Cogenitive

So now for an economics rant.  In Sebastian Mallaby’s post today in the Washington Post, he states that “The claim that the financial crisis reflects Bush-McCain deregulation is not only nonsense. It is the sort of nonsense that could matter.”  And goes on to argue that “deregulation is the wrong scapegoat” for the current financial crisis that has frozen credit markets, led to a drop of nearly 50% (as of today) in the stock market from highs a  year ago, and appears to be the worst economic crisis to hit this country in 70+ years – and you know what I’m talking about.  I can’t really quibble with his opening arguments that the current crisis is in large part due to the Fed’s recent policy of letting asset bubbles inflate, waiting until they burst, then cleaning up afterwards with the liberal application of dollars and easy credit.  His insight that the Fed faced a choice between managing consumer inflation (due to the rise of cheap consumer goods from China) and asset inflation (due to the massive influx of capital seeking returns from China’s profits on those consumer goods) is valuable, and helped me understand a bit of the history of the current crisis.  His assertion that unwise deregulation was not a major factor doesn’t seem right to me though, and his supporting arguments seem a bit simplistic and disingenuous.

He first argues that the Investment Banks, regulated by the SEC, and commercial banks, regulated by the Fed and other agencies bought up large chunks of CDO’s, CDS’s, etc… built on top of questionnable loans, and that lightly regulated hedge funds seem to have steered clear, so therefore regulation didn’t help.  I’m interested to understand the latter point about hedge funds, as it might offer some guidance into how to manage these kinds of things, but the mere fact that the I & C Banks were “regulated” does not hold much water.  Which brings me to the subject of this post: these entities were “subject to regulation,” not “regulated,” or at least not effectively regulated.  As a recent article in the New York Times reports, the SEC was almost entirely absent when it came to actually overseeing the operations of the Investment Banks.  The Commission actually deregulated the banks by removing capital constraints (that might have reduced their exposure to these assets), they barely investigated them or follow up on the results of what audits they did undertake, and they didn’t take advantage of any of the new information the banks agreed to share in exchange for the removal of the capital constraints.   I don’t have the salient reference, but I believe the story was largely the same for the commercial banks.  While these institutions were certainly subject to regulation, the actual oversight performed was minimal and the ability of the agencies charged with their oversight has been gutted in recent years. 

He then argues that “super-regulated” (his words) Fannie Mae’s and Freddie Mac’s appetite for lousy mortgage backed securities further inflated the bubble.  Fair enough, but I don’t think their appetite for these asset classes was driven by regulation – I think it was driven by their directive to promote homeownership.  This is not regulation; this is the result of their role as quasi-governmental entities that have to make some concessions to the government masters who’s implicit (now explicit) guarantee allows them to borrow at below market rates.  This is government meddling in markets, not regulation.

My opinion is that the problem is not too much or too little regulation, it’s ineffective regulation, coupled with government meddling (i.e. politics) in markets.  So whoever becomes the next president of the United States, I hope they take a hard look at the regulatory infrastructure that exists today, how well it’s performing its stated function, and where it needs to be shored up.  I certainly hope they don’t go for a simplistic or ideologically motivated solution (more regulation, less regulation), and instead find a few smart people (from both sides of the aisle), to try to figure out how to bring our regulatory scheme up to date with today’s complex and global markets.

And one more thing: I’m getting really sick of hearing about how “free markets” are self regulating, and if the regulators/government would just get out of the way, everything’d be find.  Conventional market theory is built on a few core assumptions, among which are that market participants are rational actors, and that markets operate on the basis of perfect or near perfect flow of information.  With relatively recent innovations in technology, markets have been opened up to whole new classes of “amateur” investors, and there are now a very large number of players in the market that respond as a herd, not on the basis in individual, rational decisions (see complexity theory and specifically agent based modelling if you’re interested in crowd dynamics and how they may affect market behaviour).  This also calls into question how perfect the flow of information is under these circumstances.  In the best of situations, information does not flow smoothly or symmetrically.  There is a class of investor that spends all of their time doing nothing but soaking up all the information they can, but even they can only focus on a small subset of any given market (and never mind any conflicts of interests these analysts may have) – the amateurs haven’t got a chance.  Then there’s this whole wave of investments and trading strategies, dreamt up by the mathematicions and physicists – the “quant jocks” – of Wall Street.  Never mind perfect information – nobody even knows how these things work, much less what they’re worth or what might influence that value.  So forget about theoretical, self regulating markets.  They don’t exist.