Speaking from middle of the financial storm, voices are raised blaming the tumult on the speculators, on the banks, on the hedgies, on the shorts, on the Republicans, on the ratings agencies, on the Democrats’ Community Reinvestment Act, on CDO’s and CDS’s, on people buying houses above their station, you name it. This is all at one level right, but that level doesn’t matter. The system, by definition, will always contain a measure of knaves and fools, because it’s populated by instances of homo sapiens. Thus, it has to be regulated to keep it running. Thus, the current meltdown is a failure of regulation and nothing else. The long term solution has to be about regulation too.

Free Markets · The evidence from history seems pretty clear; if what you want is an increase prosperity and decrease in poverty, free markets are the way to go. This doesn’t mean that the markets are an end in themselves, they are an economic tool. It doesn’t mean they are “natural” either; across the course of history a huge proportion of humans have lived in tyrannies of one sort or another in which nothing, including the market, was free.

And finally, it doesn’t mean that they’re self-sustaining. Any economics undergrad can explain why banks, which by definition borrow short and lend long, absolutely must be regulated, and backed with public-sector insurance, if they’re going to be viable at all; and any society needs banks. The whole finance industry, which history suggests performs a necessary function, is a fragile tower of faith and trust (Don’t believe me? Check the headlines) and there have to be rules, and policemen there to enforce them, or you get, well, late 2008.

Greed · It doesn’t matter whether or not greed is good, because it’s just not going away. The surprising and counterintuitive thing about markets is that by aggregating the greed of individuals and institutions, on a level playing field with clear-cut rules, you get pretty decent outcomes with respect to asset allocation and meeting needs and avoiding waste. (I didn’t say optimal, I said pretty decent.)

The problem is that greed is after all greedy and thus motivates people to play as close to the edge of the rules as possible, and in a certain proportion of people, to break them cheerfully. This will never stop. Some speculators will always try to max out their leverage. Some bankers will always try to minimize their reserves. Some home-buyers will always try to get something bigger than they can afford. And so on and so on.

That means the regulations have to be written in such a way as to work even when people are trying to game them, and make it straightforwardly possible to detect and punish rule-breaking.

The Regulatory System Was Broken · I can’t imagine anyone disagreeing. They relied centrally on the notion of “credit rating” and that turned out to be a tissue of lies, in practice. They relied on balance sheets which while at the best of times arguably contain a certain amount of accounting sci-fi, in the finance business in recent years turned out to be to have almost no truth amid the fiction. And so on and so on.

What Now? · We don’t want to abandon free markets. We also don’t want to go through late-2008 very often. So we need better regulation. This doesn’t necessarily mean stricter regulation, just better. Obviously, the next US administration, and also the EU, and also the big Asian governments, are going to have to buckle down and conduct some agonizing reappraisals, and in principle be willing to blow up big parts of the regulatory system and start again.

I’m not an economics professional so my opinion on regulatory mechanics is not very interesting. But it seems crystal clear that government has absolutely no more important task, starting now.


Comment feed for ongoing:Comments feed

From: jeff (Oct 03 2008, at 15:07)

Interesting that there hasn't been a call for inquiries to investigate the people behind this mess. Whatever regulations are put into place, the regulators must not contain any of the same people that were involved in this mess. Use experts from the financial industry, not Congress.


From: Billy (Oct 03 2008, at 15:13)

Yesterday I attended an economic panel discussion at the local university focused on the current financial problem. It was staffed by 5 economic professors w/ lengthy private and government sector careers.

I liked this brief essay better. Some background information and well written, thought through opinions.



From: Erik Engbrecht (Oct 03 2008, at 16:27)

What about the Canadians?


From: Jess Austin (Oct 03 2008, at 16:46)

This is a pretty good summary, but it leaves one thing out, which I consider to be regulation's biggest challenge. That is, regulatory capture. Regulators do not, as some "free market" people claim, hold back enterprise at the behest of the state. Rather, they hold back small enterprise at the behest of large enterprise, and so are fundamentally a conservative force. This is typically assumed to be in "the people's interest", but it often manifestly is not so.

When rules are clear, impartial, and predictable, anyone can compete. When they are Byzantine and capricious (hmmm, are there regulations like that?), they require an army of lobbyists and attorneys to navigate. This makes for a more "predictable" marketplace, but such a market typically does not meet the needs of consumers.

I certainly agree that some markets should be regulated. Especially those populated by idiots, such as banking.

However, not all markets. My experience is primarily in telecom, and I know in my heart that the American consumer would have been better served had the FCC never existed. If the FCC ceased to exist tomorrow, there would be a short period of adjustment, but within 6 months urban and rural consumers alike would have a much wider variety of communication and media options at drastically lower prices. And it isn't just the FCC. If you really want to be sickened, go to a state PUC hearing and listen to all the cat's-paw "consumer advocates" that Verizon and ATT&T send up.


From: Bilgehan (Oct 03 2008, at 16:50)

When net capital requirements for investment banks decreased in 2004, a consultant from a financial softwarehouse opposed the motion. His two page letter to SEC is rather dramatic when read today:



From: JulesLt (Oct 04 2008, at 01:05)

Being a Mancunian, I've a keen interest in the development of the free market, and how it also went hand in hand with social progress (the free marketeers, ironically, being what we would now consider to be Liberals).

One of the things they did establish was that for markets to function properly, a free and (crucially) independent press was required, and set up a trust to fund an independent newspaper (this eventually became the UK's The Guardian, which now has a media empire, and therefore vested interests, of it's own).

Perhaps one of the problems was that we've reached a situation where people largely choose to read/watch news that reflects their belief system.

We should perhaps be asking if the WSJ, Financial Times, etc, did all they could in providing the markets with the information needed to function?

(Yes, that was the credit agencies job too, I guess it is a case of who shall watch the watchmen).

A line I always use - 'free markets are the best engine for economic growth, but you still need to know where you're driving'.


From: Martin Seebach (Oct 04 2008, at 01:51)

Your fallacy is in this sentence:

The system, by definition, will always contain a measure of knaves and fools, because it’s populated by instances of homo sapiens.

The system that makes regulation is also populated by people - politicians to be exact. Thus, regulation will also be flawed.

At least a contributing factor in the current crisis, was the Clinton administrations wish to make home ownership available to more people - many of whom could not afford it on the free market - through Fannie and Freddie. Not exactly regulation, but very much the work of politicians.


From: Varun (Oct 04 2008, at 02:24)

Here is the problem:

Free markets are GREAT! However, a market is NOT a natural occurance. A market needs to be created and maintained. And to create a market, regulations are necessary.

A market without regulations will devolve into a power struggle. The strongest (in terms of military strength) entity will ALWAYS win out. This is not a market.

On the other hand, a real market, imposes rules on the people who participate in the market. Once the rules have been imposed, people are free to do what they please, as long as it is within the rules. Often, the rules need to be extended, or reduced. This strengthens the market. The republican ideology, however, believes a free market is one which has NO RuLES at all. Unfortunately, that does not lead to a free market, but a guerilla market, the effects of which we are just beginning to feel.

The Republican ideology is extremely flawed because it was just that, an ideology, and not a scientific measure of what happens in real life.


From: Wille (Oct 04 2008, at 08:07)

<i>across the course of history a huge proportion of humans have lived in tyrannies of one sort or another in which nothing, including the market, was free.</i>


One could say the same about (minus tyranny) modern markets. There are tens of thousands of pages of regulation and over 12000 people employed at regulators at only the Federal level in the US.

Were where they?

One of the problems I believe is that politicians want to "control", give dictats in their legislation, however this sort of thing is easily "hacked" and circumvented.

Financial markets need more transparency, not more control.

With transparency self regulation will follow, actors will make more informed decisions.

Controlling an opaque system is impossible, having individual actors making informed (and good) decisions in a transparent one is more likely though.


From: Bob Aman (Oct 04 2008, at 10:18)

I could not possibly agree more on all counts with Tim. And as a result, I've got nothing more to add.


From: Raymond Lutz (Oct 04 2008, at 19:02)

Monsieur Bray, exercise your french financial vocabulary and learn about possible regulations mechanisms here


"Quatre principes et neuf propositions pour en finir avec les crises financières" de F.Lordon

Treat your ears to his french accent in this Sorbonne video segment:



From: PaulT (Oct 07 2008, at 03:29)

Greed PLUS incompetence seems to have been a contributing factor. I've seen reports from senior financiers, who admitted that they didn't really understand a lot of the financial instruments (such as CDOs) that they were dealing, but the profits were too good to miss. Once it started to go bang, there was little understanding of how to extract themselves (and subsequently, the rest of us). I've worked in and around banking (in IT) for a number of years and it's clear that the faith in models, precluded the idea that most derivative models have a very small envelope of "accuracy" (or match to real markets) - when the envelope is breached, then the model is useless. Of course, they'll all tell you that such conditions can never occur........


From: len (Oct 07 2008, at 06:26)

The worldwide credit crisis has multiple causes but it is a shallow analysis to use the phrase 'deregulation' and a cynical self-serving analysis to lay this at the feet of one political party.

Because I don't want to start a troll war here over the American elections, I have to point out the role of the Community Reinvestment Act and the partnership of the HUD agency with the non-profits who actively sued banking institutions to force them to give out subprime loans while also being the agents of the sales.

While on the surface, trying to provide housing to those who can't afford it, it is precisely this kind of overregulation that forces a free market to do what it would not otherwise: give out loans to unqualified applicants with the promise that if they fail to meet obligations (which they most certainly will), the government will make good the loans.

Such acts remove the risk from the lending institutions and place it on the backs of the taxpayers. This indemnity trading is at the root of the crisis.

If you want to examine the culture of this, it is a socialist approach to goods and services. In a system of mixed free and regulated markets, this culture fails to ensure that risks are allocated where the risks are taken: at the point of the loan.


From: robert (Oct 07 2008, at 13:22)

The CRA spouting is a load of crap. Independent analyses, you can find them if you care to look, have shown that ~75% of "subprime" loans were done by Mortgage Companies. Such were NOT subject to the CRA.

Most of this mess is not "subprime" related anyway. It is ARM related. And specifically contractual ARM, not prime rate ARM. You can look it up.


From: Aristotle Pagaltzis (Oct 08 2008, at 02:08)

In my understanding of the situation, this crisis is the effect of the combination of over-regulation of one part of the market and deregulation of another – putting the lie to the ideological platitudes on both sides.


From: len (Oct 08 2008, at 06:03)

That's about right, Aristole. It is a mixed set of bad controls, no controls and dinking with the controls for social engineering. A perfect chaos recipe.

@Robert: I'm looking at the geo-maps for the agencies involved. You are seriously misinformed. CRA plays a huge role in this. Banks that fought it were sued and threatened. Then the unscrupulous found they had the perfect mandate for conning the mortgage applicants. The result is the US is now sitting on a lot of bad paper and bailing out through borrowing. Credit may loosen up for awhile but the house of cards is coming down.


From: robert (Oct 08 2008, at 17:32)

read it and weep (and, yes, I'd believe him before you).

"It's telling that, amid all the recent recriminations, even lenders have not fingered CRA. That's because CRA didn't bring about the reckless lending at the heart of the crisis. Just as sub-prime lending was exploding, CRA was losing force and relevance. And the worst offenders, the independent mortgage companies, were never subject to CRA -- or any federal regulator. Law didn't make them lend. The profit motive did. "



From: robert (Oct 13 2008, at 05:25)


Paul Krugman just won the Nobel for Economics. While he may not have been the first, or only, publicly speaking economist to voice what many of us anonymous ruminators were thinking; he certainly was the principal one assaulted by the right-wing fringers as the situation developed.

It turns out that Sweden went through this a decade ago, and found a solution. Not the first one expounded by Herr Paulson.


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