Why smart regulation is the answer

Discussion in 'Economics' started by Renegen, May 19, 2008.

  1. I wanted to make this thread to maybe start a discussion with the smart people on this forum. I know most traders are hardcore believers in capitalism and free markets, but I've come to believe this view to be flawed.

    We all like to think we see the big picture, that we're right and the sheeple don't know any better, but it's a bit more complicated.

    I've recently read "Other People's Money" by Noni Prims, released in around 2003. She is an (ex, presumably) Goldman Sachs managing director, so she knows her stuff. The book was a revelation. Everyone go read it. In one of the pages she predicted that Paulson would go back to Washington. It talks of course about the 2001 market crash and what caused it and she spends a lot of time on 3 industries, the banking industry, the energy industry and the telecom industry.

    Sure, we all know a lot of fraud took place, that there was an internet mania that caused billions in losses for everyone, but did you know a lot of it had to do with deregulation?
    Noni Prims repeats the pitfalls of deregulation on every page, granted, but the pieces all perfectly fall into place. For example, the telecom and energy industry used to be heavily regulated. Enron was a small pipeline company and Global Crossing didn't even exist before the deregulation.

    But after heavy lobbying(Ken Lay used his PhD in economics to argue for deregulation) the barriers were brought down. All of a sudden energy companies were buying up fiber optic cables! Small energy companies everywhere borrowed billions(blessed of course by the banks) to build capacity, and Enron built up its trading business. Enron by the end had 90% of its revenues come from trading. All it did was buy up capacity or energy then trade that energy for higher prices. Many states had their electricity bills multiply many fold, did deregulation suddenly make the whole system more efficient? Not even close. And of course a lot of these companies either went bankrupt taking away jobs and pensions or either survived with heavy debt which they then had to pass to consumers, increasing prices.

    And this brings us to banking of course. The book was written in 2003, and the author again prophetically (if anything it boosts Goldman's reputation) said that the new safeguards put in place were laughable. The problem at the core lies with the banks. You see, the banks back in 1998 had their business change with the Glass Stegall act repeal which lead to the consolidation in the industry. Deregulation is good right?
    Wrong, because simultaneously, the use of derivatives was being widespread. We all know that the toxic CDOs that caused this latest market collapse were created by banks, but who created the subprime loans? <i>Those very same banks</i>

    Who relaxed the loan standards? (and thus increased house prices) <i>those very same banks</i>
    The commercial side of the bank is able to make the loans, while the investment side is able to distribute them to investor.

    I don't think the blame is laid enough on the banks for the sub prime crisis. We blame Greenspan, maybe the government, maybe greed, but a large part really falls on the banks.

    Anyway. Most of the stuff up to now is just a revision for most.

    I still remember when Paulson proposed that we might need additional regulation, every person in here was heard cringing and going in slow-mo "No, don't kill the sacred cow!" Everyone thought it was nothing but a political move right? It probably was, just in a much different manner...

    Anyway, so why has the market failed? Let's analyze the assumption. The assumption is that having a free market will allow people to act in the most beneficial way for themselves, and therefore they would act in the most beneficial way for the economy. The assumption is that government is too slow and too stupid and should never be allowed to interfere with the market.
    Really, when it comes down to it, the needs of the individual and the needs of the society are aligned ONLY under free market capitalism. We believe in free market capitalism after all because it is most beneficial to society.

    Now let's look at <i>reality</i>. In our complex society, we're almost all subject to moral hazard. Moral hazard is the equivalent of the Greenspan put. If we succeed, we earn the rewards, if we fail then nothing bad happens to us. It is a very powerful force in our society, much more than a buzz word.

    Take for example trader Jerome Kerviel. He wasn't a bigshot, he was a regular employee. Yet in the complex environment he was part of, his short term objective(reach his bonus) were not aligned with the long term objective of his bank(steady increase in earning). The concept of moral hazard is EXTREMELY important, because the whole free market assumption lies on the individual managing risk the most efficiently. But Kerviel had no incentive to manage risk efficiently, and he therefore took as much risk as possible to reach his bonus. He is not a rogue trader, he is not a bad apple, expect such situations to continue.

    Let's get back to banking. Citigroup with trillions on its balance sheet cannot be allowed to fail, never. The wisest person on earth would never agree it would be good for society to let Citigroup fail. Bam, you've created moral hazard.
    Because of the Glass Stegall act repeal, banks are also able to get rid of bad loans they make, so Citygroup and other banks have absolutely no incentive to manage risk efficiently. They WILL create bubbles whether intently or by mistake as long as their short term goals (hit the quarterly numbers) are not aligned with the long term goals of society (stable, profitable bank making conservative smart loans etc)

    But you tell me, obviously the banks defrauded their customers, selling them crappy CDOs since the saying is "buyer beware" after all isn't it? Well yes and no, remember I said that moral hazard exists everywhere? What does Joe Blow care whether he buys toxic CDOs for his mutual fund that will go off in 3 years, Joe will be working at a hedge fund in 3 years from now! No one has any incentive to manage risk for the long term.

    Hell the shareholder doesn't even care about the long term.

    The whole assumption of the free market rests on the individual being able to manage risk more efficiently than some 3rd party(like the government). IT IS SIMPLY NOT TRUE.

    You see, 2001 was not the case of a few bad apples, Bush was lying to your face. It was the case of structural problems with the American economy that have not been solved.

    One of the most popular thread in the economics section is the thread on whether Obama will be good for the markets (and the economy). Obama has been heard a few times saying protectionist comments. No he is not retarded. I have not discovered the light bulb here, if anything the book made my ideas clearer. Many people know that it takes smart regulation, that some industries are better public, that others might need to be more free and should have little red tape. But these people dare not speak up unless the mass media, economists, and people with high IQ everywhere lash at them with a vengeance. This free market theory has become a religion. If it happens that Obama has a few progressive, enlightened economists on his staff, that we should let him be. No wonder politicians are forced to dumb down their dialogue, even people who fashion themselves as smart could end up being wrong!

    No I am not advocating to tax everyone to the hilt, I am not advocating to make every industry public, what I am advocating is critical thinking, not dogmatic statements. What can we do to fix the problem? Simple, the Glass Stegall act could be a beginning. Another beginning would be to make some of the loans illegal, to *gasp* selectively regulate the banking industry. Up here in Canada our banking industry is regulated and it works great.
  2. Daal


    smart regulation is a good idea the problem is where will the smart regulators come from?unless you devise a way to make that happen trying to increase regulation will only make things worse, you will be trying to create laws to correct human biases using people subject to the same biases.

    Bank regulators bought into the AAA from the rating agencies just like everybody else, does deregulation makes it possible for bad people to do bad things like in the enron?sure, but thats WHAT WOULD YOU EXPECT to happen. a certain % of the population are crooks and liars if you increase the amount of behavior people are allowed to engage in you will increase the amount of people engaging in that behavior including the crooks who will do that behavior with dishonesty, there is nothing new about that and it certainly has nothing to do with deregulation but with human nature and math
  3. Really, there's not a thing besides your vote that you can do to affect the government or policy. Instead of being so distressed about the financial system, why not just look at the great trading opportunities that are the result of all of this mess. Somehow, I think we'll muddle through all of this, as the sky isn't falling. Meanwhile, try to take advantage of the volatility. For an astute trader, these are the best of times.

  4. Tell me, weren't the regulations in the energy, telecom and banking industry already in place? Obviously someone was able to put them there, and they were better than what we have now.

    You're trying to generalize your stance about regulations when in fact they should be applied selectively. I guess a lot of people think in generalizations, that's what science is about. Hasn't trading taught you anything? Every situation is unique.

    And what I'm aiming for here is not as impossible, fact, right now other countries have regulators and policy experts coming up with new regulations. The free markets co-exists with them, they are not two opposed forces. Also what you talk about is not as arcane and as impossible to separate as you put it, I have brought forward easy examples.

    I will give you the reason why the CDOs were AAA rated. Now before I do that, can you agree with me that every bubble is meant to end? Goldman Sachs traders thought about shorting sub prime in december 2006, it was plainly obvious that the CDOs were not AAA, don't generalize there either. Also some people have not bought at all, they had done their own analysis.

    Why were they sold? I've already talked about that.

    But why did they get high ratings? Because if they didn't get high ratings they wouldn't be marketed. The CDOs are derivatives created by derivative experts using complex math. They would hammer and jam together different bonds until the whole behaved better than the individual parts. It's easy. The models might have also been wrong so it's not a surprise they were originally thought of as safe.

    Noko, that's not true. The government is always as good as their people want it to be. Why continue to elect corrupt morons in office? And I don't mean just Bush. Education is at the base of all things, that's what I'm doing. And don't worry, I am taking advantage of the opportunities, but I feel money for the sake of it is empty.
  5. Daal


    tons of people in congress dont believe in evolution(including ron paul), others think free trade is bad, others think government run enterprises more effectively than the private market. the level of ignorance on the regulators creates a problem that you failed to solve
  6. Daal


    btw, I already explained to you that limiting peoples behavior with regulation will decrease the amount of mistakes or fraud associated with that behavior, you seem regard that as a 'good thing'. by that logic locking every mortgage lender in jail would be great because it would have prevented the housing bubble.
  7. I don't exactly understand what you're saying, the 2nd and 3rd example are open for debate, and you're still generalizing.

    And it all begins with education, you get the word out and start debate. If the regulators are incompetent, you retrain them or you fire them.
  8. vince111


    bear sterns and citigroup failing or going bankrupt is how the free market 'regulates' industries or markets.,,,but gov't intervention and self-interest gov't lobby groups interfere with the 'free market'.

  9. You bring up very valid points which show merit. The difference between us is that I have absolutely no concern about who's in office, what policies are in place, what regulations are in force. I do think the USA is a pretty good place to invest, and I'm pretty bullish on America as a whole, for a plethora of reasons. That being said, back in the 70's when I started trading in the wheat pit, I used to worry about all the news, reports, policies, numbers, and politics. I was a real junkie for reports and releases, trying to trade them. I found that my excessive concern was affecting my edge, so I learned to divorce myself from events and emotions, and concentrate on trading. It took me a few hard years to finally get over it, but I finally did. I figure that what's going to happen is going to happen whether I like it or not, so I might as well make a few bucks and worry about what really counts....my family, friends, neighborhood. As Tip O'Neill once said..."All politics are ultimately local."

    By the way, you had a very good post and brought up many points that some would consider "food for thought."
  10. Vince, Bear Sterns(well maybe Bear Sterns) and Citygroup should never fail. The way banks are setup, they can become insolvent pretty fast. I believe 100% big banks should never be allowed to fail, unless you want another great depression. If a bank the size of citygroup fails, it will wipe out bad loans but also good loans because of the leverage they use. It will decrease the money supply and the worst thing that can happen in our economy is deflation. That banks are propped up should not be seen as corrupt Wall Street tactics and government. Even the most rational populist advocate would have the same position.

    So we're stuck. That's why bank regulation is a must, because you cannot have a perfectly free market with banks of this size, it's a fantasy. As for the other industries it becomes more complicated.
    #10     May 19, 2008