Saturday, September 13, 2008

Heavy Regulation, Dysfunctional Governance

Financial regulation has produced a lot of laws and a lot of spending but poor priorities and little success in using the most important laws to head off a disaster. The pattern is reminiscent of how legislators often seem more interested in building new highways — which are highly visible projects — than in maintaining old ones.

The biggest financial deregulation in recent times has been an implicit one — namely, that hedge funds and many new exotic financial instruments have grown in importance but have remained largely unregulated. To be sure, these institutions contributed to the severity of the Bear Stearns crisis and to the related global credit crisis. But it’s not obvious that the less regulated financial sector performed any worse than the highly regulated housing and bank mortgage lending sectors, including, of course, the government-sponsored mortgage agencies.

In other words, the regulation that we have didn’t work very well.

There are two ways to view this history. First, with the benefit of hindsight, one could argue that we needed only a stronger political will to regulate every corner of finance and avert a crisis.

Under the second view, which I prefer, regulators will never be in a position to accurately evaluate or second-guess many of the most important market transactions. In finance, trillions of dollars change hands, market players are very sophisticated, and much of the activity takes place outside the United States — or easily could.

Under these circumstances, the real issue is setting strong regulatory priorities to prevent outright fraud and to encourage market transparency, given that government scrutiny will never be universal or even close to it. Identifying underregulated sectors in hindsight isn’t a useful guide for what to do the next time.

~Tyler Cowen in today's NY Times, "Too Few Regulations? No, Just Ineffective Ones"

4 Comments:

At 9/13/2008 5:20 PM, Blogger bobble said...

"But it’s not obvious that the less regulated financial sector performed any worse than the highly regulated . . . bank mortgage lending sectors . . .
In other words, the regulation that we have didn’t work very well."

two words: GLASS-STEAGALL, repealed during clinton admin, was the key regulation we did not have.

if commercial banks choose to benefit from FDIC insurance, then they cannot be allowed to speculate like investment banks.

simple and effective.

The repeal enabled commercial lenders such as Citigroup, the largest U.S. bank by assets, to underwrite and trade instruments such as mortgage-backed securities and collateralized debt obligations and establish so-called structured investment vehicles, or SIVs, that bought those securities.

Citigroup played a major part in the repeal. Then called Citicorp, the company merged with Travelers Insurance company the year before using loopholes in Glass-Steagall that allowed for temporary exemptions. With lobbying led by Roger Levy, the "finance, insurance and real estate industries together are regularly the largest campaign contributors and biggest spenders on lobbying of all business sectors [in 1999]. They laid out more than $200 million for lobbying in 1998, according to the Center for Responsive Politics..." These industries succeeded in their two decades long effort to repeal the act.[9]

 
At 9/14/2008 11:10 AM, Blogger the buggy professor said...

"Under these circumstances, the real issue is setting strong regulatory priorities to prevent outright fraud and to encourage market transparency, given that government scrutiny will never be universal or even close to it. Identifying underregulated sectors in hindsight isn’t a useful guide for what to do the next time." ---Tyler Cowan

......

1) Nobody really knows what the right degree of regulation should be of a very complex, ever changing web of financial institutions that have --- over the last 30 years or so --- both helped and hindered global economic growth.

....

2) More specifically, the combination of deregulation across numerous industries, not just financial ones, has helped the US economy move quickly from an industrial-based system to a knowledge-based system based on knowledge and ideas . . . but, simultaneously, has repeatedly dislocated the economy because of the excessive risk-taking and poor management of risk and allocating capital efficiently that have marked many of these financial innovations.

......

3) Consider the lengthy list of dislocations:

* The stock market balloon of the 1980s and then the bust on Black Monday in late 1987, the biggest one-day decline in US stock-market history. The balloon was accentuated by promises of brokerage firms that, thanks to computers, they would swiftly move the investments of their clients that were falling a given percentage over to the bond market. The reality: only a few big investors were helped this way.

* The S&L (Savings and Loan) fiasco of the late 1980s, which required a government bailout.

* The dot.com ballooning stock market of the 1990s --- balloons built into the nature of capitalism, it seems (best explained by Hyam Minsky, and not dead Austrian economists) --- and subsequent crash.

* The Long Term Capital Management hedge-fund fiasco, with tens of billions lost even though the hedge fund was run by two Nobel Prize-winning economists with 25 Ph.D. economic analysts. Another government rescue needed (1998). (True: hedge funds have, more recently, done better than commercial and investment banks, never mind independent mortgage-brokers, in staving off a fall in capital and profits . . . a sign, again, of the complexities of financial management and the problems facing regulators.)

*The subsequent accounting scandals entangling firms like Enron, World.com, and the like that, it seems, did little other than manipulate balance sheets. The real shocker was that so-called outside accounting scrutiny of corporations and financial institutions turned out to be something of a joke, with these accounting agencies free, simultaneously, to work out lots of sweetheart deals with those they were scrutinizing . . . not least, thanks to changes in accounting regulations of the late 1990s.

* The head-spinning innovations in "fee structures" that mark almost all the financial sectors of the US economy . . . to the point that credit-card holders, thinking they may have to pay, say, 20% max interest rates on short-term loans may in fact be paying five times that rate.

* The gigantic flaw that followed: the subprime innovation, carried out in a sort of Ponzi-scheme by independent mortgage firms (another innovation), with commercial and investment banks then getting involved --- hey, who cares about credit-analysis, just pass on the risky paper to the buyer down the road
-- and then excessive snowballing of all this on a vast global scale.

* The subsequent bust of this subprime hoopla, and the worse consequence, a huge credit-squeeze . . . credit the life-blood of our economic system. Then quickly followed by the failure of certain key brokerage firms and the near default of Fannie and Freddie, both necessitating rescue by the US government and Federal Reserve, even as the same was true of certain key commercial and investment banks . . . with more bailouts certain to occur.

* And, if we're to believe Alan Greenspan --- a follower and true-believer of Ayn Rand ---- the speculative causes of the huge upsurge in oil prices starting last winter, with its dislocations, followed by the subsequent collapse starting in late July.

.......

3) All this has occurred in the US, with world-wide repercussions.

I pass over, just in mentioning, nothing else, the Asia financial meltdown of 1997-98, with (interestingly) China and India --- both not deregulating their financial markets --- the only countries not to have been badly hurt.

No, I am not recommending Chinese or India-style regulations here. That would be absurd, even loony.

.....

4) Let's leave aside, too, the underlying causes of these financial excesses and subsequent crashes --- analyzed effectively by Hymam Minsky, a great economist who had been a former stock-broker and investor --- and look at the mix of regulations and deregulations in finance that mark this country's current combination.

On Minsky, see: http://en.wikipedia.org/wiki/Hyman_Minsky

Cowan, in his article, does not mention the kind of appointments that the Bush-W administration has made to head most of our financial regulatory agencies . . . virtually one and all headed by political hacks and incompetents, with little or no interest in effectively carrying out their regulatory role.

.

The causes of such bungling may be numerous --- not least, just plain incompetence, with the Bush administration specializing in way too many outrageous appointments (though not, fortunately, at the top in the Treasury department or in Bernanke's nomination to take over the Federal Reserve).

Just as the private sector needs highly qualified managers, so does the public sector --- and that includes, note, the military, where the appointment of General Petraeus, after nearly 4 years of disastrous occupational policies in Iraq, radically and fairly quickly changed the situation on the ground in that country.

Political ideologues opposed to regulation, regulators who identify with the interests of the industrial firms --- like the accounting firms who had sweetheart deals with the firms they were supposedly monitoring --- and hack incompetents will botch things up just as much in the public sector as they will in the private sector.

.........

5) The conclusions?

Nobody really knows the right degree of regulation in the financial sectors, not least because the rapid innovations --- facilitated by the Internet and all sorts of excessive capital running around the world as China and India and Russia and Middle East oil-rich countries boom (with no effective internal financial markets for investment and hence huge outflows into the US and the EU) --- are hard to keep up with.

But with do need to find ways to make all these financial institutions more transparent and accountable --- the latter meaning to their investors, borrowers, and the public in general.

And that requires an administration and a Congress that don't seem to toady to special interest money and ideologies opposed, in rigid principle, to effective regulation.

......

6) On a wider political level, the new populist backlash --- with 80% of the US public repeatedly saying our country is on the wrong track and suffering from a very bad or fairly bad economy --- has been fueled by these financial dislocations, one after another, and to the point that it seems punched out mentally.

Add in the rapid growth of income inequality --- not unrelated, to put it mildly, to these financial innovations and instabilities and outright shenanigans at times --- and all of us should be geared to deal with a soured American public view of our economy until far more confidence in our economic, financial, and political elites is restored.

Otherwise, ladies and gentlemen, it's a repeat of the 1790s Whiskey Rebellion, the Jacksonian populist onslaught on new financial institutions, the populist agrarian rebellion of the late 19th century against Wall Street and industrial giants, the muckraging surge that followed, the Progressive breakthrough that accompanied it, and the 1930s more radical turn in the Great Depression.

And restoring confidence means that people like us posting in this thread are again convinced that our financial institutions do what they are supposed to all the way back to Adam Smith: allocate capital efficiently and managed financial risk-taking properly.

.....

Michael Gordon, AKA, the buggy professor

 
At 9/14/2008 7:05 PM, Blogger juandos said...

"The gigantic flaw that followed: the subprime innovation, carried out in a sort of Ponzi-scheme by independent mortgage firms (another innovation), with commercial and investment banks then getting involved --- hey, who cares about credit-analysis, just pass on the risky paper to the buyer down the road
-- and then excessive snowballing of all this on a vast global scale
"...

Well golly gee! Sounds suspiciously like the Social Security/Entitlements scam the federal government is running on its citizens...

If the federal government can do it, why not banks and other lending institutions?

 
At 9/15/2008 4:11 AM, Blogger randian said...

The complaints about hedge funds are really class warfare arguments: that they are vehicles for the rich to steal from everybody else. Of course, they wouldn't be vehicles for the rich if it weren't for the Securities Act of 1933, which essentially makes it impossible to offer private investments to anybody who isn't rich. Most commenters on hedge funds are ignorant of the Act's mandates.

 

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