Salus Populi and the Market – Automatic Regulation

In California, Climate Change, Economics, Financial Crisis, New Deal, Political Ideology, Politics of Policy, Regulation, Social Democracy on July 9, 2009 at 11:29 pm

In my last post (and the post before that), I mentioned the importance and difficulty of talking about financial regulation, a task which has been made all the more difficult by an arcane financial products industry that isn’t really understood even by its experts.

So in trying to get to grips with this topic, I’m trying to triangulate in on it from different angles – one of which, the idea of a public bank as a yardstick I discussed last week. Today, I’d like to bring up an important point about financial regulation, that the problem we face is three-fold: deregulation, un-regulation, and regulatory capture (and potential incapacity). Pretty much all that needs to be said about the impact of deregulation has already been said. And quite a bit has been written about the government’s refusal to regulate the new “shadow financial sector.” And if that were all there was to the story, it would be fairly easy to fix the financial sector. The problem is regulatory capture and potential incapacity – regulatory capture seems to be nearly inevitable, as long as financial institutions can offer jobs to former regulators, contributions to electeds and party organizations, and financial experts to the regulatory agencies themselves; even if that weren’t already a massive conflict of interest that allows financial institutions to game the system, you have the problem that even a completely honest regulatory watchdog might not have have the financial, personnel, legal, and expertise resources needed to actually regulate – and Congress certainly hasn’t shown itself particularly interested in keeping the FDA up to scratch, let alone the SEC.

So what do you do if old regulations are gone, there aren’t new regulations to deal with new problems, and the regulators either can’t or don’t want to regulate? This brings me to a point brought up by Matt Yglesias, when he pointed out that the failure of regulatory authorities to recognize and halt this crisis:

..leaves us with an appreciation of crude measures rather than hubristic efforts to get the regulations precisely right…The best you can hope from a regulatory regime is that it will be a satisficing [sic] solution wherein some fairly crude rule will improve on the outcomes generated by the unfettered market. When that’s not the case, we may as well let the market go unfettered even though that, too, will be somewhat sub-optimal.

What we don’t need is to look to the newest fad in economics (behavioral economics, I’m looking at you) to give us a flawless model for predicting when market faiilures will happen. What we don’t need is “regulation for the 21st century,” or for any new paradigm. What we need are regulations that work without regulators – automatic regulation.

Automatic regulation doesn’t refer to some sort of sci-fi legislation that creates self-enforcing, self-aware regulatory cyborgs. Although a Wall Street Robocop would be a cool idea, I’m actually talking about regulation that establishes clear and transparent bright lines that any informed member of the public or the media can understand. The Glass-Steagall Act’s separation between commercial and investment banking was virtually self-evident: if people could deposit their money in a bank, that bank wasn’t allowed to underwrite securities (stocks and bonds); if a bank floated bond issues and acted as a broker in the securities market, it couldn’t receive deposits. A reserve requirement, like the Fed’s reserve requirement or the 1860s rules that required "national banks" to back their bank notes with T-Bills, is easy enough to check: you look at how much money the bank is circulating, and how much it’s supposed to keep in reserve,  and if the two numbers don’t balance out, there’s a problem. Bob LaFollette, one of the forgotten heroes of American Progressivism, in his 1924 third party race for the presidency called for the breaking up or nationalization of all corporations with (either 9% ot 15%) of market share – a radical proposal, but one that would have been easy to administer.

Automatic Financial Regulation:

In thinking about how to create automatic regulation for the financial industry, three broad categories of regulation come to mind:

  1. Bright Line Regulations – the proposed limitation of oil derivatives seems like a good place to start in terms of automatic regulation – extending these limits to other commodities such as electricity and waster might prevent a future Enron-like fraud-via-false-scarcity (such as befell California).  Another example of how one could establish an automatic regulation in finance would be to ban tranche-ing, preventing one step of the process by which uncertain assets can be repackaged into a more marketable form. Restoring transactions on margin, or establishing a small transactions tax would further reduce speculative bubbles, market “hurn,” and pump-and-dump schemes without restricting long-term investment. If these ideas seem a little scattered, and underdeveloped, I accede to that, but I would point out that all of them rely on relatively simple prohibitions or requirements, reducing the effort of oversight.
  2. Competing Public Ratings Agencies – one major area of the financial sector whose inherent weakness has allowed bubbles to become more frequent in recent years is the fact that the major ratings agencies for stocks, bonds, derivatives, and so on are for-profit private institutions whose livelihood depends on a reputation for providing good ratings for their clients. In this, we see a parallel between virtually all of our recent financial scandals – in the Enron/WorldCom/etc. corporate scandals of 2003, it was accounting/consulting agencies who helped conceal the bookkeeping fraud that made most major American corporations seem more profitable than they really were; in the housing bubble, the subprime/securitization/tranching system wouldn’t have functioned without housing evaluators whose conflict-of-interest-ridden valuations helped spiral real estate prices out of rational bounds. Hence, I would argue that one major systemic change that should be done is to create a number of public rating agencies for stocks, bonds, other securities, and real estate, who would be required to use common standards of valuation, and whose ratings would only be published as averages – complicating if not completely eliminating the process of agency capture.
  3. Right of Private/State Suit to Enforce – arguably one of the most important elements in the civil rights bills of the 1960s were the provisions allowing private citizens to bring suit to protect their own rights (Title VII of the 1964 Civil Rights Act, and Section V of the Voting Rights Act), allowing enforcement to continue even when the government was hostile to civil rights enforcement. In recent years when the regulatory agencies have been captured by conservative ideologues, the use of state suits to force the EPA or similar agencies to enforce the laws have been crucial in preventing the total undermining of environmental and other regulations. Hence, one crucial factor in creating automatic regulation must be a clear mechanism to allow private groups, state attorneys general, and the U.S Justice Department to bring lawsuits against both regulators and the subjects of regulation to require that bright lines be enforced.

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