On government, regulation, over-regulation and free markets

I want to talk about why people blame government for the state of the economy more than Wall Street and what I think the remedies are. This will be a long post. So feel free to bookmark it to read it and the links when you have a moment.

Where is the outrage?

There was a time when I asked “Why No Outrage?”. In 2008, it seemed to me that Americans were very passive about the credit crisis. After Lehman and AIG, this changed somewhat but even in February of 2009 I said “There is a deep sense of apathy in the United States regarding this massive economic implosion that remains stunning.”

Eventually, though we got the Tea Party and Occupy Wall Street movements. Now the outrage is everywhere. On Tuesday I wrote about those movements:

Third-party movements like the Tea Party and Occupy Wall Street are about corporatism. Their main appeal has to do with defending democratic values that are violated by bailouts for special interests. I see both movements concentrated on the nexus of government and corporate interests with the Tea Party focused on government’s complicity and the Occupy Wall Street movement focused on corporations.


Regarding Wall Street, I have said "Forget about Goldman" because I think you have to look at government’s role first since government sets the agenda and creates the rules of the game. What you want is government setting adequate ground rules, letting ‘the players’ play freely but enforcing the rules. Not enforcing the rules leads to crisis.

Bill Black: Hijacking protests for political gain

Government gets the blame

You may not have seen this, but Gallup recently did a poll asking people whether government or banks were to blame for the economy. By a two-to-one margin, people blamed government.

Here’s what the Gallup people said about the survey:

Americans are more likely to blame the federal government for the nation’s economic woes than to blame Wall Street — although Americans say both entities are to blame. These attitudes have significant political implications. Both the Tea Party movement, which has targeted the federal government, and the Occupy Wall Street movement, which has targeted big financial institutions, are in sync with significant segments of the U.S. population.

At the same time, it would appear that neither of these movements can afford to dismiss or ignore dissatisfaction with the "other" entity they are not explicitly targeting. This would seem to be particularly relevant to Democratic candidates for office, including Barack Obama, whose possible efforts to adopt the "blame Wall Street" positioning as a major part of their campaigns could risk failing to acknowledge the even larger enmity the public holds for the federal government itself.

Here are some graphics from that article:

Why blame government?

Here’s my view. I am a big believer in free markets. Freer markets and more limited government are my preferred ideal. However, I am a realist. I understand that markets are never truly free and government fulfils a necessary function. When discussing the approach to regulation that ended up as the faux regulation/regulation-heavy approach of Dodd-Frank, I said:

My bias is toward a relatively free market buttressed with adequate rules as a regulatory framework and sufficient regulation of those rules. I don’t see a need to create more rules. That would just retard growth and wouldn’t alleviate the problem of irrational exuberance. Certainly, bringing all financial agents (money market funds, insurance companies, derivatives and hedge funds) under a comprehensive regulatory umbrella is a priority but this can be done in a way that is consistent with the existing structure. Why burden the system with a system risk regulator as another layer of oversight? Better to just hive off the essential bits into a tightly regulated oasis, de-coupled from the rest as Volcker suggests.


…Just to be clear… just because I am labeling the [approach that the US is taking] regulation-heavy doesn’t mean I think these regulations will be substantive. They will add a layer of regulation to seem substantive but will be filled with loopholes in order to allow business as usual. An example is the loophole in derivative regulation that allows for off-exchange customized derivatives. Everyone knows that means actors will gravitate to just those products. When Byron Wien predicts that regulation will be industry friendly, that’s what he means.

I think most people get that. What they see in the US is an economy in a world of hurt. At the same time, American banks are back to making money (from an accounting perspective at least) and paying large bonuses. This juxtaposition of households still over-indebted and business back in the saddle is not just in financial services; income gains may be slowing but US companies have been making record profits for some time.

Now, these record accounting gains are odd because the financial services sector is hiding bank losses due to the removal of mark-to-market accounting. If assets were marked to market as accounting rules dictate, we would see a much worse financial picture across the board. Moreover, seemingly banks are so undercapitalised that they can’t resume more lending to small and medium-sized business or individuals and have to start charging for debit cards and for checking accounts. That is the prudent thing to do, yes; but it is very much at odds with the trumpeting of record profits.

So what I think most people intelligently infer is that these institutions have been given a helping hand by government and unfairly while individuals have been saddled with unpayable mortgages and job losses.

How do you react to this?

People expected serious criminal investigations (or scapegoats at a minimum)

If you have any faith in the system, you at least think “regulators are great for prosecuting criminals and scapegoats after the horse has left the barn,” as one commenter suggested. “They would appear to be nearly worthless for preventing the crisis they were actually created to prevent,” he says. But at least they will make a show after the fact.

That was my view too. In August 2008, even before the Lehman collapse I wrote the following about the apparent fraud at Countrywide and the insanity of Bank of America buying the company:

Basically, the LA Times is showing that Countrywide represents the most obvious case of mortgage fraud, predatory lending, and other ills that caused millions to take on loans they would otherwise not have. As mortgage lending is at the core of the problems facing the U.S. economy, doing a few Countrywide perp walks would be a coup in any politician’s book.

But, then there’s Angelo Mozilo. He is a man who made hundreds of millions of dollars while the mortgage market fell apart and people lost their homes, dreams, and life savings. The U.S. government, the state governments and many an Attorney General will do everything they can to be the first to arrest Mozilo to parade around before the U.S. public. This is what politicians do — Attornies Generals are politicians too.

And, remember, Mozilo was also the originator of IndyMac, which spectacularly went bust this past month.

Why Bank of America took on this kind of open-ended legal risk is beyond me. But, one thing is for sure: we will see convictions at Countrywide.

Ex-Countrywide CEO is the new Ken Lay

I think a lot of people felt this way. This never happened, of course. There have been almost no criminal referrals let alone convictions for what the FBI was already calling an “epidemic of fraud” in 2004. What’s more is the Swedish banking crisis response that I called a model for the future has not been the preferred way for dealing with crisis. Instead, we have seen the Japanese response of propping up zombie banks, Spain being a recent example.

Silly me. This is one of the dumb things bloggers say when they believe the system is not completely infected by cronyism.

So what about crony capitalism? Give me a framework for how it works.

I did a thought piece on ‘kleptocracy’ in March 2008 after Bear collapsed and was ‘rescued’ for JPMorgan’s benefit. I called it “A populist interpretation of the latest Boom-Bust cycle“. At the time, I was just putting it out there. I had just started blogging, so no one was really reading any of this. But since that time, the piece has become a good working framework for how I see the political economy in large stratified societies. (See my thoughts on the political economy of the European sovereign debt crisis, for example).

Here’s how it works in terms of booms and busts:

  • Minsky’s theory of stability leading to instability is the heart of any analysis of secular leveraging and deleveraging cycles. What happens is that a long period of stability leads to an increase in leverage and risk in the private sector. My take is that it’s like increasing the safety of cars leads to an increase in driving speed; people naturally force the system to its operational limit.
  • Government officials are not immune to this push to the operational limit. Eventually, regulation becomes lax and easy money enters into the picture. Look at the contrast in statements by Fed Chairmen Ben Bernanke and William McChesney Martin as prima facia evidence. Inflationary monetary policy leads to an expansion of credit throughout the economy, the basic building block for a boom-bust business cycle.
  • Easy money is always bad. Deregulation is toxic when combined with desupervision and de facto decriminalisation as Bill Black calls it. If you are going to deregulate, I say increase regulatory oversight at least through the first business cycle. That would have saved us a huge headache on investment bank leverage, mortgage-backed securities, the proliferation of ARMs, and CDOs.
  • But what also occurs here is that the government becomes captured by the Corporatist. Certain favoured sectors insinuate themselves into getting special treatment. The ‘Corporatist’ is a kleptocrat interested in furthering the gains of himself and those allied with the corporatist and at the expense of others, by coercion if necessary. The Corporatist tilts the playing field in his direction by either getting government to look the other way or to tip the balance in his favour
  • We live in a large stratified society. Some will always have more power and wealth than others. There will never be a situation in which the economic playing field is level. Moreover, it is axiomatic that those with the means and access will always have greater influence over government than those without.
  • So, in a very real sense, the socioeconomic elite of any advanced, stratified society will always have disproportionate control of the economic and political system. When you hear someone saying “get government out of the way and allow the free markets to work”, you should be thinking about the influence and control this would naturally engender.
  • (Corporate, union, and non-profit) lobbyists will then use their access and influence to tilt the playing field in their favour by helping craft legislation, changing laws or simply getting government to look the other way. That’s what getting government out of the way means.
  • The inflationary monetary policy of the government is extremely distortionary and favours the Corporatist as it redistributes capital to economic actors whose costs rise after they receive income i.e. the Corporatist and his allies from those whose costs rise before their income i.e. everyone else. Those who live from a fixed and interest income like pensioners find their costs rising with higher inflation while their income decreases in real terms.
  • When profits run up in those areas in favour, many of the the Corporatist’s allies sell out to the general public as investment capital and human resources flock to those endeavours. Eventually, investment opportunities dwindle as the favoured sectors suffer overcapacity.
  • Some turn to fraud and obfuscation to keep the gravy train going. When the malinvestment can no longer be sustained, souring investment returns are unmasked and wide-scale fraud is uncovered. And when the asset price bubbles pop, revulsion steps in, credit contracts and the bubble currency depreciates, as hot money flees the depreciating assets.
  • An expansionary monetary policy in a post-bubble environment can cushion a hard landing but does only lengthen the period before full economic recovery. Captured by the Corporatist, the government attempts to revive the status quo ante via bailouts and stimulus instead of using stimulus as a way of cushioning the downturn and increasing employment as the economy re-balances which means inequity is apparent in much starker detail due to the gravity of the downturn.
  • The populace becomes angry. Stimulus is no longer supported. Austerity rules. What if the banks had been bailed out under harsher terms or nationalized? How would that have affected the political debate today?
  • Depression ensues as it did in 1937 in the U.S. and 1997 in Japan. Insiders are prosecuted for malfeasance. Incumbent government is overthrown.

This is basically the view I have maintained since I wrote The recession is over but the depression has just begun and I see the Tea Party and Occupy Wall Street movements as validating this thesis.

What do you do about cronyism then?

I will skip the political discussion and focus on the operating environment for financial services. Here’s how I put it in the past.

Let me start off saying that the ideal would be to have the ground rules set so bankrupt companies can simply fail, preferably with minimal knock on effect. For that, you need systemic redundancy. That is what any complex system needs: redundancy.

Don’t replace an all-consuming belief in the elite shaman policy maker for undying faith in free market shamans who tell us all will be well if we let the chips fall where they may. Both scenarios are not redundant. When failure strikes, it is catastrophic. We saw a lack of redundancy when we let the chips fell where they may during US panics in the 19th century (1819, 1837,1857, 1873, 1893 and 1907). And we are seeing it now again despite the regulatory controls put in place.

A better approach to regulatory reform is to build natural redundancy into the financial system. People are obsessed with efficiency, especially the so-called ‘rationals’ who are the most inclined to build systems and make policy. Let’s not get frustrated by the inefficiency of redundancy. No system is fool-proof. But having multiple checks on system failure is better than having one.

A commenter wrote me when I first wrote about this:

I am an engineer. One of the primary goals in engineering is to prevent systems from failing. As such, one of the objectives is to prevent system failure if a component fails. The redundancy concept you have at the beginning is one of the key tools in preventing a progressive system collapse due to cascading failures.

A factor of safety is another key tool in achieving this. One of the few places in finance that really uses a factor of safety is the Graham & Dodd method of security selection. However, in finance this type of approach is generally viewed as too conservative. If engineers approached their designs with the same approach to factors of safety as the financial sector, we would all be in jail for gross criminal negligence.

We need to make sure that the larger firms operate with higher factors of safety and that each of those firms needs to be sufficiently small so that the failure of one cannot take down the system.

In engineering, it was found necessary over the past century to have buildings, electrical, plumbing, and fire codes in order to have safe buildings. The accounting and other regulatory standards need to be raised to the level that we currently expect of our building codes. To date, greed has prevented that. Society decided decades ago that allowing unregulated developers in building construction was unacceptable. We need to now take the same approach with the financial sector.

Key from the outset here are incentives. As blogger Tom Hickey pointed out to me when I first wrote about this:

“capitalistic systems and market economies are based on incentives. The incentives have to be correctly designed to produce efficient and effective outcomes, not only economically but also socially. Economies are for societies rather than vice versa.

Shaping incentives is essentially different from erecting fences and gateways. The Maginot line demonstrated the folly of the latter. We need to change the incentives in order to change the results.

"Efficiency is doing things right, and effectiveness is doing the right thing." (attributed to Peter F. Drucker)”

Here’s how I would go about it:

  1. Assume an unlevel playing field: if we assume that some actors in business are naturally advantaged and will use these advantages to tilt the playing field in their favour, we must assume these actors will overreach, take on too much risk and subject us all to a catastrophic failure. Therefore, we must devise rules of fair play which are both monitored and enforced through sanctions to prevent this. This necessarily means we have to have regulations and regulators. Assuming that markets are self-regulating is folly which invites bad behaviour. Do I want law makers dictating how private enterprises should structure their compensation schemes as the Europeans want to do? No, that is what I call regulation-heavy. But, I do want consumer protections (think seat belts or child labour laws), anti-trust laws (think cases against Standard Oil or AT&T) to be robust and enforced. To me this is the first line of defence against market failure.
  2. Assume regulations are inadequate: I think proposals to regulate financial services compensation schemes are wrong. It’s over-regulation. There are multiple regulators trying to accomplish a lot of different tasks. The US needs less regulation, not more. The US need to streamline this, eliminating all the duplication and regulatory overlap, instead of adding a layer of regulation with the systemic financial regulator. This is the same approach the US took to terrorism in creating the Department of Homeland Security layer and the Director of National Intelligence position instead of eliminating layers. And when there is bad regulation or over-regulation, one thing results: people devise (legal and illegal) schemes to get around the regulations. That’s certainly what has happened in the financial services sector. The profit motive is too large to prevent this sort of thing. And what invariably happens is that the market becomes distorted and more fragile as a result. This, in turn leads to unexpected and catastrophic failures. Expect the same from Basel 3 capital regulations.
  3. Assume markets fail. We should assume that markets fail – and catastrophically. That means that we often reach a critical state where panic is the order of the day and where smooth bell curve mathematical functions don’t work. The likely outcome of these situations without a lender of last resort is catastrophic business failure and economic dead weight loss. This naturally leads to social unrest and muscular government responses, as well as economic depression and military adventurism. Allowing markets to fail and sitting idly by is not an option. This means we must create market structures, institutions, rules and safeguards to prevent liquidity crises from becoming solvency crises. This is a primary reason the Federal Reserve exists – to act as a provider of liquidity.
  4. Assume regulators will be captured: But we should assume that these regulators will be captured by industry and fail. How else would you explain the sanctioning of increased leverage in the investment banking sector early last decade? At one point in time, net capital rules which governed the amount of leverage investment banks could use limited them to 12:1 ratios. Policymakers changed the rule in 2004 to allow 30:1 leverage and the gross increase in balance sheets which ensued. Had Lehman been limited to 12:1 leverage, its failure would have been less problematic. How do we make this regulatory failure redundant? By creating a market structure that can handle failure. And that means, first and foremost, banks must be limited in size as a share of assets. Too big to fail is too big. Full stop.

My view is that systems fail and we need to be prepared for that failure. Throwing up your hands and acting like you can just give up and let things take their course is an invitation for anarchy and its necessary successor, despotism. What we should do is structure a system that sets basic mechanisms in place to prevent market failure but that is redundant enough so that it can deal with market failure. Moreover, one flaw need not bring down the whole system if it is redundant. We shouldn’t trust the shamans who counsel absolute faith in the infallibility of the policy illuminati. But neither should we trust the shamans who counsel absolute adherence to a non-existent free market.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.