Don’t regulate, rationalize

I know it’s mostly bull, the hippie management bromide that “in Chinese, the word for crisis is danger plus opportunity!” I don’t care. We’re gonna go with it here. I see the current financial crisis as dangerous, but also a tremendous opportunity to fix a lot of things that have been broken for a very long time.

The “sophisticated” banking systems and capital markets that we’re always flogging to developing countries are like nuclear reactors of the Chernobyl design. Sure, they are very powerful, very sexy. When they work they can light up whole cities, and that’s gotta be attractive if you’re sitting in the dark. But they have deep weaknesses, structural flaws, inconsistencies that are resolved only with generous applications of duct tape. Everything seems to work most of the time, but they are an accident waiting to happen. When an accident does happen, there is a story, perhaps a true story, about the particular screw-ups that were proximate cause. But focusing on those misses the point. We ought to get the engineering right before trying to operate the plant.

Financial systems are much more massive enterprises than nuclear power plants, and much more important. We need to redesign our financial system not only to be more robust, but to be more effective. Lost in the flamboyant pain of the current crisis is a quieter tragedy. We have misallocated natural and human resources on a vast scale over the past few years, and it won’t have been the first time. The real economic meaning of financial losses in the housing sector is that hands and minds were squandered bulding houses when they should have done much better things. Timber was felled and oil wells pumped dry, and what we made turned out to be of less value than what we destroyed. We could have predicted and avoided that. A reasonable financial system would have predicted and avoided that.

Treasury Secretary Henry Paulson has mooted a variety of reforms in response to the present financial crisis. Reading through, those proposals amount to a rationalization of the hodge-podge institutions that regulate financial markets. That’s not unwelcome, but it’s not what’s needed. It’s like responding to the Chernobyl meltdown by issuing three-ringed binders filled with better procedures about how to manage the plant. Regulation can compensate for minor flaws. But it can’t overcome a design that is structurally unsound. Our financial architecture is structurally unsound, so our task is not to rationalize the regulatory regime, but the financial system itself.

That will require changes far more challenging to incumbent firms than what Mr. Paulson proposes. Institutions that are too big to fail and/or capable of moving market prices unilaterally don’t sit well with the theory of financial markets. Financial firms can be regulated utilities that handle essential plumbing but bear little risk, or they can be aggressive risk-seekers looking to play every angle and milk every opportunity. They cannot be both. The gentlemen at Mr. Paulson’s alma mater may not like the implications of that, but the principle is correct regardless, and we ought insist that it not be fudged. The “Nationally Recognized Statistical Rating Organizations”, and the constellation of professional norms and judicial safe-harbors that link their opinions to the behavior of institutional money are an abomination, a legal discouragement of the independence of judgment upon which accurate prices and market stability are based. Their special status simply has to go the way of the dodo. This has to go a lot farther than merging the SEC and the CFTC. Rather than placing our faith in the Fed as an ever-watchful superhero, saving us all when financial catastrophe strikes from outer space, we can and should better manage our affairs here on Earth to avoid those catastrophes in the first place.

These have been great times to be a cynic. But, at long last, appropriate cynicism is finally getting priced into the market. There’s not much intellectual alpha left there. When this all washes out, we do want an informationally efficient, market-based financial system. It’s time to start talking specifics about what we need to do to get there. Before very long, all options may be on the table. Let’s have some good ones ready to go.


14 Responses to “Don’t regulate, rationalize”

  1. Benjamin Reeve writes:

    Hear Hear! Can we vote for you, elect you to something? Would you mind running the country for a while?

  2. wimpie writes:

    Steve, not sure if wēijī is where we want to go right now.(but giving Benny and Hank wedgies might be useful)

    The jī of wēijī, in fact, means something like “incipient moment; crucial point (when something begins or changes).” Thus, a wēijī is indeed a genuine crisis, a dangerous moment, a time when things start to go awry. A wēijī indicates a perilous situation when one should be especially wary. It is not a juncture when one goes looking for advantages and benefits. In a crisis, one wants above all to save one’s skin and neck! Any would-be guru who advocates opportunism in the face of crisis should be run out of town on a rail, for his / her advice will only compound the danger of the crisis.”

  3. ramster writes:

    “Financial firms can be regulated utilities that handle essential plumbing but bear little risk, or they can be aggressive risk-seekers looking to play every angle and milk every opportunity. They cannot be both.”

    The thing is, employees of “regulated utilities that handle essential plumbing but bear little risk” don’t get paid mid 6-figure salaries with 6 or 7 figure bonuses. Regulated industries don’t have annual $40 billion bonus extravaganzas. CEOs of utilities don’t get paid hundreds of millions of dollars (or even billions) per year. The entire demented, utterly un-moored from normal people’s reality, compensation structure of the modern financial industry only makes sense in the current framework that you correctly decry.

    Given that, the vested interests arrayed against the reforms you suggest aren’t going to be beat. Read some of the comments in the right-wing and libertarian blogoshpere on McCain’s recent statement on a mortgage bailout. Bailing out Wall street is apparently a-OK, but the poor shmucks with the dodgy mortgages are getting what they deserve. This anti “class warfare” message will then filter out through Rush and Fox news to the mindless sheep who are too stupid to realize that they’re being played for chumps. Wall street titans have a direct connection into the cabinets of either party’s presidents (e.g. Rubin, Paulson). It’ll take a full blown Depression with a helluva lot more pain than people feel now before there’s enough popular support for real reform. A McCain presidency, with its even lighter regulation of Wall street and a few more multi-trillion dollar wars should do the trick.

  4. DownSouth writes:

    “It’ll take a full blown Depression with a helluva lot more pain than people feel now before there’s enough popular support for real reform. A McCain presidency, with its even lighter regulation of Wall street and a few more multi-trillion dollar wars should do the trick.–ramster,

    I couldn’t agree more.

    Coming on the heels of the housing crisis will be the retirement one, delineated in this PBS Frontline investigative report…

    Policy decisions were made beginning in the early 1980’s, and one by one, the financial underpinnings of the average American household are being intentionally and systematically destroyed.

  5. No offense, but this is a fairly vague post. What are you trying to say?

    The fact is that the CDOs and such are not well-designed for transparency. Sketchy loans need to be packaged individually in order for transparency to work, or at least they need to be easily visible in the loan information. If these weren’t packaged in such a non-transparent manner, I’m sure more of the purchasers would have been smarter about their purchases.

    Of course, no amount of regulation can pop a bubble. However, without the bad information which purchasers were given (AAA CDOs full of junk bonds) the bubble wouldn’t have gone on nearly as long.

    There’s a lot of potential for better information in regulation. SEC filings are a great start, but they’re just a start. The SEC needs to provide all information in downloadable spreadsheets, for example.

  6. Larry writes:

    Is it enough (or even right-headed) to say that importance itself is the quality that invokes regulation? That any private institution, whether bank, investment bank, hedge fund, or whatever that becomes “too big (too important, really) to fail” gets the treatment? I.e., if we’re going to bail you/your investors out, play by our rules?

    Conversely, if you’re not in that category, you have wide latitude?

  7. Please don’t elect me for anything. I find writing stuff people actually read terrifying enough.

    No disagreement that a reasonable restructuring of the financial system would run head up against the interests of some very powerful people. Still. Reason and persuasion may not be everything in this world, but they are not nothing either. We oughtn’t think about financial reform in all-or-nothing terms. Despite running up against vested interests, some good ideas may win the day, and that could matter a lot.

    Also, I think it possible that the times may turn pretty bad. If not very soon then a little bit later, the games we are playing may hit Stein’s Law hard. If things do get bad, anything becomes possible, and that usually means policies that are at best rash and sometimes downright terrible have their day. I think we should be having serious conversations about what good policies would look like, so if a vacuum does emerge in difficult times, there’s some hope we fill it with something good.

    Larry, I don’t know that it’s enough, but I do think your principal is fundamentally right. Entities capable of entirely internalizing the bad consequences of their risk-taking, and who don’t rig the game by exercising market power, need not be regulated at all as far as I’m concerned. But entities whose pain will inevitably be socialized, ad hoc via defaults against counterparties unsuited to bear risk or directly via bailouts to prevent the former, are quasipublic entities, and should be managed as such. It’s up to the entities themselves to manage their affairs carefully if they want their freedom. A moderate-size hedge fund that only accepts investments from rich individuals and that doesn’t use bank leverage can do what it wants, as far as I’m concerned. A hedge fund that persuades a major bank to offer lots of undercollateralized credit and that accepts investment from pension funds and university endowments must cede control to the public as it shifts risks to the public.

  8. undergroundman — sorry about the vagueness. i don’t disagree, and quite agree with you regarding the structure of CDOs. i’ve a half-written post on securitization that comes to conclusions quite similar to yours.

    for a nice view of how opaque CDOs are, check out this delight from Going Private.

  9. Your argument is not vague, but the fix you propose is vague. Some of the problems with financial markets are just plain built into human nature. Bubbles have and will continue to happen. The only way I can think of to fix them is to step in and forcefully stop the buying, or let it happen. As I said, in this case the bubble wouldn’t have went on nearly as long if information would have been better.

    I think the most important part of regulation is ensuring that information is good. But that’s not going to overcome all problems because most people are just not that smart.

    Anyway, I’d be interested to hear more details on what you think the solution is. Also, I believe that financial institutions can handle “essential plumbing” and carry a lot of risk — they just have to be smart about it.

    Let’s hope a lot of these banks collapse; unfortunately, that’s not going to help things because the people running them will run the next banks. That’s the inherent flaw with the system: the foxes are guarding the hens, and when those hens die, they’re going to move on to the next and make more money because they have “more experience”.

  10. Gegner writes:

    Um, the ‘solution’ to this debacle is actually quite simple…but as you point out, it’s going to raise the hackles of the (currently) powerful.

    Hanging in the balance here is not just civilization but our survival as a species.

    So, where do we begin? Naturally the first step is to identify the problem…which I put forth as the ‘nature’ of money.

    What people think money is and its one useful purpose to society are completely at odds with one another because of the laws governing money’s use(s.)

    Change the laws and you can solve the problem.

    The first question we need to ask is what is the ‘purpose’ of money?

    Money serves society as a ‘regulator’, it limits access perishable/high demand goods and services (end social usefulness of money)

    With this as a given, who ‘needs’ money?

    The only ‘entity’ that ‘needs’ money is the individual.

    How would the individual ‘get’ money?

    There would be but one way to get money and that would be to work for it.

    How would you prevent others from cheating people out of their money?

    You eliminate cash…all money will exist as numbers in an account, accessed via a debit card, with no provision made to transfer funds between individuals.

    Shorthand…your money is for you. The only way to get it is to work for it and you can only spend it at the store (which no one owns.) What you ‘spend’ is merely erased from your account, no one gets it…neither the store nor the field of endeavor that employs you needs money to operate.

    Herein you will find the solution to every ill facing our current ‘for profit’ social model.

    Simply put, no individual piece is more ‘important’ than any other when it take all of the pieces to comprise the functioning whole.

    This is just one piece of a much larger plan…a plan that starts with the rule of law and places those laws beyond the reach of the ‘self-interested’…

  11. Larry writes:

    The other principle I would add to the “too important” rule is that regulation would have to do more good than harm. Some risks are worth taking even if there is a big downside.

  12. g13can writes:

    Your passage about misallocating natural and human resources to build houses is dead on. Asset inflation can’t go on forever. Maybe the time has come to scuttle this badly leaking vessel and let everyone aboard find something else to do.

  13. huh? writes:

    How does the store buy stuff to put on its shelves?

  14. Eric Hoffer writes:

    “The only index by which to judge a government or a way of life is by the quality of the people it acts upon. No matter how noble the objectives of a government, if it blurs decency and kindness, cheapens human life, and breeds ill will and suspicion- it is an evil government.”