Redstate

Fever for Regulation

By blackhedd Posted in Economy | federal reserve | Financial regulation | new york times | Paulson — Comments (5) / Email this page » / Leave a comment »

You may or may not have noticed Treasury Secretary Paulson’s speech last Monday, in which he unveiled a blueprint for modernizing the Federal government’s regulation of financial markets.

If you did notice it, you probably yawned. The report has been in the making for over a year, and although it contains a lot of good ideas, it’s neither directly responsive to the current market disorders, nor particularly likely to be enacted in whole or in part.

The editorialist at the New York Times noticed the speech, however. Their (predictable) response is that Paulson’s plan is far too reluctant to clamp down on market behavior that can result in stress (and crisis).

Unfortunately, I don’t get much sense that the editorial powers at the New York Times have direct knowledge of how real markets work. As it turns out, markets are human too.

Let me tell you what I mean…

The Times editorial is full of standard-issue language that betrays a specific point of view about the nature of financial crises. Here’s a sample:

To understand the White House’s blueprint for regulating the financial markets, start with what the Bush administration did not do. It did not offer America a plan to respond to the ongoing credit crisis or to the Federal Reserve’s dramatic intervention to prevent the collapse of Bear Stearns. It certainly did not provide a roadmap for avoiding this sort of meltdown in the future.

And another:

But as Congress moves forward with its investigations of the credit crisis, it’s important for lawmakers and the public to realize that the administration’s ideas are fundamentally flawed.
Its proposals are premised on the notion that market discipline is the most effective tool to limit risks to the financial system. Current events show how absurd that is.

Ok. Let’s understand specifically and clearly the mindset that underlies these comments. Here’s one way to encapsulate that mindset:

Financial markets are like complex machines. They behave in ways that are understandable by experts. All you have to do is apply the correct adjustments to them, and they won’t do bad things.

In this view, which is shared by many economists (but by few participants in real markets), the reason we’re in a financial crisis is because creative innovation changed the markets in ways that regulators didn’t respond to.

I would say rather that creative innovation has changed markets in ways that no one actually even understands yet, much less has any power to regulate effectively.

Exhibit A is the “shadow banking system,” a term used by Bill Gross (the chief investment officer of PIMCO Funds, a large bond mutual fund operator), among others.

What’s the shadow? Credit derivatives, for the most part. This is the witch’s brew of bizarre terminology you’ve heard people slinging around for months now (credit-default swaps, collateralized debt obligations, structured investment vehicles, auction-rate bonds).

To avoid a long, geeky analysis, let me just say that financial engineering has strongly reduced friction in the flow and allocation of global capital. Reducing friction in capital markets is effectively the same as creating more credit.

Whenever you create more credit, you have to find good, efficient uses for it, otherwise you get bubbles. And bubbles burst.

Underneath this 30,000-foot view, there is a huge amount of poorly-understood detail. Regulating it properly is necessary, but it will take years to do it right. Doing it in a hasty and half-[tailed] way, so as to capitalize on the current political moment, is a recipe for disaster.

The New York Times, and many other people, assume that you can prevent financial crises if you regulate markets the right way.

But this misunderstands market behavior, because it misapplies the lessons of human nature. Markets are not like machines. They're like people.

Market participants are motivated alternately by fear and greed. Sometimes fear is stronger than greed.

If you have even the slightest sense that someone you’ve made a deal with is, or will become, unlikely to pay you back in full, what’s your response?

Well, unless your counterparty is a member of your immediate family, your natural response is to pull your money out and either sit on the sidelines or trade with someone else. In markets as in real life, people always take care of their own interests before they take care of someone else’s.

I defy anyone reading this to tell me that they would behave any differently.

As soon as one player gets the creeps about someone else, news spreads fast and soon everyone does. This can happen literally overnight, as it did to Bear Stearns.

Markets always overreact to stress, because people overreact to stress. The only way to avoid financial crises is not to have financial markets in the first place.

To mitigate crises when they occur is a legitimate and essential policy objective, as has been borne out by decades of Federal Reserve history.

But it’s naïve and foolish to suggest, as the New York Times explicitly does, that the correct policy objective should be to prevent crises before they occur.

-Francis Cianfrocca ("blackhedd")