17 September 2008

A Balanced Regulatory Meal

A frequent Second Glance commenter has asked for my views on the financial market mess. More specifically he'd like me to reconcile my general disdain for regulation with this disaster which appears to have been caused by a lack of regulation.

I would love to opine at length on the topic, but like many of the shell shocked investment firms out there sitting up to their eyeballs in worthless securitized debt instruments, I don't really know what the heck is going on.

So, as any good libertarian would, I will avoid the direct question by stating a hypothetical that no one can disagree with. Then I will claim that the hypothetical is relevant to the current question, even if the relationship is tenuous. Then I will claim that there was never any paradox to reconcile in the first place. Here it goes:

As we all know, hindsight is 20/20. So my question is "what would we have done differently, if given the chance?" If your answer is, "we should have had the gov't cracked down on predatory lending and the proliferation of high exposure investment instruments," I would just laugh. I'd laugh somewhat nervously, partially because I don't know what the hell that really means. But I'd also laugh because the Monday morning quarterbacking only works until next Sunday.

It seems the golden phrase these days is not more or less regulation but "good regulation." Good regulation is just another way of saying let's make rules which constrain the choices of corporations with the intent to limit harm or provide benefit to some individuals. Unless you have a vendetta against the word "regulation," good regulation doesn't sound so bad, right? Who cares about corporations when the individual is at stake?!

To which I must reply with a platitude because it is so fitting yet never gets considered seriously during the "solution" or regulation proposal phase, that is, "actions often have unintended consequences." Let us say that we enact all the regulation that is supposedly needed to "keep this from ever happening again." My question would be, in the process have we created an even bigger monster, requiring even more regulations to defeat? And where does it end? And if its so good now, why didn't we think so before, and will it be good later?

This is not to say that regulation is never needed, or that it was not needed in this case. It is only to say, that we shouldn't use the fact that voluntary exchange has gone south as a sufficient rationale for enacting regulation. Especially since once in place regulations have a tricky way of making themselves permanent residents. Regulations change the rules of the game. In the new game, maybe we limit the upside by limiting the downside. Maybe it is better to sustain transitory losses, however painfully, to remove the ceiling on growth in the future.

These are a lot of tough questions, and the easy answer is to just enact smart or good regulation. The hard part is figuring out if we are doing less harm than good.


chris said...

The government seems to have assumed that the marketplace would take care of itself here, and according to conservative economic theory it should. Arguably this market was structured to fail, though. My understanding is certainly not complete or perfect, but this is it: you've got salesmen who make commissions when they make loans, and receive no penalty if a loan fails - their personal incentive is solely to make more loans. You've got ratings companies who got paid by the financing companies to rate loans, whose incentive is therefore to rate them highly so they sell well for the financing company. You've got insurance companies who look at the highly rated loans and agree to insure the financial companies against loan failures, and these insurance companies counted on worst-case predictions to write their policies. "This is the absolute worst that has happened in the past 100 years, so we will make sure we are safe in that case - the worst case scenario." Of course, this turned out to be the 500 year flood instead of the 100 year flood, and now the insurance companies (AIG) can't pay up for all the mortgage failures.

Are incentives properly aligned here? Is government intervention necessary? Maybe. It seems that sometimes markets just delude themselves and ride the wave of euphoria and profitability. Or perhaps it's that situations get so complex that no one really has the full picture and just trusts that their arrangements can be taken at face value (e.g. a AAA batch of mortgages really is solid).

"Regulation" might be the wrong word. What about "oversight"? Is it possible for the government to oversee (and predict) a situation that the private industry itself didn't even see coming? Honestly, probably not. So some sort of preventative regulations are needed, in my opinion. You do need to be careful when regulating because there are always unintended consequences, but "being careful" when doing things like this is a platitude, as you said. The real statement is that you need to be "flexible" when implementing this kind of policy. Do your in-depth analysis, implement what seems to be the best solution at the time, and be ready to adjust as necessary. Your solution will need adjustments.

chris said...

Oh, as for what particular policies should be implemented, I couldn't begin to tell you. I don't know nearly enough about the markets. I hear some Lehman guys need work though; maybe they could help. (That was a joke, but the chief officers of failed companies probably do have a pretty good idea at this point of what went wrong for them, and what policies might fix it.)

chris said...

Oh, one more thing. Sorry, I know when you see 3 comments you're going to be like "wow, I'm getting a lot of readers!" I take responsibility for this deception.

I said earlier that the markets may have been structured to fail. Why then has this crisis only occurred now? I submit that it may be because computers and the internet have raised the complexity of the market beyond the level that one person can fully understand. It could be that so much real time communication, instant purchasing, selling, in-depth modeling (which people may come to trust to give a correct answer without fully understanding the underlying programming and assumptions), worldwide debt trading, etc. is possible now that business is more efficient than it used to be and new opportunities and markets have been created, but everything is also more complex. The housing bubble was the catalyst that came along and exposed for the first time the price we pay for these new ways of trading debt, and this new found complexity in general.

Maybe I'm way off, and maybe markets have always been structured exactly like this only with paper, but I don't think so. I don't see how it's possible. Conversely, maybe the markets have always been too complex for one person to grasp, and there was some other factor keeping them in check. I'm sticking with my technology = complexity = non-thorough market analysis/understanding = surprises hypothesis though.

chris said...

I just read a WSJ op-ed at lunch that argued some of what you're arguing, and some of what I'm arguing. It's here: http://online.wsj.com/article/SB122169320421449849.html ("Bad Accounting Rules Helped Sink AIG")

My only question after reading the article is if current accounting rules create a false sense of losses, don't all companies recognize this, and so shouldn't other companies be amenable to financing temporary bailouts? But they're not - they won't touch these companies with a ten foot pole. I think we're seeing more than just poor representation of facts due to arcane accounting rules.

chris said...

A lesson in economics: fixing one problem often creates another unexpected one! http://www.neatorama.com/2008/09/29/epic-tow-truck-fail/