fraud on the over-the-counter market and in unlisted securities throughout the country. The primary assumption of the Securities Exchange Act of 1934 that a broad market is dishonest, or inherently undesirable, yet remains to be proven. This interpretation by the

$35 36 $37 238 $39 40 Note how stock prices lagged behind earnings since 1934. Source: Standard Statistics.

Commission seems to go beyond the actual terms of the act. A stagnant stock market causes a stagnant new issues market, and thus a stagnant employment market. Then follow more disturbing legislative measures to correct these evils. The Government attempts to act as substitute for the private banker and private employer.

The CHAIRMAN. I understand that the decline there in the price of securities was measured in relation to its earnings.

Mr. FRIEDMAN. Yes; the two curves show that. I can bring one of the charts up to you if you would like to see it. I have a few extra copies here for the members of the committee.

4. Violent declines harm business.-The elimination of insiders makes the decline far more violent. Sales of automobiles and other consumer goods move sensitively with market quotations. Any sales manager of an automobile company will tell you that. Of course, this was the pre-war situation and will probably apply after the war.

A sudden or sharp decline of stock-exchange quotations makes potential buyers feel poor. They stop buying and thus can initiate a decline in business which often feeds upon itself. The discharge of workers and loss of national income thus is part of the price we pay for the doubtful benefits of a thin market. A violent decline of stock prices

also affects borrowing power of businessmen who may have collateral loans. A wild break in the market of several points between two sales as in 1937 also frightens banks who have collateral loans, who thus become more reluctant to lend on commercial loans because securities in loans are not only shrinking more rapidly than usual but are less salable than before the days of the Securities Exchange Act of 1934. This in turn is reflected in unemployment. The evil effects on new issues for exemption and employment of brief, violent fluctuations of stock prices was clearly explained by James F. Hughes, an authority in this field:

For more than a century the most important steps in the sequence of financial developments leading to sustained business prosperity were the continued advance in stock prices and the increased volume of new issues of corporate securities after a rise in the market when the public had confidence to buy them. It was these periods of speculative and investment interest in equities that were primarily responsible for corporate expansion of productive facilities. This type of business spending for a capital equipment produced general prosperity and added to the real wealth of the Nation. To the extent that such prosperity was financed by common stock, the increased future productivity of the country was freed from the burden of previously created bonded indebtedness. This was the way venture capital and speculation built up a rich nation. Unfortunately, the Securities Exchange legislation entirely overlooked the historic role of speculation and venture capital over the many decades prior to 1929. Speculation in the stock market was legislated out of existence and this combined with politically attractive but economically unsound policies has dried up the flow of venture capital from a broad stream to a tiny trickle. Other policies and attitudes contribute to the stagnation in the flow of private capital into productive enterprise but the fundamenal difficulty is found in the technical helplessness of the stock market, the ultimate home of venture capital.

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Regulation has tended to create a type of market that, thin or fat, provides the wildest short-swing fluctuations in speculative history. * * However, the quick exhaustion of the stock market after a brief but sensational investment stampede works against the building up of any broad interest in equities. Under these conditions it is extremely difficult to distribute new stock issues. Industrial activity and employment therefore loses the support of any sustained flow of new money into business enterprise.

Professional speculators working steadily from day to day gave a continuity to market trends over relatively long periods of time. This gradually built up a general confidence in the stock market and greatly facilitated the flotation of new capital issues. Under these conditions the stock market made a positive contribution to the continuity of business recovery.

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The foregoing comparison of the way the stock market used to operate and the way it operates now may explain why it is impossible to sustain a 1929 level of business activity with a 1942 financial mechanism.

5. Socially useful speculation has been restricted and discouraged and socially useless gambling has been tolerated and encouraged.Private enterprise is based on the element of risk. Speculation in securities is a part of the machinery of private production and of the economic process. The entrepreneur creates a risk. Stock speculation distributes the risk. The consumers and general public benefit if the venture succeeds. So does the speculator. They all gained-for example, in the development of the telephone. If the venture fails the speculator loses, as in the development of some automobiles and some radios. Loss is not inherent or inevitable. But gambling in lotteries, sweepstakes, and horse racing involves no enterprise. It has 10 social benefits. The risk is created artificially and is transitory. The loss is inherent and inevitable for at least one-half the total amount participating.

There is an important difference between speculation and gambling, Speculation involves taking of risk based on study of the facts, and on appraisal of future possibilities. The speculator is necessary in the long-range development of patents or of new industries. Risk is inherent in the very nature of private enterprise. In economic life some fluctuations are inevitable, as prices, interest rates, etc. The speculator attempts to anticipate these. The speculator hazards his money on the hope of reward, but also faces the possibility of loss if the venture fails. The national economy benefits by such risktaking. The speculator makes an economic contribution. He puts up capital for new enterprise. This requires a broad and liquid market for all securities. Taking a risk is the essence of both speculation and gambling. But speculation is not gambling. Gambling depends chiefly on pure chance and little upon study and analysis, and less upon vision and imagination. In Communist Russia betting on horse races, lotteries, and other forms of gambling are legal, but in capitalist Holland they are prohibited. On the other hand speculation in stocks and private enterprise are prohibited in Russia but are encouraged

in Holland.

Mr. YOUNGDAHL. Mr. Chairman.

Mr. CROSSER. Mr. Youngdahl.

Mr. YOUNGDAHL. You say socially useless gambling increased during this period?

Mr. FRIEDMAN. I shall shortly give you some figures of its amazing increase.

Mr. YOUNGDAHL. All right.

Mr. FRIEDMAN. Since risk-taking in economic speculation has been restricted in securities, risk-taking in gambling has cropped up in fields which are neither economically productive nor socially desirable. Since 1934, there has been a tremendous increase in slot machines, "numbers rackets," foreign lotteries and hospital sweepstakes. The number of States in which pari-mutuel betting at horse races has been legalized has risen 30 percent since 1934, the year when the Securities Exchange Act was passed. Comparing 1934 with 1939, total wagers at all United States race tracks rose 82 percent, but New York Stock Exchange transactions fell 19 percent. That was from 1934 to 1939. But if you compare 1933, before the Securities Exchange Act was passed, New York Stock Exchange transactions fell 60 percent by 1939 while wagers at United States horse-race tracks rose over 90 percent. For 1941 the diversion in trend is even greater. Surely the rise in gambling since 1934 is not accidental.

The amount of money wagered at our race tracks in 1939 was over $300,000,000. That excludes three States, New York, Louisiana, and Missouri, in which no records were kept at that time. This amount exceeds the volume of transactions on some of the smaller stock exchanges. The amendment to the 1934 act may restore risktaking to its legitimate economic function in a system of private enterprise. The stakes are the economic development of the country; the motive is not recreation or a spree at the race track.

Risk is inherent in life. Like absolute truth, absolute security is unattainable, and the assumption that the Government can obtain it for the individual has proven an illusion. Charles Mackay's Extraordinary Popular Delusions of History-which is a book well worth rereading-deals with the tulip craze in Holland 300 years ago. When the boom collapsed, the government was pressed to find

a remedy for the losses. The government refused to interfere and advised the tulip owners to devise their own plan. "To find a remedy was beyond the power of the government." This was also the attitude of our Government authorities during the 1920's in the matter of the Florida land boom and in the suburban real-estate boom of the same time.

Mr. YOUNGDAHL. Mr. Chairman.

Mr. CROSSER. Mr. Youngdahl.

Mr. YOUNGDAHL. I think I remember your saying that useless social gambling was encouraged.

Mr. FRIEDMAN. Tolerated.

Mr. YOUNGDAHL. Tolerated; but not encouraged?

Mr. FRIEDMAN. Well, of course, encouraged. When 30 percent more of the States legalized opening of race tracks or legalized betting, I do not know whether you would call it toleration or encouragement.

Mr. YOUNGDAHL. Was there no such gambling, which you call socially useless, prior to that time? Probably you have not gone into that. Did they not exist during the 1920's. Was that not done during the period 1920 to 1934?

Mr. FRIEDMAN. Relatively not to the same extent as after 1934. The fact is, if you will get the statistics on the subject, you will find that the restrictions on risk taking by economic speculation on the stock exchanges resulted in risk taking cropping out in other forms. We did not know what the numbers rackets and other new gambling devices were in 1929.

Mr. YOUNGDAHL. What I am trying to get at is what is your conclusion?

Mr. FRIEDMAN. My conclusion is that people will take risks and speculate and if they are not permitted to engage in economically useful speculation, they will engage in something that is economically useless.

Mr. YOUNGDAHL. Why is it that they left speculation on the socalled exchanges?

Mr. FRIEDMAN. Because you have taken interest out of the markets by excessive restrictions.

Mr. YOUNGDAHL. You mean that the markets are too thin, that there is not enough volume?

Mr. FRIEDMAN. Too thin and too inactive and devoid of sustained trends. The capital gains tax plus the Securities Exchange Act of 1934 has crippled the machinery so that the markets do not respond, except in violent fits and starts, like dead muscle touched by an electric current.

Mr. YOUNGDAHL. In this chart that you passed around it appears that the earnings have been steadily falling behind.

Mr. FRIEDMAN. The market price has fallen behind earnings.

Mr. YOUNGDAHL. Yes; the market price. Are those the gross earnings, or the net earnings?

Mr. FRIEDMAN. Those are the net earnings for 400 corporations. Mr. YOUNGDAHL. Would you say that fear on the part of the public because of the possibility of new taxes and further regulation is responsible for that?

Mr. FRIEDMAN. Well, in 1934 I think it was chiefly due to the fact that people got frightened. New taxes and war risks were not live

issues then. The whole machinery of the stock exchange legislation was designed to discourage speculation. That was the publicly avowed purpose of some of the gentlemen who were making the rules. They said speculation was bad under any condition. Prohibiting speculation would not be an economic evil if there could be found any other basis for the system of private enterprise. But look over the world and where else, outside of the area of private enterprise will you find as great benefits resulting.

Mr. YOUNGDAHL. I understood you to say that certain features of the law were good for the protection of the investor.

Mr. FRIEDMAN. The law on the whole is tremendously good and there are only a few minor points that need correcting. I think any person who is fair and looks at the whole situation realizes that the principles of this law are desirable. We have improved on the British, French and Dutch system where the government utterly refuses to interfere. I think the law reflects progress in the concept of the extension of governmental power over the people who willfully do wrong.

Mr. YOUNGDAHL. Do you feel that the making of some changes in the act at this time such as have been recommended here will probably ease some of that fear and bring back a better condition in the market?

Mr. FRIEDMAN. Yes, there is no doubt about it. You might put the changes into effect for 1 year and let them lapse unless extended by the Congress and then observe the result. What does the scientist do in his laboratory? If he finds that he is running on the wrong track he will try some other procedure and then watch what happens. Mr. YOUNGDAHL. That is all.

Mr. CROSSER. Go ahead.

Mr. FRIEDMAN (continuing):

6. Can ethics be legislated?-The Prohibition Act was devastating in its effect in the 1920's. It was repealed because it restricted the liberties of the individual and required a great deal of Government "snooping". Excessive investigation into the affairs of private business is not in keeping with the Anglo-Saxon political tradition. The excessive regulation of the stock exchange is not suited to the present situation. It is too outdated. It would certainly have prevented the 1929 boom because it is preventing even normal market activity. The law reminds one of the French generals who in 1940 were fighting with 1914 technique. Legislation always follows an evil. Hindsight does not cure lack of foresight. It merely salves one's conscience.

It is a principle of the common law that it is preferable to allow a few guilty to escape rather than to abridge the freedom of the individual by continuous and excessive "snooping". A classic paraphrase of this principle of the common law is given in a dissenting opinion of the late Supreme Court Justice Holmes:

We have to choose, and for my part I think it a less evil that some criminal should escape and that the Government should play an ignoble part.

A more recent statement of the same principle was expounded by Supreme Court Justice Roberts:

Congress may have thought it less important that some offenders should go unwhipped of justice than that officers should resort to methods deemed incou sistent with ethical standards and destructive of personal liberty.