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December 09, 2008

Comments

I had always understood that one of the advantages of free-market capitalism is that it does not require or expect individual virtue, only self-interest. This is part of the "conservatives are pessimists about human nature" idea that I talked about in the Rule of Law thread. In practice, though, conservatives seem to have been just as unreasonably optimistic about human virtue as anyone else.

No, that's not quite true. There's a real strain of Calvinism in American conservatism, where you assume that outward success is a sign of inward virtue, and that the rich have less need of regulation or control than the poor -- instead of just more ways to resist regulation.

DocSci, your comments remind me of John Rogers axiom of political thought:

Liberals have a child-like faith in government.
Conservatives have a child-like faith in corporations.
Libertarians have a child-like hatred of both.

I'm not sure what's redundant to say, but side by side with the necessity of regulation - to correct for the problem of capitalism being capitalists - is the question of which particular manifestations of capitalism aren't going to be effectively regulable at all. In the latter aspect, no matter how many misbehaving goal-posts-moving capitalists we will be able to point to, the problem will be the branch of activity - in which case, the talk of the importance of regulation can be a sleeping pill of a side-track, rather than a cure.

I mean to say this quite narrowly; this isn't a slam at the general incentives-system of capitalism. But there can be basically unsound incentive-situations, and you'd only regulate the larger picture by, not regulating, but eliminating them. For example, I think that credit default swaps need a very serious look, and it has to happen at this juncture. Under circumstances where people who are taking risks, and who are supposed to be gauging and worrying about the risks, can "sell the risk downstream" - and therefore they incur more and more risk, more and more heedlessly, because for them there is only upside from going ahead - can there actually be a sound working regime of regulation of "selling the risk downstream"? Or is this a just plain unsound incentive arrangement - or, maybe worse, an arrangement that will be waiting to find unsoundness, that we will know about afterward - that cannot be safe and must instead simply be terminated (in favor of lender reserve requirements, or use of one-step-away debt insurance firms only, of etc.)?

The question doesn't need expressions of confidence or doubt, intuitions for or against - it needs study through modelling. Who is working on this? Does anyone know?

If we don't have answers, or if we don't know what sort of answers we want, my worry is that we are likely to be naive virgins for anyone knowledgeable- and experienced-sounding who says that responsible regulatory systems are being put in place.

Good article, Eric. This all seems obvious to me, but to my unending shock, it is not obvious to most people.

Taking the analysis a step further, ANY ratings or evaluation system can be corrupted, and when there is enough money at stake, it will be. We can try to minimize the effect. For instance, the moral hazard in allowing underwriters to review their own customer's offerings was obvious even before the fact, and the agency officials and legislators who allowed banks to do their own ratings were clearly not qualified to manage a hot-dog stand, or were corrupt themselves. Still, even an "independent" rating agency bends to industry pressure, as we now see.

Letting competitors rate each other is not a good answer either. At best, they'll lie for their own profit. More likely, they'll conspire against the public. Forex, back when Spitzer indicted Smith Barney for fraudulent underwriting practices, SB's competitors had to have noticed that SB routinely overrated its own customers' IPOs. Why didn't they report it and profit off of SB's discomfiture? The only rational conclusion is that the competitors were all in tacit agreement to ignore each others' frauds on the market.

Government agencies are a little safer, but only a little -- 'regulatory capture' is as old as government itself, and the history of the Bush Interior Department shows how easily an agency will bend to political (=commercial) pressure. The APA tries to solve that problem in certain areas by transparency, notice-and-comment, and appeals procedures. But (1) that adds such a great burden of time and cost that it won't work for day-to-day market regulation, and (2) it generates such a flood of information and argument that it is very hard to isolate corruption in the first place, or get anyone to pay attention once you find it, just ask any public-interest lobbyist.

The ratings problem is not confined to the financial field, btw. I hear tell that the medical 'peer review' system is now corrupt, because companies like Merck and Smith-Glaxo-Kline figured out that their expensive treatments will sell better with 'independent,' reputable proof that the treatments provide benefit proportionate to the cost. As this example shows, a professional creed doesn't help much either.

The best answer is to set up highly-specific countervailing market incentives. If we create large enough rewards for catching fraud, and keep monitoring to make sure the rewards have kept pace with the size of the market being regulated, we may get somewhere. For instance, the False Claims Act, under which a qui tam relator sues fraudulent government contractors on behalf of the government and keeps a percentage of any ill-gotten gains recovered.

So you need to empower outside actors with (1) access to records, and (2) a strong commercial motive to uncover fraud.

In short, you need a strong private tort system.

It is probably not accidental that we have had such extreme corruption problems since the passage of the Private Litigation Securities Reform Act of 1995, which made it much harder for tort plaintiffs to get data on securities fraud cases. And yes, PLSRA solved real problems of frivolous 'greenmail' suits and 'fishing expeditions,' but I think the cure turned out to be worse than the disease. Recent changes in pleading standards, sanctions, punitive damages limits, and class action case management techniques have probably made PLSRA unnecessary.

So I think a big part of the answer is to repeal PLSRA.

Tilting tax/money policies back towards consumers and savers rather than investors would probably also help: investment fraud thrives when there are too many investment dollars chasing too few consumer dollars.

And yes, PLSRA solved real problems of frivolous 'greenmail' suits and 'fishing expeditions,' but I think the cure turned out to be worse than the disease. Recent changes in pleading standards, sanctions, punitive damages limits, and class action case management techniques have probably made PLSRA unnecessary.

So I think a big part of the answer is to repeal PLSRA.

Agree completely.

Also, with what Alex said and Doc Science.

Funny that you should mention Henry Blodgett, since he just penned a hoocoodanode retrospective looking back over the late 90s tech bubble and the housing bubble in the Atlantic.

Now it is very tempting in reading over this piece to just see the self-serving whitewash (who is to blame? Nobody and everybody, that's who. Which means not me. Nope, nobody here but us chickens!), but I think he makes some key points that remain true even if they are stumbled across by somebody looking to cover his own tracks.

First off, I think he correctly identifies a major problem - incentives which were semi-rational (at least on the short time scales people normally operate on) at the personal level added up to collective madness on a longer time scale:

It’s easy to lay the destruction of Wall Street at the feet of the CEOs and directors, and the bulk of the responsibility does lie with them. But some of it lies with shareholders and the whole model of public ownership. Wall Street never has been—and likely never will be—paid primarily for capital preservation. However, in the days when Wall Street firms were funded primarily by capital contributed by individual partners, preserving that capital in the long run was understandably a higher priority than it is today. Now Wall Street firms are primarily owned not by partners with personal capital at risk but by demanding institutional shareholders examining short-term results. When your fiduciary duty is to manage the firm for the benefit of your shareholders, you can easily persuade yourself that you’re just balancing risk and reward—when what you’re really doing is betting the firm.

This gets back to a problem I mentioned in an earlier thread – our model of corporate governance is deeply dysfunctional, because the nominal owners have responsibility (i.e. it is their money which is on the line) with little real power, and the managers have power with little real responsibility. And neither group has been thinking on time scales at all commensurate with the distribution of major events which constitute most of the risk profile they should have been concerned with.

Other points which IMHO seem relevant are:

- Structurally similar bubbles are a recurrent phenomenon and have happened at different times and places spanning a wide variety of cultures and business environments. This suggests that something recalcitrant in human nature is at work. Tulip mania will always be with us.

- The largest bubbles seem to recur on a multi-generational time scale, suggesting that both personal and transmitted memories play a role in suppressing the conditions which allow bubbles to grow exceedingly large, but these memories decay over time. As a rough rule of thumb I'd say 3-4 generations appears to be about the amount of time it takes for people to completely disregard what was learned from the last collapse.

This suggests to me the regulatory reform to block future bubbles from becoming as large and destructive as this most recent one will help, but only to the extent that the political willpower exists in our population to continue making some sacrifices in terms of the efficiency of our economic system as a necessary price for avoiding or mitigating systemic catastrophes. Just as freedom isn’t free, neither is insurance against calamities. And if we aren’t willing to pay that price, then any regulatory framework is bound to break down or be circumvented over time, because of the “Quis custodiet ipsos custodes?” problem.

So while I endorse many of the structural reforms and tightened regulation being proposed here and elsewhere, in the larger view I see this as a cultural problem, and we are now in the process of correcting that problem the only way these things ever get fixed - by living thru the consequences and passing the memory of how much double plus ungood it all was down to those who will come after us.

In short, you need a strong private tort system.

Easier said than done. How can you have a strong private tort system without evenly distributed liability and strong information symmetry between officers and shareholders?

Asymmetries in information and liability, between officers/BOD and shareholders/stakeholders, are what allow modern corporations to be so ruthlessly efficient. To the extent that you reduce them you make it harder to have a growth-based economy with high returns to scale. I personally don't think that would be such a bad thing, but that's very much a minority view.

I agree that repealing PLSRA is a fine idea, and umpires are a great thing, but there's still the question of who hires the umpires, and who monitors the umpires, and inevitably who decides that it's time to fire them.

But some of it lies with shareholders and the whole model of public ownership.

Hoocoodanode that a perpetual limitation of liability would lead to risk-seeking? Really though, what TLT said. This is ultimately a cultural issue as much as anything else.

From Rajan & Zingales (formerly of the IMF), in "Saving Capitalism from the Capitalists":

"Capitalism's biggest political enemies are not the firebrand trade unionists spewing vitriol against the system, but the executives in pin-striped suits extolling the virtues of competitive markets with every breath while attempting to extinguish them with every action."

At least now I know what "hoocoodanode" means. (Hoocoodanode? Apparently, not I.)

Re: The cultural problem - I have conservative friends who will rail against regulation, yet cannot identify a particular regulation and explain what is problematic about it. (No, I don't think they are representative of all conservatives.) This may be a separate, but possibly related, phenomenon from the cultural problem in our financial institutions, and I think it stems from years of swallowing spoonfed talking points. It's a vague notion that has taken on a life of its own, having gone unquestioned for so long. I hope that changes, if it hasn't already.

radish, if ratings agencies can easily be sued in tort for negligence or collusion, that will solve much of the problem.

Suits against corporations tend to generate better self-governance institutions over time. Granted, no braking system works really well in a bull market.

And speaking of capitalists.

Sheesh.

I have a friend who works in a related branch in London and her explanation was pretty simple.

Everyone is asked to configure a rating, but you only get paid if your individual rating is the one that is used. Some companies actually care that the rating is sound and generally go with ratings agencies that they personally trust, but many just go with the rosiest rating (in their short term interest). This leads to an inevitable race to the bottom for actual analysis. Since most of the new stuff (and there is always a new and crazy way to make money being floated)is crazily byzantine, there isn't really a good way to justify analysis, so much of it turns into who can sell there BS rosy outlook the best.

The interesting side note is that she figured there was absolutely no way to regulate any of it because as soon as you put someone in charge of regulating one part of the charade, everyone would just find new and interesting ways to do an end run on some new and obscure investment that the government never dreamed of and so hasn't included in its regulatory oversight.

I heard a little bit of the notion that the existence of a regime of regulations can tame the harsher elements of capitalism and inspire the trust necessary for the capitalist system to work. I'm not against reasonable regulations. But, I think a healthy distrust of the other party is necessary for the system to work. To the extent that regulations coax people to no longer beware of the other party they are perhaps harmful.


I'm not against reasonable regulations. But, I think a healthy distrust of the other party is necessary for the system to work. To the extent that regulations coax people to no longer beware of the other party they are perhaps harmful.

This seems to me like a the-devil-is-in-the-details proposition. It all depends on where you draw the "reasonable regulation" line and how well that judgement holds up empirically.

After all, the logical extension of the idea that regulations inspire trust when caution would have been better is that I should pack some heat at my next meeting with business consultants because who knows, they may decide to show up heavily armed as well and one can't be too careful when dealing with people like that.

I don't think that is what you are actually saying dave, just pointing out that the abstract philosophic principle seems IMHO to be less important than the decision as to where to draw the line.

TTLIA,

I'm not sure it fits to blame bubbles on a mentality that looks only at short-term results. Consider the tech bubble. Most of those internet "giants" had no short-term profits, or long-term either. The whole ideas was that these companies were the future, and the short term didn't matter.

OTOH I agree there is a certain cultural forgetfulness that helps bubbles along. When I was a lad I served a term.... No, wait. When I was a lad the 1929 crash and the Depression were part of the collective memory, as recent as the Reagan Administration is today. The stock market was considered a very dangerous game indeed. No longer so.

I don't think that regulation to prevent systemic catastrophes needs to hurt our economic efficiency. I'm far from convinced, for example, that the benefits of marginal derivative trading is worth the risk in pure economic terms. I wonder, without having a concrete argument, whether some of the risk management involved is really just offloading risk onto society at large in various ways.

if ratings agencies can easily be sued in tort for negligence or collusion, that will solve much of the problem.

Maybe. I certainly agree in principle. I'm just skeptical about whether it would sufficient.

The part I like is that it's a market-ish solution. If any stakeholder can benefit from identifying negligence then everybody has an incentive to pay attention, and having people duke things out in court now and then lets everybody assess the risk of engaging in, or the reward for identifying, negligence and malfeasance.

The problem is that in practice this "market" -- the opportunities for suits against ratings agencies and the number of agents who could realistically take advantage of them -- would be very small compared to the financial markets to which it would be coupled. It would practically beg to be swamped or cartelized. Internally it would have high barriers to entry, few transactions, few agents, and high capital requirements, but only internally. Compared to the market next door it would be tiny.

The point being that regulatory capture doesn't require government to be one of the parties. If the rewards for acting as a freelance regulator of ratings agencies were, on average, less than the rewards of looking the other way, then we'd be right back where we are now. The ratings system collapsed not because there was no market and no possibility of competition between ratings agencies, but because the entire industry was captured swamped by the market it was supposed to be regulating rating.

Most of those internet "giants" had no short-term profits, or long-term either. The whole ideas was that these companies were the future, and the short term didn't matter.

Depends on which perspective. From an investor in an IPO, or even at a later point, the short term fix is the key: the stock prices kept going up, so buy and flip. This was the advent of the day trader era, when long term holding of stock became a thing of the past.

From the I-Banks' point of view, the short term fix derived from hyping value (and also setting up laddering schemes through IPOs and other public offerings) outweighed long term concerns about integrity of the markets/their reputations as reliable sources of information.

good post -- and i personally appreciated the underwriting tutorial. that would have been useful earlier today when i was at a talk listening to a guy tlaking about that.

anyway, since you mentioned Henley's "Strong Hayek," I was wondering if you had thoughts on its application to foreign policy. i thought it was an intriguing idea

Eric,

You make a good point wrt the IB's perspective, but I still believe that most investors buying into the internet bubble were doing so because they though these companies were onto something, rather than as day traders.

Of course the whole IPO scam deserves a chapter, or a book, of its own in history of financial stupidity. One section needs to deal with the gullibility or outright idiocy of a press that happily described IPO's as "successful" if the price shot up the first day.

I still believe that most investors buying into the internet bubble were doing so because they though [sic] these companies were onto something, rather than as day traders

They keep records of this sort of thing, and that's not what the records show.

The amount of volume in trading in internet stocks during the bubble precluded the idea that most investors were buy and hold. Or even buy and wait a few days. It was an arcade. It was the only stock market environment that has scared me so far.

now_what,

That there was a high volume of day trading in internet stocks doesn't preclude the possibility of there being buy-and-hold investors as well. The day traders add to the b-a-h volume, they don't replace it.

Why would day traders create a bubble in the absence of an underlying belief that these companies were bound for greatness? There have always been day traders playing around with penny stocks. There are today. Where's the stock bubble?

anyway, since you mentioned Henley's "Strong Hayek," I was wondering if you had thoughts on its application to foreign policy. i thought it was an intriguing idea

Rather intriguing. I think such circumspection and modesty should be the essential backbone of our foreign policy.

The reflexive use of the military for putative "humanitarian" missions and/or neoimperial efforts creates more problems than it solves, or at least the costs outweigh the benefits.

There are other more efficient, less destructive means available in most situations.

Further, the militarization of our society imperils domestic freedoms and necessary investment in our own domestic imperatives.

radish, I agree that regulatory capture and private-ratings corruption are essentially the same phenomenon, but I don't see how it applies to tort plaintiffs. Do you envision preemptive collusive class actions by the market participants? Intervention by class members is a fairly good built-in guard against that sort of thing.

The problem I do see is, how do you show that an inappropriate rating caused the plaintiff to lose money before the bottom drops out of the market? (The prospect of getting sued after a crash will not deter effectively, and the whole point here is deterrence). Still, when anybody pulls $$ out of the air, somebody must be losing. The trick is to give that guy a cause of action. Maybe people who bought down options based on reasonable accounting principles could sue for fraud on the market or some such?

Or maybe we can create statutory penalties for accounting fraud re assets over $xM in claimed value, and a qui tam system to bring private players into it? I know, sounds like a full-employment act for defense attorneys, but it may be worth that cost. I feel strongly that only market forces can effectively police the markets.

The problem I do see is, how do you show that an inappropriate rating caused the plaintiff to lose money before the bottom drops out of the market?

Yeah, exactly. The question is, how serious a problem is it? Meaning how complicated would those suits have to be in real life?

The plaintiff's claim is "defendant's rating was wrong" or "defendant's balance sheet was misleading" rather than "defendant's breakfast cereal poisoned my children" or "defendant sold me a car with no brakes." They're much murkier and more easily obfuscated questions than your typical tort claim. (otherwise why have ratings agencies and investment banks and auditors in the first place, right?) Even if you get discovery you can't expect a smoking gun.

So if the barrier to entering the "freelance regulator" market is too high for normal people who have suffered damages, there's adverse selection and the deterrent effect is diluted. The deterrent effect relies more on the number of potential plaintiffs than the potential size of the awards. But plaintiffs have to rely on specialists with both the expertise necessary to file the suits and the willingness to accept the risk of filing on contingency. If those experts can make a better living as one of those fully-employed defense attorneys instead then the whole system breaks down.

I agree that only market forces can effectively police markets. I'm just not convinced that the threat of tort works as a proactive deterrent in situations like this, unless there's also some mechanism to simplify the suits.

"the inherent weakness in capitalism is not the system, per se, but rather the greed of the actual capitalists operating within it. "
Which is, of course, a distinction without a difference. It's not like a capitalist system exists in a lab. Agree with the conclusion. We need regulation.

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