Wisdom from Arnold Kling. His fundamental insight is that each round of regulation fixes the last set of problems and creates the conditions for the next crisis. We're always fighting the last. war. My question—do we keep making the same mistake over and over because politicians and the rest of us don't notice the flaws or because the politicians have the incentive to pretend to fix something even though it's going to lead to the next disaster?
The cycle of regulation
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Or… because it's better to stop the bleeding with regulation you have a better grasp on, even though you know there are going to be unforseen consequences in the future.
Of course regulation has unintended consequences and insofar as we can figure those out ahead of time, we'll have better regulation (or no regulation at all). I think you can accept that and still find good reason to address the causes of the current crisis.
By the way – what regulation caused this crisis? I know CRA and that sort of stuff caused imbalances in the housing market. I accept that. But another huge driver seemed to me to be the repeal of Glass-Steagall and lax oversight of CDO's, etc. I'm getting out of my depths now with this stuff – but I think it's too simplistic to say "today's regulation will cause tomorrow's crisis". Bad regulation is bad and bad deregulation is bad. Good regulation is good and good deregulation is good. We can't operate off of a "regulation is bad and deregulation is good" story. Not that I'm accusing you or anyone else of doing that – but I think it's in the air.
Wasn't this Mises' insight in his Critique of Interventionism?
I don't think its either or, I think it's both. The level of ignorance in the general public about the effects of regulation is astonishing.
Daniel, the only part of the glass-steagall act that was repealed was the part that didn't allow the the same holding company own both a commercial and investment bank. Banks are still not allowed to gamble in the stock market with deposits. NO part of Glass-Steagall would have prevented the mortgage crisis and the banking institutions that had both retail and I-banking operations ended up doing better than unconsolidated institutions.
CDOs are merely ABS, which have existed for decades without issue. There's nothing inherently wrong with them
Where do we begin with which government regulation is to blame for this? Let's start with the credit rating agencies which were a government created oligopoly via SEC regulation. What if a bank thought the oligopoly's ratings were bogus? Too bad. All regulated institutions were REQUIRED to accept the oligopoly's ratings.
Dumb capital requirements which forced the use of mark to market accounting without flexibility in reserve requirements to handle crisis.
And then there's the effect of a too low interest rate and Fan & Fred on the mortgage market and the subsidies that government created for the housing market which skewed decisions of private individuals. Shall I go on?
Speaking as someone who is heavily regulated by the alphabet soup of agencies which regulate Wall Street, all I can say is that regulation works only to disadvantage customers and reduce competition for insiders. All of those regulations are sold to the public as protection for them. If you call protection from lower transaction costs and higher returns "working", then regulation is working spectacularly and the regulation proposed so far will work even better. Of course, if the regulators suddenly put onerous requirements on industry insiders, we'll rebel and because the industry is now dependent on us as regulators have effectively regulated out competition, they'll give us what we want. That's why Options market makers got their locate exemption back within a couple of days of the SEC taking it away in September.
It's the same in every industry. The industry captures regulators because it's a co-dependent relationship and the people in industry are much smarter than regulators. Any regulator who seems intelligent is immediately hired away by the industry at a multiple of current comp and the regulatory body is left with the dregs. Having captured the regulator, the industry proceeds to insulate itself from competition and from the requirement of efficiency. The public pays the price.
How's that working for us then? So, yes. I'm guilty of thinking that regulation is bad. All the fraud regulation is aimed at stopping is already covered by U.S. law.
Methinks –
First – thanks for the detail on pertinent regs.
I think you're reading me too strongly, though. I'm not defending regulation – I'm just suggesting that it's oversimplified to attribute the crisis of today to "yesterday's regulation" entirely. It seems that "irrational exubberance" over mortgage backed securities enabled this crisis, and CRA's and Fannie and Freddie threw gas on the fire. MAYBE regulation could have diffused that irrational exubberance, maybe there was no way it could have. But I don't see why regulation is assumed to be the chief culprit.
I don't think the fact that credit rating agencies are a government-backed oligopoly necessitates poor decision making. The problem was they rated the securities poorly. That COULD have been derived from their oligopolist status… not sure why you're assuming it does though. Maybe it has nothing to do with that. That's all I'm saying. The leap of faith you seem to be making is between the oligopolist status of the rating agencies and their poor predictions.
I think this post is being very quick to assume the connection back to regulation. I'm sure there are connections (like I said, I'm not defending regulation) – for example, your remark on capital requirements rings especially true. But I'm not sure if that outweighs the basic, plain-vanilla stupid bets that were placed on mortgage backed securities.
As for Glass-Steagall repeal – I heard an argument somewhere that repealing the restrictions on holding companies allowed banks to sell mortgage backed securities to themselves which built up the market for them. Could preservation of the restriction have prevented things? I have no idea – but perhaps it could have improved the situation somewhat. Again – I'm out of my depths on the details of that.
I just think the temporal correlation between financial deregulation and a crisis that was delayed a few years by artificially low interest rates should at least raise eyebrows. We've had cheap money in the past – it lead to bubbles but not a crisis of this magnitude. So I'm not absolving Greenspan – but if we look at that in the context of what happened in the late 90s, it seems at least to be potentially fertile ground for more research.
That's hardly a defense of regulation – but it is a plea not to fall back on the "regulation is always bad" mantra.
Daniel–People make plain-vanilla bad bets in markets all the time. Investors lose money, companies go bankrupt. But when everyone loses at once, something different is afoot. It could be mass psychosis, or it could be regulations imposed on everyone.
Yes, almost everyone made an incorrect bet on housing. That was not irrational exuberance, though, if they were unaware of the oligopoly and thought that those venerable ratings agencies had looked into the matter and rated the securities AAA. The oligopoly status only enters in the same way it always does when regulations create barriers to entry: we are left to speculate about the possible counterfactuals if (1) financial institutions of all sorts weren't required by law to use the oligopoly's ratings, and (2) Nassim Taleb and the like had been allowed to set up more conservative rating agencies.
I am still waiting, though, for someone to explain how Fannie and Freddie contributed to the crisis (apart from putting taxpayers on the hook for hundreds of billions). My understanding is that they held onto their subprime securities (hence the loss to the taxpayers), rather than selling them to financial institutions. Am I wrong about that? If not, then how can they be responsible for the hit taken by the non-GSE financial system?
Jeffrey Friedman
Daniel,
It seems that "irrational exubberance" over mortgage backed securities enabled this crisis, and CRA's and Fannie and Freddie threw gas on the fire.
I disagree. Note that the mortgage market existed for a very long time before people became so irrationally exuberant. Fan & Fred were only allowed to buy conforming mortgages until a few years ago. How many times in history have we had an abnormally low interest rate kept there intentionally by the Fed (I'm lumping the Fed with regulation)?
It seems that "irrational exubberance" over mortgage backed securities enabled this crisis, and CRA's and Fannie and Freddie threw gas on the fire.
I think you missed the part where I said that regulated institutions were REQUIRED to make decisions based on these ratings. Refusal to do so would have meant running afoul of regulations. I think you also underestimate the effect of a government created oligopoly on people's belief that since it's heavily regulated, the product is safe and conservative. The oligopoly, protected from competition, has no incentive to invest in more rigorous risk analysis. They did the minimum the regulator required – which is all regulated firms do.
Hedge funds and foreign banks were not required to accept Fitch, Moody's and S&P ratings. However, they also had little choice as regulation effectively killed competition and there weren't other firms offering ratings. Of course, I know a lot of fixed income analysts who questioned some ratings and effectively stayed out of auctions because of their disbelief, but the majority pretty much accepted that the golden three knew what they were doing. After all, they were closely regulated by government and probably had very conservative metrics. Right?
My argument is that competition would have produced better ratings because the purpose of credit ratings is to measure relative risk. The better they can do that, the better the institution using the ratings can manage its risk. Risk management is very important to everyone. Competing firms would fight to develop better risk measures and, without the requirement of accepting blindly the ratings of an oligopoly, the ratings agencies would have made their rating process more transparent to users, leading to more careful decisions.
The bets on MBS were stupid. The problem isn't so much that the MBS trade went bust, it's the size of the bet. However, MBS has also been around for decades without a problem. The real question is what changed to create this problem now? What changed was interest rates, regulation and an increase in government created subsidies for the mortgage market.
I don't know about the Glass-Steagall argument because those firms also tended to do better in the crisis. I'll have to look into that.
I just think the temporal correlation between financial deregulation and a crisis that was delayed a few years by artificially low interest rates should at least raise eyebrows.
What financial deregulation? Can you name any? In my decades in the financial industry I've been subjected to tons of new regulation. There's at least one or two every year that directly impact just me and my business. I can only imagine how much new regulation there is in aggregate. Except for interest rates, I haven't seen any deregulation. Where's the deregulation? I'm not being obnoxious, but I find it's a mantra that people who are ignorant of actual facts repeat without thinking about it.
Of course, the funny thing is that everyone was having kittens over the scary systemic risk that "lightly regulated" hedge funds represented. Hedge funds have been blowing up left and right with minimal impact on the "system". The sector that took this the "system" (in quotes because I'm not sure that they system is clearly defined) down is the most heavily regulated sector.
So, before we draw a temporal correlation between deregulation and anything else, we must first present some evidence of deregulation – without conflating RE-regulation with DE-regulation.
I think one reason this has lead to such a crisis is that we were meant to have a recession after the tech bubble burst. The stomping down of interest rates and subsidizing a single asset nominally prevented one by blowing up another bubble in another part of the economy, causing an even larger distortion. It's not all Greenspan's fault and I'm pretty convinced that the Fed is just a political tool, so I don't even know how much real autonomy Greenspan had.
Fine, I won't fall back on the regulation is always bad mantra. I'll qualify it. Regulation is good for me (the regulated) and bad for you. So, no. Regulation is not always bad.
Actually, Daniel, I presented my argument for why I think regulation is bad – reduces competition, increases costs and stifles innovation while not achieving its intended effect.
I know you're not making a case for regulation. But since you're saying that regulation is not always bad, I'd be interested in your arguments for why and when regulation is a positive.
We must acknowledge, of course, that the market is driven by human psychology.
"Irrational exuberance" had its roots in, in what?
I thought that it was a response to stimulus created by low FED rates. Isn't that what monetary stimulus is for, to promote some exuberance"
What is "good regulation"?
I think that "good regulation" lies in the prohibition on force and fraud that is supported by most thinking people.
This type of regulation keeps politicians out of our way until someone's acknowledged rights in property are violated. In this regard, we are all supposed to be equal. Though some seem to be more equal than others, those with political influence.
What is bad regulation?
Bad regulation is that which violates rights in property, or protects violations of rights in property.
How do we identify bad regulation?
Bad regulations are likely those which require devoted bureaucracies and which increase the burden of entry by newcomers into economic sectors thus restricting regulation by competition.
I occa
Inadvertent posting…oops.
I occasionally hear talk of "good regulation" and it typically is hoped that such regulation will protect the little guy from economic power. But while the goal of such regulation can be stated, the actual details tend to be lacking.
For one thing, such regulation arouses the interest of vested actors, existing business, and the natural human response to the incentives that have been created mean that the targets of such regulation will seize the opportunity to gain advantage. Happens all the time.
Utilities are a nice example.
Phone, electrical, and similar industries accepted government regulation in exchange for monopoly status and thus were given a guarantee of profits.
A guarantee of profitability.
Thanks regulators.
Don't have the time to respond to everything. I don't feel the need to either, because a lot just seems to be "this is how regulations are bad"… and I'm saying I pretty much agree with that so there's nothing to defend.
I find the CRA counterfactual you provide lacking insofar as it's not the only counterfactual out there. One argument is "oligopoly made them rate it poorly". I find that relatively convincing. Markets help elicit dispersed information – but if the information isn't there to begin with there's no reason to believe markets will improve the situation. What differentiates me and you, Methinks, is that I'm not assuming that the information about CDO's, etc. was out there to be revealed by the market in the first place. I'm not disputing the distortions of oligopolies – but for Hayek's presentation of markets as synthesizers of information to work (I paraphrase – I'm not a Hayek expert), you have to assume that the information is there to synthesize in the first place! It's a big leap of faith.
So anyway – that's one counterfactual – comparing oligopolies to free markets in CRA's. Oligopolies clearly didn't do a fantastic job, but I'm personally not convinced markets would have done much better.
But wait! There's another counterfactual! What if regulators just said "you aren't allowed to securitize in X, Y, and Z way – too complicated, too risky, can't do it". Now – I'm not trying to make a blanket criticism of securitization. Obviously it would be disastrous if we disallowed securitization. But let's imagine the possibility of target bans on certain "innovative securities", as the press has a habit of calling them. Maybe we have some efficiency losses because of the lost opportunity to trade CDO's. I fully grant that. But it's perfectly conceivable that if the oligopolized CRA's couldn't assess the risk accurately AND the market couldn't assess the risks accurately (which I think isn't too crazy of an assumption), then an outright ban might be a regulation that offers a net positive.
I'm not trying to defend every little nit-picky regulation that you have to deal with, Methinks. I fully sympathize with you on that.
But faith in the market needs to be put into perspective. The market is a tool, and what you get out of it is only as good as what you put into it. Let's think of Hayek's conceptualization of markets as synthesizers of dispersed information, because that's most relevant to a discussion of CRA's and risk assessment.
Yes – markets do a good job at syntheisizing information. But if you put in bad information or if information on the riskiness of an asset just plain isn't available to our imperfect human minds, how do you expect a market to do anything to prevent the implosion of those mortgage backed securities??? That's all I'm saying. In that case, maybe a ban would be better than a bad market outcome from incomplete information, and it might also be better than a distorted oligopolistic interpretation of a bad market outcome from incomplete information.
As for "is financial deregulation reality or just a mantra", I think when you stack up:
1. Letting commercial banks be investment banks
2. Allowing banks to get involved stock and insurance brokerage business
3. Allowing interstate banking
I think on net you can say that there was major deregulation of finance in the 1990s.
I'm sure they also thought up lots of stupid rules for you to follow, and I'm sure the statute book on financial regulations has gotten thicker. But in terms of real substantive changes, I don't think it's so far-fetched to say "on balance – on the big stuff – there was considerable financial deregulation in the 1990s".
And I'm not saying that's a bad thing! I'm just saying that it's worth inspecting exactly what we disassembled in that short of a time period, and think about what of it should have stayed regulated. I'm sure most of the deregulation was great and deserves to be maintained – but I don't think it's crazy to make the connection and revisit it.
And again, I caveat – this is not my field. Please feel free to take this apart and point out where I'm wrong. But I'm not trying to say anything too outlandish – I'm just saying "maybe we should reevaluate the deregulation of the 1990s in light of this crisis". That reevaluation could very well come up with a clean bill of health on deregulation.
Maybe you wouldn't call it 'regulation', but it seems that implicit government guarantees backing Fannie/Freddie, quotas placed on Fannie and Freddie by government to buy certain amounts of loans from low income borrowers to perpetuate the groupthink that homeownership at any cost was a good thing, along low interest rates led by the Fed were certainly government actions that helped bring the mess about and that current government actions are seeking to solve, but are already creating unintended consequences that are spurring more government action.
It is unclear that new regulations fix the old problem. The causative events of the problem often cease to exist before regulations are proposed. Additionally, many problems that require government intervention to protect the public are usually those that receive a lot of public media attention.
The public and the entities modify their behaviors prior to any regulatory effects. For example, peanut butter sales are down due to the recent salmonella problem and the responsible company closed. Peanut butter companies across the US have or are modifying their production processes to prevent a reoccurrence and parents are choosing other foods for their children.
Undoubtedly, the government will issue new food production regulations and take the undeserved credit for "fixing" the problem. The reality is that regulations are often parallel to the corrective change in behavior, but not the cause.
Since there will be an industry and consumer change in behavior after a negative event prior to regulations, the concern about regulations becomes whether they match (codify) the natural reaction of the public and the industry or whether they distort the natural reaction and cause new problems. In addition, sometimes other industries use similar methods or inputs for different purposes but must modify their behavior and cost structure to comply without any of the benefit.
As for the current financial crisis, the first cause is not yet determined despite the public media and politicians. Most mortgage defaults and foreclosures are limited to a few states, California, Florida, Arizona, and Nevada. Yet house price declines are a national problem even in areas of the US with below historical average defaults and foreclosures, such as the Northeast. Supposedly, we were in a housing bubble, yet the areas of the US with the greatest appreciation were the areas with the greatest increases in the number of new housing stock. Since when does economics allow for price increases when there is an increase in supply and more than enough to meet demand?
Similarly, studies of subprime mortgages (see St. Louis Fed) show that at the end of three years, eighty percent of these instruments cease to exist through refinancing, repayment, etc. Due to their high loan to value ratios, when house prices declined subprime defaults dramatically increased because the homeowner could not refinance the mortgage or repay the mortgage through a sale of the home. In other words, house price declines happened before the defaults happened and were in fact a cause of the increase in subprime defaults.
If defaults did not cause the decline in house prices, what did? What structural changes were occurring in the US economy to make homes worth less across the US and not just in areas of overbuilding and high mortgage defaults?
Bear Stearns went bankrupt about a year ago for liquidity reasons. It was unable to continue to post collateral to fund its revolving debt. The market value of Bear's mortgage collateral declined substantially in value. It no longer had sufficient collateral to continue its operations. The mystery is that on a cash flow basis at that time and currently, the collateral is worth much more than the market price. What other factors besides mortgage defaults and foreclosures depressed and continue to depress the price of mortgage securities?
Until the underlying causes are determined, any regulatory response "fixing" the financial system has an excellent chance of missing the mark and causing significant future structural problems for the US economy.
The fact that this is not obvious to those writing these policies is a bit distressing. One might expect that the supposedly elite minds occupying high office would have come to understand those three magic words from Hegel.
One would clearly meet with disappointment.
What differentiates me and you, Methinks, is that I'm not assuming that the information about CDO's, etc. was out there to be revealed by the market in the first place.
The only reason I said that is because I know that it was. But, CDO's were only the beginning. The ratings agencies also screwed up MBS. In fact, by law, the information to properly rate those securities had to be made available to the ratings agencies. If the information were unavailable, I wouldn't blame the ratings agencies. What they did was got very sloppy with assumptions in their ratings. Despite that, their ratings had to be accepted.
Sell-side analysts were blamed for not catching the fraud at WorldCom. However to catch the fraud, one would have to have access to non-public information – insider information. No sell side analyst could be expected to be privy to non-public information. So, the faulting of sell-side analysts in this case is an error.
I'll leave my response to the CRA issue there as your opinion is based entirely on an erroneous assumption – the information was not available. Actually, the bigger problem was the assumptions they made about the future and the natural collusion among ratings agencies which intensifies when competition is reduced, but that's not what you're talking about.
You go on to say that, in general, the market may not have all the necessary information. That's true. But in that case, how do you expect the government to have more information than the market in order to write regulation that will prevent bad outcomes?
That's the promise of regulation.
WRT faith in the markets….I think they will produce the best possible outcome. They won't produce a good outcome for everybody all the time. That's not possible. Unfortunately, that is the promise of regulation. We pay to get that regulation. The real question is, Daniel, are we getting what we pay for? And by "we" I mean "you" because regulation writes in a lot of cozy economic rents for me.
I don't think it's so far-fetched to say "on balance – on the big stuff – there was considerable financial deregulation in the 1990s".
I can't think of a single regulation that was reversed rather than re-regulated in the 1990's and I can think of plenty of new regulations. Surely, if there was "considerable" financial deregulation in the 1990's you could come up with ONE example. I don't think that when one makes a claim of "considerable" that it's so far-fetched to ask for a couple so that we can examine the impact of this regulation. Which supposed deregulation happened in the 1990's that had such huge consequences?
1. Letting commercial banks be investment banks
2. Allowing banks to get involved stock and insurance brokerage business
3. Allowing interstate banking
1.) commercial banks were never allowed to be investment banks. Even if owned by one holding company, the two banks were kept as entirely separate entities. The only thing that changed is that they could be owned by the same parent. Each bank continued to operate in its own interest. Interestingly, banks in other countries NEVER had that false separation and have never suffered for it. The assumption is that since the GS Act was altered slightly in the '90's this must have precipitated the collapses in 2008. But if it only took ten years to kill the U.S. banking industry, why did it take 100 years to kill the other banking industries in other countries?
2.)All of that had to be kept separate from commercial banking operations. Also, that actually helped banks. The insurance business is profitable and so is brokerage. The losses from bad loans in commercial banks were actually offset by gains in profitable businesses. As can be expected, diversification worked.
3.) How does interstate banking have an ill effect on the bank? States are merely fake borders. Are the laws of economics different in Maryland than in Delaware? In fact, interstate banking allows banks to diversify their customer and depositor base. Why would that have a negative effect on banks?
I forgot to mention about the CDO's – the big problem with them wasn't the structure itself. The biggest problem was the rating and the leverage. The two go hand in hand. Generally speaking, a broker will let you lever up higher quality assets more than lower quality assets. What we ended up with was low quality assets levered like high quality assets.
Sorry, I know the posts are already many and long but this is an important point.
The three items you provide are not deregulation. They are changes in existing regulation. The rules for leverage, disclosure and regular cavity checks by the regulator never changed.
Don't forget that interstate banking was, at least in large measure, a regulatory response to bank failures arising from loan portfolios that were overly geographically concentrated because – you guessed it – interstate banking was not allowed.
Please note, too, that the type of restrictions placed on financial institutions by Glass-Steagall were quite unique in the world. Why would lifting these restrictions cause calamity in the U.S. while having virtually no impact in the rest of the world? Not that it's not logically possible, but it does call for some explanation.
you have to assume that the information is there to synthesize in the first place!
I think the idea is that the information is "discovered" through the activities of many agents taking risks in the market. Success is an indicator of good information.
The market is a tool,
Many of us do not see the market as "a tool", we see it more in the sense of the economic environment in which we interact in our productive and consumptive activities.
Perhaps failure to grasp the nature of the market is what leads to intervention failure.
I think that you would have a hard time anyone other than a free-market enthusiast to admit that any of the crisis's were caused by the regulation put in place to prevent the last crisis.
Typical arguments, usually widely accepted by conventional wisdom, is that crisis are caused by 'the other party,' greed and nepotism.
You will rarely find an honest discussion of the true causes, even when generally accepted by economists – which is, itself, a rare event.
In short, we make the same mistakes because few can actually agree that a mistake was made or what that mistake was.
RE Methinks -
"I'll leave my response to the CRA issue there as your opinion is based entirely on an erroneous assumption – the information was not available."
I didn't assume the information was not available – I said that you have to assume that it was available. You later say that that information had to be provided to the CRA's – but CRA's can't predict the future. The banks could have provided the CRA's with every single piece of information they had – they still wouldn't know for sure what future default rates would be – and if those future default rates where unknowable AND they were concealed in excessively complicated CDO's, it's reasonable to assume that CRA's were unable to accurately assess risk. Some information is definitely off limits to everyone – like what exactly will happen in the future. Everyone is also subject to some degree of "bounded rationality". If you assume the market will always figure it out that's great – I'm fond of markets too. But you're essentially assuming your conclusions. There's good reason to believe that even a perfectly competitive CRA market wouldn't have seen this coming, because of the information and calculation constratints.
RE – "Actually, the bigger problem was the assumptions they made about the future and the natural collusion among ratings agencies which intensifies when competition is reduced, but that's not what you're talking about."
Again, no. I did talk abotu that and I said the oligopoly is going to introduce inefficiencies. I said that quite clearly. I'm not a dew-eyed innocent when it comes to market interventions.
I'm just saying that you make huge leaps in assuming that perfect competition would have done any better at predicting this crisis.
And you didn't ultimately address my other counterfactual. What if the government identified the most complicated securitization methods and declared them off limits. Banks just plain couldn't use them. Drop all CRA restrictions. Drop all limits on interstate banking and diversification of activities that may remain. Drop all the frustrating regs that you deal with everyday – but prohibit the most complex securitization schemes that allowed these mortgages to go systematic. I can't say what would happen – but I think it's at least conceivable that that system would out perform a competitive market or an oligopolized CRA industry. And what would be the cost? Some arbitrage and liquidity opportunities would be unavailable to us because of the prohibited securitization practices. It would admittedly be an efficiency loss.
Doesn't that at least pass the smell test of a regulatory solution? It has costs but they seem minimal. That's all I'm saying. It strikes me as intellectual laziness to a priori assume that regulations will always hurt. No sob story about how many regulations you deal with is necessary – I understand the problems involved.
I know you wrote a lot more than that, but I can't respond to it all. Hopefully this reframes my position with a little more clarity. Thanks for indulging me and clarifying your details – I'm not a finance expert.
Daniel,
Of course I assumed your were talking about all known information and not the future. What idiot would assume that one must have information about the future to make a decision? We make assumptions based on probabilities which we assign based on known information and reasonableness.
The assumptions the CRAs made regarding the future were extremely unreasonable within the parameters generally used in the industry. In the case of MBS, they assumed that the price of houses will never decline. That is to say, in their risk model, there was a ZERO percent probability of a decline in the price of housing. That's just one such egregious mistake. Had they made assumptions more in keeping with reality and industry standards, the ratings on the MBS would have been lower and the leverage would have also been lower. That was a preventable mistake. I'm not trying to be unreasonable.
CDOs' only complexity came from the fact that they were a mix of loans, but it's precisely the job of the CRAs to slog through that mix to figure out the credit rating. Otherwise, there's no point in having a credit rating agency. All fixed income departments have bond and credit analysts.
Competition and a lack of regulation requiring firms to adhere to the oligopoly's rating would have encouraged firms to question the ratings assumptions. We do that all the time with information. That would have taken care of the problem I mentioned. It's not the difference between having a downturn and not having one, but it is part of the difference in severity.
And you didn't ultimately address my other counterfactual. What if the government identified the most complicated securitization methods and declared them off limits
I thought I did. Complicated for whom? What I find complicated, you may find simple and what I find simple, you might find complicated. So, who's definition of "complicated" are we going to use? Also, "complicated" is not synonymous with "risky". Equity options are complicated compared to stocks and bonds, but they are also perfectly hedge-able. Bermuda options are WAY more complicated still. MBS and CDOs are not complicated. They're fairly simple. It's just that nobody bothered to ask what was in them – they figured the regulated CRAs took care of that.
The most complicated and difficult thing about any of this is the risk measures used in Basel II to regulate banks and the calculations used by brokers and banks in extending leverage – which are also regulated.
I have no idea why you think the system you described would outperform a competitive market since it has more restrictions.
My a priori assumption that regulations won't work as advertised comes from long experience. If you repeatedly do the same thing and expect a different result, there's something very wrong you. So, yes, in theory it is possible to write regulations where the benefit outweighs the cost. However, as I have to make decisions based on probability, I assign a probability to that outcome that would not be significantly different from zero because I know who writes the regulation and the people to whom they apply it and I know how well the regulation didn't work in the past. Let's just say we help them write the regs. Based on my assigned probabilities and my assumption of the cost and the benefit – which I can assess by looking at past regulation – I come up with a negative expectancy. If you consider that intellectual laziness, so be it. I consider it stupid, or at best naive, to assume that doing the same thing that has cost more than it was worth in the past will magically yield better results in the future. It's possible, but if I ran my business that way, I would have been bankrupt long ago.
Also, Please refrain from constructing and mowing down your insulting straw man about the "burdens of regulation" on me, complete with idiotic assumptions of "sob stories" after I repeatedly told you that the costs of regulation for me are VASTLY outweighed by the benefits. The cost of that same regulation to you is much greater than the benefit. They essentially put you at my mercy and you pay me for the pleasure. If you think it's wrong for me to find that unfair to you, then Okay.
I'm just saying that you make huge leaps in assuming that perfect competition would have done any better at predicting this crisis.
I haven't seen any presumption here that there is such a thing as "perfect" competition. Whatever "perfect" would mean in such a context. It's as likely as "perfect" regulation. Any idea what that would look like?
I am also unaware of claims here about "perfect competition" predicting anything.
What proponents of free markets claim is that, because profit and loss are both borne by market actors, they will have the greatest incentive to avoid crisis and those that are competent at it will succeed while, for those that are not, the converse will be true.
One shortcoming of attempts to regulate market actors is that regulatory agents have no incentive to avoid causing harm in the market sectors subject to their regulatory purview, because they are not paid according to the performance of the market they are regulating. Unless, of course, those subject to the regulating agency exercise some sort of influence.
RE – Methinks:
You keep telling me how burdensome your regulations are. I don't want to empathize with you – I want to figure this out. Stop bringing it up and I will.
However, apparently we've finally gotten to the point where you will say:
"it is possible to write regulations where the benefit outweighs the cost."
Isn't that what I've been saying this WHOLE TIME!?!?!??! I know the majority of regulations are inefficient. Just because I don't conform to everything on Cafe Hayek doesn't mean I'm ignorant of this. All I tried to start out saying is that it's wrong to go into this with the assumption that regulation is always the problem and regulation is never the answer. That seems ridiculously closed minded to me.
If you're coming to the point where you're saying: "it is possible to write regulations where the benefit outweighs the cost." Then I think we can end this.
Bypassing all the above comments and going straight to the post by Russ.
What Kling is saying about the field of finance, I have been saying about the competing ideas of capitalism and freedom as opposed to socialism and slavery, since I finally had my "road to Damascus" insight in the 1980s. An insight I have shared here before.
Socialist legislators, agitators, believers, and evangelicals create the conditions that degrade, erode, and destroy all of the valuable and useful tools of conservatism, tools such as,standards, morals, ambition, innovation, creativity, consideration, and responsibility. Then when the inevitable bad results strike, they cry loudest that it was failure caused by resistance from conservatism and then use that chaos as an opportunity to create even more destructive policies and ideas.
Socialism has single handedly degraded all those tools to the point where the average American no longer has a clue about what a market is much less if it is free or not. Standards? It is to laugh, kids get passed through schools for showing up, not for proving an education. Even college degrees are in many cases useless as proof of an education.
But, socialism has many adherents and the MSM has been virtually locked in since the 50s, so few people ever even learn of what is being done to them, and because of the "freebies" they have been given by socialism, they can't be motivated to nake the effort.
There is nothing that we call evil in today's society that can't be laid directly at the feet of the socialist devotee. Once they have created evil, they use the fear caused and use it for an excuse to create even more evil. This is a cycle that has been going on for far too long. Time to turn it around.
Socialism?
vidyohs – Please don't tell me you're one of those people that believes Obama is a socialist.
Are we really at the point where we acknowledge no spectrum in between laisse faire and socialism? I expect this kind of oversimplification from Glenn Beck, but I'm surprised to see it on a fairly erudite blog like this.
OK – time to sit back and see what kind of comments I just stirred up.
You keep telling me how burdensome your regulations are.
Where, other than your own mind, have I said I find them burdensome?
"it is possible to write regulations where the benefit outweighs the cost."
Once again, you didn't read what I said carefully. It is THEORETICALLY possible. It just hasn't been done before. Sort of like like cold fusion is theoretically possible.
Thus, I expect regulations to be a net negative in aggregate in the future. That's called "negative expectancy". The quickest way to whittle away wealth is to enter into negative expectancy trades. In the case of regulation the trade is paying by giving up efficiency and innovation and increasing opacity in exchange for protection you are not receiving. You will never receive protection because regulators are too far removed from the core business of the regulated and always involve the regulated in writing regulations. Thus, regulations are always written in such a way that the cost is vastly outweighed by the benefit for the regulated and the cost vastly outweighs the benefits for the customer. Of course, I'm also a customer of regulated industries and I don't wish to be forced to pay to receive something which is far less valuable.
Unlike law, regulation is meant to control the behaviour of the industry in such a way as to produce a more positive result than if each actor controlled himself within the natural occurring parameters. To accomplish this, the regulator must have more information than all industry participants (including customers of the industry) COMBINED. Are you saying that's possible? I'm saying if it were, I would've never had to leave my family in the Soviet Union and move here.
As I've said before, if you think that not wishing to enter into negative expectancy trades is going to yield positive results, then I can't help you. I realize that I'm using language you probably don't use daily but as a card-carrying economist, I expect you understand what I'm talking about since finance is merely a branch of Economics.
Just to be clear, I'm not against regulation from an ideaological standpoint. If I could find a net benefit, I would be all for it.
I saw your "theoretically" but didn't think it changed anything. Perhaps I don't see something that's "theoretical" as being as unlikely as you do. I didn't realize that you were ascribing the probability of successful cold fusion to successful regulation. I tend to think successful regulation is far more likely and has always been far more likely.
You now say:
"Just to be clear, I'm not against regulation from an ideaological standpoint. If I could find a net benefit, I would be all for it."
Again – hasn't that been all I'm saying? I'm not advocating these issues you keep raising.
Daniel Kuehn,
I'm finding the discussion between you and Methinks very interesting. I am still waiting for you to answer a couple of Methinks' questions though. Seemed to blow right past them. Maybe you did answer, but I can't find them.
1) Methinks asked for one example of deregulation in the 90s that wasn't actually just re-regulation. So?
2) Methinks asked for your argument for why and when regulation is positive. Real world examples maybe?
1.) I listed three major deregulation initiatives in the 1990s. I'm sure they found lots of other regs to tack on top of them – and I'm not justifying that. But a lot of the regulatory superstructure hampering the financial sector was removed in the 1990s. The result was a wave of efficiency-enhancing consolidation. Generally I think that was a very good thing. I wasn't disputing the necessity of deregulation then. I was just left scratching my head over why Methinks focused on all the additional regulation in the last 10-20 years but missed the general thrust of the deregulation of the 1990s.
2.) A really easy answer is basic health and safety regulations, non-discrimination regulations, anti-child labor regulations, and minimum wage laws. Do they reduce some efficiency? Absolutely they do. I understand those basic arguments against these sorts of things. But I think by sweeping away some of the most egregious hardships that used to be common place, all of these offer a net positive. Now – have their been some health and safety regulations that are excessively odious and unhelpful and unnecessary? Of course there are. But pointing that out doesn't prove that regulations are always bad.
I also acknowledge that Methinks posed a lot more questions than even the two you brought up, which so far I haven't answered. I'm currently commenting on about four Cafe Hayek posts, where the weight of opinion is against me – AND believe it or not I have a day job to do too
So it's very challenging to respond to everything. I hope you find that I'm putting in a good faith effort and responding to as much as I can.
MILTON RECHTS–Please give us a link to that St. Louis Fed study!
DANIEL–You're misunderstanding Hayek's view (although sometimes he did, too!). Prices are data about what other people have bought and sold things for. That's not much in the way of "information."
Prices serve two roles: they constrain what you can buy, and they force you to theorize about what you might sell. Lots of people made money theorizing that the prices of mortgage-backed securities were too high. The same analysis that they used could have been used by competing rating agencies, had these been allowed by law. And regulators, too, or those who would like to write future regulations, might have gotten it right. All are human; all could hit on good theories. By the same token, being human, they could be wrong.
Nothing about markets prevents mistakes. Market participants, like regulators and legislators, are ignorant of a complex world; error comes with the territory. The ultimate question in political economy is whether it's better to have one theory (the regulator's or legislator's)–just as fallible as anyone else's–govern all decisions; or competing theories, some of them right, such that people acting on them make money; others of them wrong, such that those acting on them go bust.
EVERYONE–Now let me correct my own ignorance. Fannie and Freddie did sell MBS to others. But how did that encourage private-sector actors to buy them? I do believe that other regulations (such as the Basel rules, mark to market, and the rating oligopoly) contributed to the crisis, but I'm not sure I see how Fannie and Freddie did.
Jeff
Socialism?
What is the ESSENCE of socialism if not the political control of resources?
Realizing that it is just a word and that there is a technical definition, I think it useful to get to essences.
Either resources are controlled by private agencies, or they are controlled by the collective agency of government, that is, politically.
Technical definitions as to the form of that control are, as far as most of us are concerned, window dressing.
Daniel,
I appreciate the demands on your time and I'm only able to spend so much time here now because of a temporary reduction in the demand on mine.
I'll try to be more brief in my posts.
1.) WRT I was just left scratching my head over why Methinks focused on all the additional regulation in the last 10-20 years but missed the general thrust of the deregulation of the 1990s.
This is because opening one window and closing two doors is not deregulation. Thus, I say that there has been no "general thrust of deregulation" over the past 20 years.
Perhaps I can provide a better answer if you can define "regulatory superstructure" and how you define "general thrust of deregulation". Then we can talk about the specific cost/benefit of these things.
2.) The fact that conditions have been worse in the past is true. The fact that we have more regulations now than in the past is also true. Correlation does not prove causation. Why do you conclude that regulation has caused these improvements?
Children laboured in the past because the alternative was worse. As a woman, I found anti-discrimination laws more hurtful than helpful. Minimum wage simply excludes the least productive and most vulnerable from the labour market entirely and increases their probability of remaining on public assistance for the rest of their lives.
The best regulations are the ones that are easiest to comply with and something the business would do anyway. But that begs the question: why bother imposing the cost of writing that regulation?
Methinks –
I think you're just arguing that we've opened one window and closed two doors, and I'm arguing that we opened two windows and closed one door… or maybe vice versa. But can we at least say that we both realize there has been regulation and deregulation over the last ten to twenty years.
From an outsider's perspective, what I see is that with the very important exception of Sarbanes-Oxley, the major sea-changes in financial services regulation have been towards dismantling the old regulatory structure, not creating a new one. That's what I mean. Not that there haven't been new regs. And perhaps that's a misconception, but if it seems to be a misconception that's held by an awful lot of well informed people, including those who aren't exactly pro-regulation.
On the "safety net" regs, we could call them – you're highlighting things that I fully acknowledge. I know the child-laborers in the third world are bringing home an important source of income for their families. I know minimum wage raises unemployment. I'm saying that if you force those children out of the labor market and provide primary education for them, it will benefit them on net even though you deny their family that source of income. It's an assertion I'm making – I don't have any immediate evidence. But it's an assertion that isn't disproven by the downsides of those regulations that you point out and that I acknowledge.
Sam-
On socialism: this has been a huge pet-peeve of mine of late. You can't call any old intervention into the market "socialist". That may seem to be the "essence" of socialism to you, but it bears no resemblance to the way socialism has been understood for a century and a half.
What exactly is the point of even using the word if everything except private ownership falls under "socialism", and complete private ownership alone falls under "non-socialist"? By that definition, every human society since the dawn of governments has been a socialist society. What exactly does that offer analytically? Nothing. It's a ridiculous assertion.
Socialism has a specific definition. We should use that definition. I'm not arguing for strict technicality – there should obviously be some wiggle room.
Would it help matters if some leftist came along and called all capitalists "anarchists" – not because they technically fit the definition of "anarchists", but because they seem to be in line with the "essence" of anarchy which sees no role for the collective agency of government? I'm sure there are some self-styled "anarcho-capitalists" out there who wouldn't mind it – but most self identified capitalists would be put off by that label and completely unconvinced by the "essence of anarchism" argument.
I'm saying that if you force those children out of the labor market and provide primary education for them, it will benefit them on net even though you deny their family that source of income.
I'm supposing that would depend on how close to the margin they are and what difference the child's income makes to the viability of its family. What if a younger child has to be allowed to starve so that the older may go to school?
Another question: To what extent were child labor laws responsible for taking children out of the factory and sending them to school
It would certainly depend on that Sam. I'm not saying the same laws need to apply everywhere, and I'm not one of those people that insists that third-world countries put an immediate end to child labor.
But in the right context, when it makes sense for a society and when the democratic process is ready – it's not that outlandish of a regulation.
As for your other question – I don't know exactly. Claudia Goldin has done a lot of work on that question – you might have to consult her. I recently finished her newest book that was coauthored with Katz and I think they touched on it briefly, but I can't recall what they concluded (that wasn't the main point of the book). Google Claudia Goldin – I think she did something in AER on child labor and education.
On socialism: this has been a huge pet-peeve of mine of late. You can't call any old intervention into the market "socialist". That may seem to be the "essence" of socialism to you, but it bears no resemblance to the way socialism has been understood for a century and a half.
I think we can use gradation. I don't think a society is "socialist" if, say, 10% of economic factors are controlled politically, but I do think it defensible to suggest that such an economy is 10% socialized.
I also think it defensible to suggest that our economy is more than 10% socilaized
You must be familiar with Fabian socialism.
I think we must be wary of incrementalism, especially if the effects of increments promote further increments.
We can throw out the term altogether if you like, and we can just discuss the essence.
How much our our economy is controlled politically and how much will it be if proposed health care reform passes.
By that definition, every human society since the dawn of governments has been a socialist society.
Socialized to some extent.
Proponents of socialism offer the promise that under socialism, political control of resources will be done for the benefit of "the people".
I suggest that, as such, technical Socialism is not realizable, and in that sense, it is useless to discuss Socialism at all.
Would it help matters if some leftist came along and called all capitalists "anarchists" – not because they technically fit the definition of "anarchists", but because they seem to be in line with the "essence" of anarchy which sees no role for the collective agency of government?
Many of them do just that. They also like to suggest that unless all aspects of market activity is regulated against any ill effects of self interest, it is an unregulated market.
Daniel Kuehn,
Just as an item of interest. A friend of mine just came home a few months ago from working on a development project in Mozambique. She was part of an NGO whose goal was to build a village school and get it functioning. The funding came from a grant from USAID.
She and her group were constantly filling out reports on how the village was meeting the child labor reduction requirements that came attached to the USAID monies. My friend said that even education workshops she attended in South Africa were almost exclusively devoted to how they were meeting their goals, not on the school or in how they were educating the children, but on reducing local child labor.
That is how it actually works. Nobody consulted the villagers. So much for democratic process.
Daniel,
I don't know how I can make myself clearer. Please stop filtering my arguments. I argue there was no deregulation. You assert that there were major changes to some "regulatory superstructure" while refusing to identify "regulatory superstructure" and provide evidence.
Further, you want me to agree to call changes in regulation "deregulation". I don't.
From an outsider's perspective, what I see is that with the very important exception of Sarbanes-Oxley, the major sea-changes in financial services regulation have been towards dismantling the old regulatory structure, not creating a new one. That's what I mean.
That's not clear at all. You simply assert the same thing using slightly different words. Aggressive assertion is not an argument. What "sea changes"?
And perhaps that's a misconception, but if it seems to be a misconception that's held by an awful lot of well informed people, including those who aren't exactly pro-regulation.
Who? I've never heard this assertion from anyone well-informed. If you're going to name anyone in congress as a "well informed source", don't waste your time. Congress is filled to the gills with the most ignorant dregs of humanity. It seems like the least informed in congress sit on financial services committees.
The scary thing is that judging by the very limited knowledge you've exhibited in your posts and your own admission of limited knowledge, you are pretty ignorant with respect to financial regulation, let alone its effects. I mean no offense as we're all ignorant of a great many things. The disturbing part to me is that you're fully willing to make decisions and support the decisions of government rooted only in your vast sea of ignorance of the issue.
Sam -
RE: "I also think it defensible to suggest that our economy is more than 10% socilaized"
OK – "socialized" makes a lot more sense to me than "socialist". This is more reasonable.
RE: "I think we must be wary of incrementalism, especially if the effects of increments promote further increments."
Perhaps, but I think people fall back on this too much. By even calling it "incrementalism" you are assuming that it is a constantly advancing process. Let's say our society is currently 30% socialized – just picking out a number. I am comfortable with that. If offered the right programs, I'd probably be comfortable with increasing it to 35 or 40% if there seemed to be a justification. But I'd shudder at approaching 50%, and I also think that reducing our socialization to 20% or 10% would be insane. I'm not REALLY an incrementalist because although I could justify moderate increases, it is not an ever-increasing trajectory. You can't call me an incrementalist. You can't call me a libertarian. You can't call me a socialist. I call myself a moderate – and I personally am put off by having the slippery slope argument applied to me when I would be in the streets if the state tried to overreach. In fact, I have been in the street over certain issues before.
RE Leftists: "Many of them do just that."
They definitely do – and it's just as unhelpful and unenlightening as seeing the term "socialist" bantered around on this blog so carelessly.
RickC -
RE: "That is how it actually works. Nobody consulted the villagers. So much for democratic process."
The villagers didn't have a vote in the U.S. Congress which sent out US Aid… and I doubt their own governments are too responsive too them either. I'm guessing the enactment of child labor laws here went somewhat more smoothly because the democratic process was a bit more strictly adhered too. I'm out of my depths, though – I don't know the history of that.
One point, though – you can have regs like child labor laws and compulsory schooling laws that are (1.) a net benefit to those they affect, (2.) obnoxious and unwanted by those they affect, and (3.) enacted as a result of a real democratic process (ie – not your friend's situation in Africa). I don't see why those three things are mutually exclusive.
So Daniel,
You're saying it's okay to force others to do something we think they should do for their own good, as long as a majority agrees with us?
RickC -
Um, no. That's what we have a "bill of rights".
Again – can we leave room for a spectrum of options here, people?
Generally speaking, I don't think it's ok to force others to do something we think they should do for their own good, so long as the majority agrees with us. That's mobocracy, that's absurd, and that's one pole of the spectrum.
I also don't think there is nothing that the majority is allowed to overrule the minority on. That's anarchism, that's absurd, and that's another pole of the spectrum.
I do think there are some legitimate options for overruling a minority and forcing them to do something. Forcing American parents and employers not to allow five year olds to work in iron foundries is one thing that I don't lose sleep over.
For the record – I'm making the assumption that restrictions on what can be accomplished through majority rule (ie – a bill of rights that protects free speech, etc. – and allocates unspecified rights to the states or the people) is perfectly consistent with what I'm calling "democracy".
I know that's not technically the definition of democracy – I assumed it was practically speaking a reasonable use of the term. Perhaps it was a bold assumption on my part, so I'll clarify that now.
By even calling it "incrementalism" you are assuming that it is a constantly advancing process.
Going forward seems to be easier than going back.
Part of the problem is the creation of interested constituencies when there is some expansion.
Teachers unions, prison guard unions, etc., usually oppose any reduction policy that may affect their jobs. Not to mention agricultural subsidies of many stripes.
Creating dependencies, as with Medicare and SS, exhibit similar tendencies.
Even war making capability has its constituency.
When people's incomes are at stake, they become motivated to organize in opposition to reduction policies.
Sam -
Sure, I buy all that. But as a very crude indicator, tax revenue as a percentage of national income has hovered at around 20% for decades. Obviously that's not at all the only measure, but come on! Obama is bringing a lot of change. Bush admittedly brought a lot of change. It's not a march towards socialism. In many ways, I think we end up changing the composition and character of government intervention as much as we change the absolute level of government intervention.
Happily, nations of people eventually must confront economic realities. In democracies, that often means regime change.
Our problem is that representatives of actual less government are not given serious treatment.
Also, we apparently must continually keep living in the zone of public debt, perpetual empire, economic subsidy, etc.
I don't think it's the best place for a people to live.
The public reaction to the federal debt is odd to me.
There once was a time when a public debt was considered an important safe guard of liberty, because it kept the sovereign in check (granted, at that time we didn't owe half our debt to the Chinese).
I'm sort of a moderate, deficit-hawk Democrat myself. So I'm no friend of large debts or unsustainable deficits. And like any true Keynesian, I'm very opposed to deficit spending during periods of growth. So I definitely don't love the debt.
But Sam – why do you throw "public debt" in the same lot as "perpetual empire". There was a time when classical liberals regarded the former as an important defense against the later.