on institutional racism, but that idea runs contrary to the sea change in social attitudes that has taken place over the last four decades. On the contrary, the practice of racial profiling grows from a trio of very tangible sources, all attributable to the War on Drugs, that $37 billion annual effort on the part of local, state, and federal lawmakers and cops to stop the sale and use of "illicit" substances. The sources include the difficulty in policing victimless crimes in general and the resulting need for intrusive police techniques; the greater relevancy of this difficulty given the intensification of the drug war since the 1980s; and the additional incentive that asset forfeiture laws give police forces to seize money and property from suspects. Since the notion of scaling back, let alone stopping, the drug war is too controversial for most politicians to handle, it's hardly surprising that its role in racial profiling should go largely unacknowledged.

The Practice of Racial Profiling

Although there is no single, universally accepted definition of "racial profiling," we're using the term to designate the practice of stopping and inspecting people who are passing through public places -- such as drivers on public highways or pedestrians in airports or urban areas -- where the reason for the stop is a statistical profile of the detainee's race or ethnicity.

The practice of racial profiling has been a prominent topic for the past several years. In his February address to Congress, President George W. Bush reported that he'd asked Attorney General John Ashcroft "to develop specific recommendations to end racial profiling. It's wrong, and we will end it in America." The nomination of former New Jersey Gov. Christine Todd Whitman as head of the Environmental Protection Agency was challenged on the basis of her alleged complicity in racial profiling practices in the Garden State. Whitman had pioneered her own unique form of "minority outreach" when she was photographed frisking a black crime suspect in 1996. Copies of the photo were circulated to senators prior to her confirmation vote. (By the same token, in February 1999, Whitman fired State Police Superintendent Carl A. Williams after he gave a newspaper interview in which he justified racial profiling and linked minority groups to drug trafficking.) More recently, Eleanor Holmes Norton, the District of Columbia's non-voting member of Congress, has tried to introduce legislation that would withhold federal highway dollars from states that have not explicitly banned racial profiling.

Although some observers claim that racial profiling doesn't exist, there is an abundance of stories and statistics that document the practice. One case where law enforcement officers were particularly bold in their declaration of intent involved U.S. Forest Service officers in California's Mendocino National Forest last year. In an attempt to stop marijuana growing, forest rangers were told to question all Hispanics whose cars were stopped, regardless of whether pot was actually found in their vehicles. Tim Crews, the publisher of the Sacramento Valley Mirror, a biweekly newspaper, published a memo he'd gotten from a federal law enforcement officer. The memo told park rangers "to develop probable cause for stop...if a vehicle stop is conducted and no marijuana is located and the vehicle has Hispanics inside, at a minimum we would like all individuals FI'd [field interrogated]." A spokeswoman for Mendocino National Forest called the directive an "unfortunate use of words."

The statistics are equally telling. Consider Crises of the Anti-Drug Effort, 1999, a report by Chad Thevenot of the Criminal Justice Policy Foundation, a group that monitors abuses of the American legal system. Thevenot writes: "76 percent of the motorists stopped along a 50-mile stretch of I-95 by Maryland's Special Traffic Interdiction Force (STIF) were black, according to an Associated Press computer analysis of car searches from January through September 1995....Blacks constitute 25 percent of Maryland's population, and 20 percent of Marylanders with driver's licenses." As this story was being written, New Jersey was holding hearings on racial profiling, and one state police investigator testified that 94 percent of the motorists stopped in one town were minorities.

Minorities are not only more likely to be stopped than whites, but they are also often pressured to allow searches of their vehicles, and they are more likely to allow such searches. In March, The New York Times reported that a 1997 investigation by New Jersey police of their own practices found that "turnpike drivers who agreed to have their cars searched by the state police were overwhelmingly black and Hispanic."

Some commentators, such as John Derbyshire in National Review, have defended racial profiling as nothing more than sensible police technique, where police employ the laws of probability to make the best use of their scarce resources in attacking crime. As Derbyshire put it in his February 19 story, "In Defense of Racial Profiling," the police engage in the practice for reasons of simple efficiency: "A policeman who concentrates a disproportionate amount of his limited time and resources on young black men is going to uncover far more crimes -- and therefore be far more successful in his career -- than one who biases his attention toward, say, middle-aged Asian women."

George Will, in an April 19 Washington Post column, contends that the use of race as a criterion in traffic stops is fine, as long as it is just "one factor among others in estimating criminal suspiciousness." Similarly, Jackson Toby, a professor of sociology at Rutgers, argued in a 1999 Wall Street Journal op-ed that, "If drug traffickers are disproportionately black or Hispanic, the police don't need to be racist to stop many minority motorists; they simply have to be efficient in targeting potential drug traffickers."

Clayton Searle, president of The International Narcotics Interdiction Association, writes in a report, Profiling in Law Enforcement, "Those who purport to be shocked that ethnic groups are overrepresented in the population arrested for drug courier activities must have been in a coma for the last twenty years. The fact is that ethnic groups control the majority of the drug trade in the United States. They also tend to hire as their underlings and couriers others of their same group." (Searle's report is available at www.inia.org/whats-new.htm#Profiling.)

Case Probability vs. Class Probability

The stories and statistics that draw outrage tend to share two common elements: They involve a search for drugs and the prospect of asset forfeiture. These types of investigations have led police from the solid ground of "case probability" to the shifting sands of "class probability" in their quest for probable cause. Once police are operating on the basis of class probability, there is a strong claim that certain groups of people are being denied equal protection under the law.

Case probability describes situations where we comprehend some factors relevant to a particular event, but not all such factors. It is used when a doctor tells a patient, "Given your lifestyle, you'll probably be dead in five years." Class probability refers to situations where we know enough about a class of events to describe it using statistics, but nothing about a particular event other than the fact that it belongs to the class in question. Class probability is being used when an insurance company estimates that a man who is 40 today will probably live to be, on average, about 80. The insurance company is not making any statement about the particular circumstances of any particular man, but merely generalizing about the class of 40-year-old men.

This distinction helps us to differentiate two ways of using information about race or ethnicity in a police investigation. As an example of the first type, employing case probability, consider a mugging victim who has told the police that her mugger was a young Asian man. Here, it is quite understandable that the group of suspects investigated will not "look like America." There is no sense in forcing the police to drag in proportional numbers of whites, blacks, women, and so on, proving that they have interrogated a representative population sample of their city, before they can arrest an Asian fellow. No, their investigation should clearly focus on young Asian men.

It's not at all impossible that a prevalence of some type of criminal activity in some ethnic group will lead to many investigations that focus on members of that group. As long as this is based on evidence gathered from particular crimes, there is nothing untoward here. If it turns out, for instance, that Bulgarians are especially numerous among purse-snatchers in some city, then a summary of police interrogations might discover evidence of "Bulgarian profiling" in the investigation of purse-snatching. But this may be a statistical mirage if it turns out that no one in the police force set out to focus on Bulgarians as potential purse-snatchers. The emergent result is an unintended outcome of policemen following an entirely valid principle of crime investigation: Concentrate on suspects who fit the description you have of the suspect.

But when we turn our attention to the type of racial profiling that occurred on the highways of Maryland and New Jersey, or that is described in the Forest Service memo, we find a very different phenomenon, one where investigations proceeded on the basis of class probability. Here, before having evidence of a particular crime, police set out intending to investigate a high proportion of people of some particular race, ethnic group, age group, or so on. Their only justification is that by doing so, they increase their chances of discovering some crimes.

Additionally, there is a fundamental difference between the type of crime, such as the mugging example above, that is usually investigated by gathering evidence about a known crime, and narrowing the search based on such evidence, and the type investigated by looking in as many places as possible to see if one can find a crime. The first type of crime generally has a victim, and the police are aware of a specific crime that has been committed. The crime is brought to the attention of the police by a complainant, even if the complainant is a corpse.

George Will, in his defense of current police practice, points out: "Police have intelligence that in the Northeast drug-shipping corridor many traffickers are Jamaicans favoring Nissan Pathfinders." This is quite a different situation than having intelligence that a particular Jamaican robbed a store and escaped in a Pathfinder. If you are a law-abiding Jamaican who by chance owns a Pathfinder, you frequently will find yourself under police surveillance, even though the police have no evidence about any particular crime involving any particular Jamaican in a Pathfinder.

We could not have any effective law enforcement without allowing some scope for case probability. If your twin brother robs a bank in your hometown, it does not seem to be a civil rights issue if the police stop you on the street for questioning. When the police discover their mistake, they should apologize and make you whole for any damages you have suffered. Such an event, while unfortunate, is simply a byproduct of attempting to enforce laws in a world of error-prone human beings possessing less-than-perfect knowledge. It will be a rare event in law-abiding citizens' lives, and it is highly unlikely that such people will come to feel that they are being targeted.

However, the use of class probability in police investigations is correctly regarded with extreme suspicion, as it violates a basic principle of justice: The legal system should treat all citizens equally, until there is specific, credible evidence that they have committed a crime. In the cases we've been discussing, we can say that the odds that any particular young black or Hispanic man will be hassled by the police are much higher than for a white man who, aside from his race, is demographically indistinguishable from him. These minority men, no matter how law-abiding they are, know that they will be investigated by the police significantly more often than other citizens who are not members of their racial group. The social cost of the alienation produced by this situation cannot, of course, be measured, but common sense tells us that it must be great.

As important, in the majority of "crimes" that such stops discover, there is no third party whose rights have been violated, who can step forward and bring the crime to the attention of the police. To discover victimless crimes, investigators must become intrusive and simply poke around wherever they can, trying to see if they can uncover such a crime. When someone drives a few pounds of marijuana up I-95 from seller to buyer, who will come forward and complain? It's not merely that, as in the cases of robbery or murder, the perpetrator may try to hide his identity, but that the "crime" has no victim.

Drug War Profiling Practices

Both statistical studies and anecdotal evidence support the view that drug crimes are the almost exclusive focus of investigation in racial profiling cases. Hence, The New York Times reported in February that, "The New Jersey State Police said last week that the number of drug arrests on the Garden State Parkway and the New Jersey Turnpike fell last year, after the department came under scrutiny for racial profiling. The number of drug charges resulting from stops on the turnpike were 370 last year, compared with 494 drug charges in 1999. There were 1,269 charges filed in 1998. On the parkway, troopers reported 350 drug charges last year compared with 783 in 1999 and 1,279 in 1998."

The Record, a Bergen, New Jersey, newspaper, obtained state police documents last fall. One document, used for training, teaches troopers to zero in on minorities when scanning state roadways for possible drug traffickers. Titled "Occupant Identifiers for a Possible Drug Courier," the document instructs troopers to look out for "Colombian males, Hispanic males, Hispanic and a black male together, Hispanic male and female posing as a couple." (One's mind boggles at how the police are able to detect that two Hispanics are "posing" as a couple as they zip by at 60 miles per hour.) The undated document also teaches troopers how to use supposed traffic violations, such as "speeding" and "failure to drive within a single lane," as a pretext to pull over suspected drug couriers.

If police have a goal of maximizing drug arrests, they may indeed find that they can achieve this most easily by focusing on minorities. Blacks on I-95 in Maryland, for instance, had a significantly higher initial propensity to carry drugs in the car than did whites. "Racial Bias in Motor Vehicle Searches: Theory and Evidence," a 1999 study by University of Pennsylvania professors John Knowles, Nicola Persico, and Petra Todd, shows that despite the fact that blacks were stopped three-and-a-half times more than whites, they were as likely to be carrying drugs. But this doesn't mean their propensity to carry is the same. If we assume that the high likelihood of being stopped reduces some blacks' willingness to carry drugs, then if not for the stops, they would have been carrying proportionally much more than whites. The Penn professors conclude they are displaying what they call "statistical discrimination" (i.e., the police are operating on the basis of class probability) rather than racial prejudice. Perhaps more to the point, they conclude that the police are primarily motivated by a desire to maximize drug arrests.

Some racial profiling defenders agree that the drug war bears a large part of the blame for racial profiling. "Many of the stop-and-search cases that brought this matter into the headlines were part of the so-called war on drugs," writes Derbyshire. "The police procedures behind them were ratified by court decisions of the 1980s, themselves mostly responding to the rising tide of illegal narcotics." But Derbyshire dismisses the argument that racial profiling is chiefly a byproduct of the drug war. He contends that even if drugs were legalized tomorrow, the practice would continue.

He is confusing the two forms of police procedure we have outlined above. The practice of laying out broad dragnets to see what turns up would almost entirely disappear but for the attempt to stamp out drug trafficking and use. Derbyshire, to bolster his case, cites the fact that in 1997, "Blacks, who are 13 percent of the U.S. population, comprised 35 percent of those arrested for embezzlement." This statistic would be useful if he were defending the fact that 35 percent of those investigated for embezzling that year were black. But does Derbyshire believe that stopping random blacks on an interstate highway is catching very many embezzlers? Or that, absent the drug war, cops would start searching cars they pull over for embezzled funds?

How Asset Forfeiture Fuels Profiling

In the 1980s, state legislatures and Congress were frustrated with their inability to arrest and convict "drug kingpins." So they passed laws that gave police the power to seize the property of suspected dealers. The dubious rationale: The "pushers'" property had been purchased through ill-gotten gains and hence didn't rightly belong to them. (Questions about establishing actual guilt were brushed aside as counterproductive.) The federal Comprehensive Crime Act of 1984 was the most important of these measures, as it allowed local police agencies that cooperated in a drug investigation to keep the vast majority of the assets seized.

In addition, the Department of Justice decided that police in states that did not allow their agencies to keep asset forfeiture proceeds could have the feds "adopt" their seizures. The Kansas City Star's Karen Dillon has done extensive investigative reporting on asset forfeiture over the past three years. She writes: "Wisconsin law mandates that forfeiture money goes to public schools, but only $16,906 went into Wisconsin's education fund during the year ending in June 1999, according to the state treasury department. During just six months of the same period, local law enforcement gave the federal government $1.5 million in seizures."

In a paper published in the September 2000 issue of the economics journal Public Choice, "Entrepreneurial Police and Drug Enforcement Policy," Brent D. Mast, Bruce L. Benson, and David W. Rasmussen report that forfeiture receipts roughly doubled every year for several years after the passage of the Comprehensive Crime Act. According to the Sourcebook of Criminal Justice Statistics, the total value of Drug Enforcement Administration seizures reached nearly $1 billion in 1992. A large amount of that revenue flows back from the federal government to state and local police departments. Dillon notes: "In 1997 and 1998, the St. Louis Metropolitan Police Department received back more than $2.5 million. In 1998 alone, the Georgia Bureau of Investigation took back $1.7 million."

A letter to the International Narcotics Interdiction Association (INIA) from the Richmond Metro Interdiction Unit, posted on INIA's Web site, is accompanied by a photo of two cops in front of a pile of $298,440. The letter says: "We took this money off a guy coming from NY to Miami on Amtrak about two weeks after returning from SKY NARC [an INIA training session] in Anaheim. It was a great school and as you can see it paid off."

The U.S. Department of Justice reports: "Collectively, local police departments received $490 million worth of cash, goods, and property from drug asset forfeiture programs during fiscal 1997. Sheriffs' departments had total receipts of $158 million."

This kind of money adds a major incentive to police efforts to discover drug crimes. The study by Mast, Benson, and Rasmussen concludes: "The results for the impact of asset seizure laws are robust....Police focus relatively more effort on drug control when they can enhance their budgets by retaining seized assets. Legislation permitting police to keep a portion of seized assets raises drug arrests as a portion of total arrests by about 20 percent and drug arrest rates by about 18 percent."

Of course, if the police begin harassing all motorists in a particular locale, support for their activities will soon evaporate. However, if they can identify a minority group that is somewhat more likely to commit a particular drug crime -- and if they know that members of that group are not politically powerful -- then the police can focus on those people in order to enhance their departmental revenue.

The usual supposition, that the accused is innocent until proven guilty, has been explicitly reversed in asset forfeiture cases. The authorities are not required to prove that a crime, involving the goods in question, has been committed. Instead, they must merely have "probable cause" for the seizure; the burden of proof is on the defendant trying to recover his property. The Schaffer Library of Drug Policy (druglibrary.org/schaffer) has found that 80 percent of those who have had assets seized are never charged with a crime, let alone convicted of one. Federal law provides for up to five years in prison for attempting to prevent one's own property from being grabbed.

It did not take long for those in law enforcement to conclude that their best haul would come from seizing goods from citizens who lack the resources to win them back. In one highly publicized case that occurred in 1991, federal authorities at the Nashville airport took more than $9,000 in cash from Willie Jones, a black landscaper who was flying to Houston in order to purchase shrubs. According to the police, that money could have been used to purchase drugs. After spending thousands of dollars and two years on the case, the landscaper was able to convince the courts to return most of the seized cash.

Sam Thach, a Vietnamese immigrant, found himself in a similar situation last year. He was relieved of $147,000 by the DEA while traveling on Amtrak. Thach was investigated because the details of his ticket purchase, which Amtrak shared with the DEA, "fit the profile" of a drug courier. He was not charged with any crime and is now fighting to retrieve his money in federal court. (See "Railway Bandits," Citings, July.)

When the University of Pennsylvania study and the study by Mast, Benson, and Rasmussen are considered in tandem, the implication is clear. The possibility of rich pickings through asset forfeiture, combined with the higher propensity for black motorists to carry drugs, provides police departments with a tremendous incentive to engage in racial profiling. It is hardly surprising, then, that police take the bait, even at the cost of racial bias accusations and investigations.

Last year, in reaction to high-profile cases of abuse, Congress passed legislation that changed the standard in federal civil asset forfeiture cases. Rather than showing "probable cause" that property was connected to a crime, the feds must now demonstrate "by a preponderance of the evidence" that the property was used in or is the product of a crime, a significantly higher legal standard. The revised law also awards legal fees to defendants who successfully challenge property seizures and gives judges more latitude to return seized property. Exactly what effect the law will have on federal agents, or on state and local cops, is not yet clear.

This Is Your Law Enforcement on Drugs

In the panic created by the drug war, our traditional liberties have been eroded. Rather than regarding case probability as a necessary component of probable cause for searches or seizures, the American law enforcement system has now come to accept class probability as sufficient justification for many intrusions.

Unfortunately, the current protests against racial profiling are not addressing the root causes of the practice. Politicians, eager to please voters, have created potentially greater problems by trying to suppress the symptoms. As John Derbyshire points out, the laws rushed onto the books to end racial profiling result in severe obstacles to police officers attempting to investigate serious crimes. He notes, "In Philadelphia, a federal court order now requires police to fill out both sides of an 8-1/2-by-11 sheet on every citizen contact." Unless our solution to this problem addresses its cause, we will be faced with the choice of either hindering important police work or treating some of our citizens, based on characteristics (race, age, and so on) completely beyond their control, in a manner that is patently unfair.

If we really wish to end the scourge of racial profiling, we must address its roots: drug laws that encourage police to consider members of broad groups as probable criminals. We must redirect law enforcement toward solving specific, known crimes using the particular evidence available to them about that crime. Whatever one's opinion on drug legalization may be, it's easy to agree that the state of seizure law in America is reprehensible, even given last year's minor federal reforms. It should be obvious that there's something nutty about a legal system that assumes suspects in murder, robbery, and rape cases are innocent until a trial proves otherwise, but assumes that a landscaper carrying some cash is guilty of drug trafficking.

Drugs, prohibitionists commonly point out, can damage a user's mind. They apparently can have the same effect on the minds of law enforcement officials.

Shaky Ground

gcallah@erols.com (Gene Callahan) — Mon, 01 Jan 2001 00:00:00 EST

A couple of years ago, my wife and I were looking at a small house in a New England town that I will call "Hampshire." The property also encompassed a strip of land in the town to the north of us-let's call it "Yorkshire." Our intention was to buy and then expand the house, but we discovered two obstacles to doing so. The first was that the lot was "nonconforming" because it was just one acre in an area zoned for two-acre lots. To do any work, then, we would need a zoning variance. The second obstacle was a creek 80 feet from the house; its proximity meant we would need approval from the conservation authorities of both towns. To help us decide whether to go ahead, we called Hampshire Town Hall and spoke to the clerk, a pleasant woman who cheerfully answered our questions. Yes, she told us, most likely we would be able to expand. According to her, about 95 percent of all variances were approved.

We weighed our decision. The asking price was very reasonable, and we loved the rolling property with its seasonal creek. But what if we weren't permitted to expand? We could always sell and move on. But this would entail two moves in two years, as our first child was on the way, and the house, without expansion, soon would be too small for us. With some trepidation, we finally made an offer on the house.

Having secured the house, we proceeded with plans to expand. That's when we discovered we would have to persuade the Hampshire Planning and Zoning Commission, the Hampshire Conservation Commission, the Yorkshire Planning and Zoning Commission, the Yorkshire Conservation Commission, and the Yorkshire/Hampshire Health District that we were worthy of the additional space.

Our architect, who had grown up in Hampshire, agreed to guide us through the approval process. I knew I had made the right choice when, at our meeting with the Hampshire Planning and Zoning Commission, one of the board members introduced our architect to another member by saying, "You remember Phil from the Hunt Club, don't you?" The architect and I had a site walk with the inspector from the health district, and another one with the building inspector. We attended one zoning meeting. We also attended conservation meetings-four of them.

I came to know the members of the Hampshire Conservation Commission like family-like my family when I was a teenager, as they considered whether to let me take the station wagon out on a Saturday night. The dominant personality on the commission was a fellow named Fred, who was also, not surprisingly, the chairman.

Fred was always smiling. He smiled at odd, inappropriate times, such as when saying, "You see, if we don't have an MA-103F Soil Test Form completed and in front of us, we're just not going to be able to proceed with your application." The smile seemed intended to assure people that Fred's request, however arbitrary and cumbersome it seemed, flowed from a fountain of wholly benign eco-concern.

One of Fred's main concerns was that everyone who came in for an approval would plant a particular species of river weed called "sedge" along the edge of their wetlands. In almost every application, Fred brought up the subject of sedge, always with great gusto. I began to wonder if Fred had ties to the National Sedge Growers Association. Exactly which plants would border your wetland was a matter of utmost concern to him. He made one supplicant agree not to plant a lawn within 20 feet of her creek as part of the terms of her approval. She had offered not to use any "chemical" lawn products, but Fred wasn't buying it. No, he explained, some future owner might be tempted to hire "ToxoLawn" to maintain that patch. The applicant was responsible not only for her own acts involving the wetlands but also the potential acts of future owners. She was enjoined from undertaking activities that, while not harming the wetlands in themselves, might tempt the guy who owns the house 20 years from now into harming them.

At one meeting we met the God of Boredom, whom we came to call Soil Engineer. He had been hired by some poor soul who was on his fourth trip to see the commission for a four-lot subdivision. The applicant also brought along a couple of fellows in suits-his attorney and his builder. Soil Engineer attempted to lull the board into submission by describing, in detail, the geological history of the lot from the Cretaceous Period to modern times. As the North American and European continental shelves separated, I found myself biting my lip to shock myself awake. I was sure that if my head slumped forward during the meeting, it would count against me when the vote on my property came.

Soil Engineer began discussing "drumlins." Don't ask me what these really are-by this stage of the meeting I was in a semi-hallucinatory state, and my recollection is that it was inside a drumlin that Frodo Baggins first encountered a barrow wight.

Fred leaned forward with a knowing look on his face. The tension in the room heightened from none to the smallest amount above none that can possibly be measured. Had Fred found, amid the nearly pure white noise of this monologue, the melody that would resolve the dispute?

"Were the drumlins formed while the glaciers were advancing or while they were retreating?" he asked.

Could this really be the deciding factor? "Retreating? Good. Approved!" No-Fred was educating an audience whose knowledge of Ice Age New England he knew to be sorely deficient. Suddenly, the applicant exploded at the commission. All over the room doodling ceased and heads picked up. He launched into a tirade about how other, larger projects had been approved, because, he implied, the applicants were wealthy developers who gave generously to the campaigns of various town officials.

Predictably, the commission was not amused. Fred graced the supplicant with a gentle smile.

"We understand that you're upset," he said, "and we'd like to help you. But we're going to need some more information from you before we can proceed."

Fred then listed inconsistencies to be resolved, measurements to be made, obscure plant species to hunt for on the land. The applicant, duly chastised, shuffled off with his contingent.

Finally, after three hours of listening to other people's cases, our turn had come. "Callahan?" the clerk said. We indicated that we were present. The clerk opened the folder for our case. "Oh, the Town of Yorkshire hasn't responded to our letter of advisement," he said. "You'll have to come back for the next meeting." In two weeks.

Another notable person on the commission was the fellow whom we came to call Yes Man. He was the lonely representative of the idea that perhaps the town should have the burden of proving that there is ecological harm, rather than forcing the applicant to show that there isn't. At a certain point he would get bored with drumlins and soil microorganisms and blurt out, "I forward the motion that we approve this application." Occasionally his boredom would carry the day, as other commission members would begin to feel the same ennui and just want things ended with the conclusion that was probable anyway.

After three meetings with the conservation commission, Yes Man forwarded his motion, and we gained our approval. But we were not done with them yet. We made a change to our building plans that did not affect the footprint, and filed the changed plans with the building inspector. Since our impact on the wetlands hadn't changed, the architect felt that we weren't required to go back to the conservation commission. Apparently, he was wrong. Our builder was confronted by the town conservation officer, who threatened to shut the job down because of the change in plans. My architect called me and told me to bring my attorney to the next meeting. The sight of an attorney seemed to change the commission's mood. The board members were immediately conciliatory and merely admonished us by saying that they would "appreciate being told about these things."

In his popular 1996 book The Death of Common Sense: How Law Is Suffocating America, Philip Howard contends that the chief legal problem in America today is not that there are too many laws but that the law is not being applied "reasonably." Bureaucrats, he argues, are not given sufficient discretion when making their decisions. The result is that our obsession with "a government of laws, not men," is destroying government's ability to act rationally. "Relaxing a little and letting regulators use their judgment is the only way to liberate our judgment," Howard writes. He moves so far from the principle of the rule of law as to recommend regulating each of America's 4,000 most polluting factories individually.

Well, here we were in a situation where the bureaucrats had plenty of discretion and were very reasonable, yet we were worse off than if what we wanted to do were simply forbidden. In that case we just wouldn't have purchased the property. Instead, we had months of uncertainty after the purchase. We wound up spending dozens of hours of our time and thousands of dollars in fees for our architect's and our lawyer's hours. It was necessary to talk very politely and sound very eco-friendly to the conservation commission, especially when dealing with Fred. He could turn stubborn on a project and request information not possibly available at the meeting, sending the hapless applicant out to spend more cash and time determining the ratio of green-backed to yellow-backed slugs on his land.

At one meeting my wife felt compelled to hide the cover of a conservative magazine she was reading, for fear of offending some liberal on the board. Board members would pop over to our property at odd times of the day and walk the land. These intrusions into our private lives were made possible by the discretion these boards enjoy. What you want to do is forbidden by default, but if you're nice and don't put up a fuss about their choosing your landscaping plants or crashing your croquet party, they'll let your project go forward. As F.A. Hayek remarked in The Constitution of Liberty: "It used to be the boast of free men that, so long as they kept within the bounds of known law, there was no need to ask anybody's permission or to obey anybody's orders. It is doubtful whether any of us can make that claim today."

Our case, while daunting to us, was actually resolved comparatively easily. When I described its history to John Charles, environmental policy director at the Cascade Policy Institute, an Oregon-based policy research center, he expressed genuine surprise that we had been able to move forward so quickly. In contrast, Reason Contributing Editor James DeLong describes in his 1997 book Property Matters the case of a Pacific Grove, California, property owner who spent over $600,000 and three and a half years to get permission to build a residence on a 1.1-acre lot.

It is precisely the discretionary power of local land use authorities and the "reasonableness" of their procedures that lead to cases that drag on for months or years. Since there is no simple rule deciding whether a particular project can go forward, regulators must invest large amounts of time to show that they have considered all factors and have not been unfair or negligent in their final decision. In fact, the system gives them strong incentives never to make any decision at all-if they can merely delay decision until the project fades away, no one can blame them for deciding improperly.

In describing the difficulties of Andrew Varlow, who wished to expand on his Marin County, California, property, DeLong comments: "The planners fret about the size of the house, the effect on views, future development in the area, the possible impact on real estate prices, and the project's 'inconsistency with the goals' of the planning group (whatever these may be; the meeting minutes do not say). No standards are announced. Varlow and his people have spent over two years on the project without any firm guidance that 'you can do this but not that.'"

Philip Howard would contend that the regulators should be held responsible for being dilatory, but this merely inserts another layer of administration making another round of discretionary decisions. After all, weren't the Marin regulators just using their legal discretionary power to withhold a decision until they felt certain that Varlow's project was "consistent with their goals"? By what guideline could the regulators be judged to have taken "too long"? And who will judge the regulators who judge the regulators?

During the third of our conservation commission hearings, our architect pointed out to the board members that we had a child on the way. They all nodded in understanding, and our approval came soon thereafter. Should this have been relevant to their decision? If we were childless pensioners, would we have had less right to expand? Hampshire is a Republican stronghold-might the decision have been different if we had been prominent Democrats? What would our odds have been if we had been a gay couple hoping to build in a fundamentalist Christian community? Blacks in an otherwise all-white town in the Deep South?

I have no idea if the applicant who yelled at the commission had any factual basis for his accusations of corruption. But a system in which a bureaucracy has discretionary powers over individual citizens will always lead to suspicions of this sort. Each case must be decided on its own, unique merits, so it becomes an entirely subjective judgment as to whether different parties received "equal" treatment.

The man who wanted the four-lot subdivision had much more trouble with conservation than we did. Because his motive was simply "profit," his standing with the commission was lower than that of a young and growing family needing living space. A commission tasked with protecting wetlands wound up assessing the moral worth of various applicants' projects.

Howard is wrong, and the defenders of the rule of law are right. Hayek, one of the greatest 20th-century advocates of the rule of law, saw that it is the keystone to liberty. People living under the rule of law have clear-cut guidance as to whether they are permitted to undertake some activity. This clarity leaves us free to plan our own actions, because we understand, vis-à-vis the legal system, what the consequences of those actions will be. All of us understand that if we kill someone and are caught, we will go to prison. Occasionally there will be gray areas in the law, such as determining when a killing might be in self-defense. But our town had set up a situation where the majority of contemplated development was in gray areas. In our case, it was never clear to us exactly what would decide the fate of our petition. As Hayek put it, "Nobody disputes the fact that, in order to make efficient use of the means at its disposal, the government must exercise a great deal of discretion. But...under the rule of law the private citizen and his property are not an object for administration by government, not a means to be used for its purposes. It is only when administration interferes with the private sphere of the citizen that the problem of discretion becomes relevant to us; and the principle of the rule of law, in effect, means that the administrative authorities should have no such discretionary powers in this respect."

In Simple Rules for a Complex World (1995), Richard Epstein argues that we should generally favor rules that offer a clear delineation of what is and isn't permissible over more complex rules that require discretion on the part of those enforcing them. He illustrates the principle with the example of lawsuits that involve harm caused jointly. For instance, your car struck mine after you failed to obey a stop sign one night. I, however, was driving without my headlights on, making it difficult for you to see me. Law that requires an "accurate" determination of how much each of our errors contributed to the accident necessitates great discretion on the part of those deciding the case-and leads to interminable trials with large legal expenses on both sides.

Epstein's suggested solution is elegant: simply split the difference, awarding half of the damages that would have been awarded had the plaintiff not also been negligent. Although this eliminates all discretion, and may seem to be unfair in some cases, Epstein contends that most cases wind up near this mid-way mark anyway. The huge administrative costs involved in the futile attempt to arrive at a "reasonable" apportionment of blame swamp the meager gains from the few cases where the result of a 50-50 split of losses is manifestly unjust.

Our problem was not that the town had set rules restricting our use of our property. Such rules are necessary, since some property uses significantly affect neighbors and, if permitted, would allow the property owner to impose large costs on others. Preventing us from building a nuclear weapons facility on our rural land in a residential neighborhood does not in a significant way impair our liberty. If we are hoping to construct such a factory, we know in advance to avoid properties with residential-only restrictions, and therefore we are still able to plan.

But the town does not really intend that its restrictions be uniformly enforced. As DeLong points out, regulators prefer vague restrictions that allow them great leeway. This type of restriction requires an administrative apparatus with large discretionary powers, which serves chiefly to enhance the power of bureaucrats. The bureaucracy avoids a public outcry because it drives up the cost of new construction, limiting its supply and raising the prices of existing homes. For the majority of homeowners in town who do not intend to expand in the foreseeable future, the large losses suffered by a small minority are an acceptable cost of protecting their own investment.

DeLong recognizes the basic problem when he writes: "Several things are necessary to restore the balance [in regulation]. The first is to assert the boundaries and certainties of property rights. Cities need to get their basic rules in place, and then let people act, without more nit-picking detailed review. A recent news article reported on the success of city planning in Portland, Oregon. What does Portland do? Well, for one thing, it follows its own zoning laws. If the code says you can build apartments somewhere, that is what you are allowed to do."

Howard fails to see that it is in the market where citizens can properly exercise their discretion over property use and that once government is given discretion in this regard, it has the arbitrary power to decree one citizen's aims more worthy than another's. Although Howard cites Hayek, he does not seem to comprehend his message. Howard has no wish to limit the state's power to infringe upon private property rights as long as it does so "reasonably."

If you enter my house and begin to negotiate with me about what I may watch on TV, the issue at hand is not how reasonably you do so. You have intruded into my private sphere and are unwelcome, however reasonable your requests may seem to you or others. The U.S. Constitution does not say that Congress should "make no unreasonable laws respecting an establishment of religion"; it says that Congress shall make no laws at all establishing a religion. Congress is not enjoined from "unreasonably abridging the freedom of speech" but from any such abridgment. Of course, these rights may come into conflict with others, and the government is well within its bounds in preventing a religious group from practicing infanticide or in punishing free speech if it is slanderous. But these are rare exceptions to otherwise clear rules. As DeLong says, "What is needed is a restoration of government of law rather than government by whimsy."

It is possible to conceive of other, realistic arrangements that would both preserve the property owner's liberty and achieve environmental and planning goals. A government, be it local, state, or federal, can set minimum guidelines that say when a project may proceed without, for instance, a wetland permit-if, say, it is more than 100 feet from any area that is below water more than six months a year. That government can then sell increasingly expensive permits that allow transgressing these limits, up to a point where certain activities, such as draining a pond, may be strictly prohibited. Strictly prohibited should mean that no exceptions can be granted, resulting in clear guidelines for the property owner. Where such restrictions impose a significant burden on property owners when compared to normal use in the area, takings law should apply, and the state should pay for the loss of normal use. (For instance, if two-acre zoning is the norm for an area, a restriction that limits a landowner to one house on a six-acre lot should require compensation.)

These permits should be made fungible, so that a market can develop in them. DeLong notes that such a system of transferable development rights has already been established in many municipalities. With a market in these rights, property owners could plan activities on a site with a reasonable degree of confidence by calculating whether the project would be worth the cost, including the purchase of the necessary rights. The revenue raised could be used to buy and preserve undeveloped properties. If the people in a town want to limit development, this purchasing of open land is by far the fairest and most efficient means available. The townspeople are not able to impose the cost of their preference for open space on isolated individuals, who have had a portion of their property rights seized in order to create a public good.

It is not only economically sensible to establish clear property rights in regard to wetlands, open space requirements, historic districts, and other land use issues. It is also morally correct. Even if a certain course of action is beneficial to a community and requires the abnegation of certain property owners' rights, this does not justify imposing the entirety of the cost of this community benefit upon a few individuals. DeLong notes that "these decisions [to restrict property use] involve a judgment by the supporters of the restriction that someone must sacrifice, and your friends and neighbors have selected you."

A healthier environment, historic preservation, open space: These are not goods that most of us should steal from a few of us. If we want them, we should all be prepared to pay our part of the cost. And citizens who want to use their property as they see fit should not have to grovel before boards that exercise arbitrary power over their lives. Having a "standing rule to live by" makes any tradeoff involved manifest and will ultimately result in both more respect for a community's true values and a more secure right to plan our individual futures.