Fighting the Last War
I was at an interesting discussion with an ideologically diverse group of people last night of the future of financial regulations. One thing that there was broad agreement on that hadn’t really snapped into focus for me previously is the idea that doing rigorously precise forensic work on how to understand “what went wrong” and then design the rule that would have prevented this is neither necessary nor sufficient to improving things going further.
The basic reason is that we can be pretty sure that no matter what we do, we don’t need to worry about this exact thing happening all over again. Investors will be extremely reluctant to get involved in the exact kinds of products that recently crashed, everyone will worry that the first sign of housing price increases is a bubble, and regulators will be keenly aware of everyone’s pet theory of what went wrong. But the crux of the matter is that though the phenomenon of financial crises repeat over time, but no individual crisis repeats itself. The trick, if you can pull it off, isn’t to prevent a repeat of the current crisis, but to prevent (or mitigate) the next crisis which is something else entirely.
50 Responses to “Fighting the Last War”
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November 19th, 2008 at 9:25 am
I think this is partially true, but not as true as you might think. Certain crises are similar enough that remedies designed to prevent one might prevent or at least reduce the severity of another.
The obvious example is that of the repeal/revision of Glass/Steagall under Clinton. Of course it didn’t lead to an inflation of the stock market into an asset bubble so large that it destroyed the economy. But it did open the door to an essentially unrelated crisis in which the traditional banking system got exposed to risks that were once confined to investment banks.
I think this goes to a point you made a while ago, which is that regulation is more like building the great wall of china than it is like building Big Ben. Precision and accuracy aren’t necessarily good things – you want to act in a broad, somewhat crude way such that you prevent a lot of things that have nothing to do with what you’re reacting to.
Smaller, more directed regulation designed ONLY to prevent the last crisis is a bad idea. But broad regulation inspired by the last crisis can have unforeseen benefits.
November 19th, 2008 at 9:26 am
I think Paulson is unwilling to deal with the real issues. To contain the problem we need to find the bottom of the housing bubble. The way to do this is to re-value loans. This is what amounts to foreclosure relief. This will wack the banks balance sheets. Then, after finding the bottom so people know the real value of the paper out there, then we have to invest in banks that might make it. Paulson put the cart before the horse and invested good money after bad.
Then, after the problem is contained, we can look at the regulation side. I wrote a post on this this morning.
November 19th, 2008 at 9:28 am
It is the same principle with risk management models. Every risk management model correctly predicted the last crisis because after every crisis they are re-engineered to reflect the narrow lessons learned.
November 19th, 2008 at 9:29 am
The financial instruments and circumstances may be different from crisis to crisis, but the psychological elements that bring a bubble about are usually the same. The Bush tax cats to the rich fueled greed and corrupt practices among high ranking executives and regulators. If the tax structure remains the same, we can be sure that a crisis will recur, fueled by the same mix of psychological motive and unchecked financial possibilities.
November 19th, 2008 at 9:29 am
I mean, yes, that’s true. I don’t really think that our policies suffer because we have too precise an understanding of previous mistakes, though. I think overall we’d be better served if everyone had a better idea of what went wrong the last time. We could reach a point where we are too focused on that, but I don’t think we’re there yet.
November 19th, 2008 at 9:31 am
The financial instruments and circumstances may be different from crisis to crisis, but the psychological elements that bring a bubble about are usually the same. The Bush tax cuts to the rich fueled greed and corrupt practices among high ranking executives and regulators. If the tax structure remains the same, we can be sure that a crisis will recur, fueled by the same mix of psychological motive and unchecked financial possibilities.
November 19th, 2008 at 9:36 am
If you can benefit from a deal, you need to have a skin in the game. It’s that simple. The investment banks took one cup of sugar and spun it into a warehouse full of cotton candy. Then they used the warehouse full of cotton candy as collateral to buy 20 cups of sugar. And made more cotton candy. Rinse. Repeat. It was always bullshit but we lived in the Land of Bullshit for a decade and a half. Basic math was on holiday.
November 19th, 2008 at 9:36 am
Well, yes — in the short to moderate term. But humans tend to have short memories, unless they are academics focused in a particular area. One of the reasons to put those rules and regulations in place is precisely to codify what dangerous practices happened in the past. They serve as a constant reminder of past mistakes, so that those past mistakes are not forgotten.
Additionally, if drafted correctly, the rules and regulations should be fairly self-explanatory, i.e., you don’t do “this,” because then “that” will happen, and that is bad. The rules and regulations are codifications of policy decisions and lessons learned from past mistakes.
At the very least, they engender a sort of institutional memory where the reason for the rules existence — the policy outcome the rule is intended to foster — becomes ingrained among those (lawyers) charged with making sure their clients don’t screw up by violating the rules. Which, of course, keeps the entire industry more or less from screwing up.
November 19th, 2008 at 9:36 am
Does foreclosure relief really solve the entire problem of proper valuation of the bad commercial paper? It seems to me that unless you are going to give relief not only to people who can’t make their payments but also to people who are underwater but still cash-flow solvent, you’re still going to have a lot of debt out there that’s secured on paper but in reality unsecured.
It seems like foreclosure relief is a good start, but there may still be some pain left before we find the “real” bottom of the market.
November 19th, 2008 at 9:37 am
Really? Because this crisis seems really similar to the collapse of LTCM in the late nineties and Enron in the early 2000s. The problem isn’t specific instruments, it’s that we allow financial institutions to leverage themselves several dozen times greater than the equity they hold based on unfounded assumptions about market behavior. When one of those assumptions falls apart, the entire system disintegrates.
November 19th, 2008 at 9:41 am
Well, there is one way that these folks are wrong. Leverage must be regulated and monitored. Looking into how leverage was added to the system by these specific products would be useful work.
The products themselves are not dangerous. It is buying something with 5% backing it up that can be dangerous.
November 19th, 2008 at 9:56 am
This is an absolutely essential point, because the way the anti-regulatory impulse brought about this disaster was not so much by eliminating old regulations, but by failing to mind the store and adequately regulate novel financial deals like mortgage derivatives.
Over at Reason.com, they’re all crowing that it’s not technically – TECHNICALLY – deregulation that’s the problem because 1) “true socialism has never been tried” and 2) the deregulation of older financial dealings that did occur tends not to have much of a relationship with the mortgage meltdown.
Ergo, they don’t have to think even for a second that their anti-regulation impulses might need to be questioned, and that Alan Greenspan is just an apostate who can be ignored.
November 19th, 2008 at 9:56 am
It’s really all about leverage. If you look at the history of financial crises they all involve some new investment vehicle, a whole lot of leverage, and a story about how “this time is different.” In the late 19th century we had a bubble in railroads. We didn’t have financial crises post-New Deal because we had the banking system under lock and key. It was only when we loosened the regulations and allowed the S&Ls to get stupid that we had another blow-up. Then the totally unregulated hedge fund industry gave us LTCM. Then we removed the leverage limits on the i-banks and they all blew up. It’s really all about limiting leverage.
November 19th, 2008 at 10:00 am
Regulating the financial markets is more like trash collection than bridge building. You can finish the bridge, and there is, a complete bridge, which will stand for a hundred years. You just need to paint it once in a while.
But there will always be more trash to collect. There will always be supergenius whiz kids who come up with a really awesome new idea that can’t possibly go wrong. So you need to keep sending the trucks out week after week, and saying you collected lots of trash last month won’t stop the streets from filling up with garbage.
November 19th, 2008 at 10:03 am
an interesting discussion with an ideologically diverse group of people
So it covered the whole gamut, from the far-right to the center-right?
November 19th, 2008 at 10:03 am
While the exact mechanisms differ, there is one consistency from crisis to crisis. It is a belief that regulation is not only unnecessary, but counterproductive, so it is eliminated or suppressed. This belief is coupled with the delusion that some type of asset will always increase in value – commercial real estate, diversified stock portfolios, energy, residential real estate – they’ve all been assumed to be on a guaranteed one way rise at times. When an investment is guaranteed to increase in value, any leveraging to buy it is good. The problem is, there is no such thing.
Regulation that includes auditing that discerns when investment practices are predicated on guaranteed returns would be useful.
November 19th, 2008 at 10:04 am
I would also add that any new rules need to address the “too big to fail” conundrum. If a financial institution will at some theoretical point need to be bailed out with billions of dollars of federal largesse, then its lending and investment practices should be prudent enough to withstand strict government oversight and regulation.
It may make bank stocks less attractive to investors seeking 12% annual growth in their portfolios, but it will provide a huge safe harbor for the assets of people who don’t want to see sudden 40% drops in their net worth every seven or eight years.
Ultimately, those willing to profit from taking risks should have to lose on the downside. There’s far too much speculation fueling our economy due to the fact that Big Finance knows they can run to Uncle Sam any time they bet wrong.
November 19th, 2008 at 10:04 am
I agree that fighting the last regulatory war is not sufficient going forward. Nevertheless, you do need to regulate against the exact problem that just happened because you just bailed a bunch of people out who took bad risks. If you don’t regulate, people will purposely take the risks again to take advantage of the private gain, public loss gravy train.
November 19th, 2008 at 10:07 am
The foundation for this quaint notion being what? That the markets are rational? That they are self-correcting? That they have adequate institutional memory? That recent events have established a deterrent?
The corollary to Santayana’s aphorism is that everyone always believes they are infinitely smarter than the last generation. The unverbalized, but quite visible belief is that they would never have acted as foolishly as those dummies did.
OK, they’ll adnmit if you press them, maybe they might have dabbled a bit, but they would certainly have bailed at the first sign of trouble. After such a glaring demonstration of the perils, it is inconceivable that they would make the same mistakes.
Which is usually true– the ones they make are typically much, much worse. Iraq v Vietnam, or Housing v dot-com, to name two
November 19th, 2008 at 10:09 am
We might as well take steps that, in retrospect, would have prevented this particular crisis. It will only take a few decades for the current players to die off and be replaced with fresh-faced suckers straight out of B school, who have been carefully taught to forget the past and trust the market.
But, yes, it would be nice if everyone tried to learn some broader lessons that will be applicable to the next crisis, and make some deeper reforms to insulate us against some of the catastrophically bad assumptions that drive individual behavior whenever the market is booming:
1) Handshake deals and self-regulation are better than clumsy old government agencies that make us do paperwork.
2) There are certain types of investments that always increase in value.
3) You can always improve your balance sheet in the short-term by increasing your leverage.
4) Independent rating agencies have the best interests of investors at heart.
5) Policies based on maximizing growth are always best, regardless of exactly what is growing or whether the increase in share value is tied to any increase in its intrinsic value.
November 19th, 2008 at 10:09 am
One thing that there was broad agreement on that hadn’t really snapped into focus for me previously is the idea that doing rigorously precise forensic work on how to understand what went wrong and then design the rule that would have prevented this is neither necessary nor sufficient to improving things going further.
Check. Because the finance people will simply alter one condition and go back and do it all over again.
The basic reason is that we can be pretty sure that no matter what we do, we don’t need to worry about this exact thing happening all over again. Investors will be extremely reluctant to get involved in the exact kinds of products that recently crashed, everyone will worry that the first sign of housing price increases is a bubble, and regulators will be keenly aware of everyone’s pet theory of what went wrong.
Actually, this did happen already: there was a real estate bubble in the late 80’s. There was the kind of market crash we’ve had in the 20’s. The specific achilles heel that causes the crash does change, but not very much. Further, people forget. Not many people remember the lessons of the twenties because most of the people alive then are dead.
But the crux of the matter is that though the phenomenon of financial crises repeat over time
And if allowed to run unchecked, financial crises repeat incessantly to the point of overlap. If you’re having a bubble, you’re doing something wrong.
but no individual crisis repeats itself.
All the serious financial crises look the same: someone created a lot of paper and sold it for more than it was worth, and they kept doing it until it because obvious that it was impossible to ever redeem that paper. Crash. That’s overleveraged. (Sweeney and mickslam are absolutely correct.)
We didn’t have bubbles between 1933 and 1980 or so, because we had many more individual banks, those banks were tightly regulated and were not allowed to create a bunch of new financial products (’financial innovation’). And that worked, except of course, bankers didn’t rake it in like they do now. How sad.
There was a long runup in stock prices between 48 and 65 and then a long rundown between 66 and 80. But neither resulted in an economically-threatening bubble or crash.
max
['So it can be done.']
November 19th, 2008 at 10:12 am
I also see a problem with corporate governance. It’s obvious, looking at the behavior of the AIG execs, that they don’t give a crap what happens to AIG – they’re just padding their own pockets. That, I think, is one of the big reasons this happened. Everyone knew these mortgages were garbage and that they would blow up eventually. The execs didn’t care, because they didn’t care if the companies they were governing blew up. All they cared about was getting big bonuses – and the mortgages, with their high interest rates, made that possible.
I imagine that part of the solution for this could be a new kind of corporate charter – something that forces a little more accountability.
November 19th, 2008 at 10:15 am
Instead of regulating the exact same situation, you have to look at some of the fundamental principles: over leverage and the lack of information about the risk due to the sale of what were essentially unregistered securities (credit default swaps) and the lack of reporting on these securities.
November 19th, 2008 at 10:16 am
To nitpick slightly with what Njori said, it actually is possible to have an asset whose theoretical “real” value will increase indefinitely over time.
Unfortunately this tells you nothing about whether the asset is CURRENTLY overvalued, that is, whether its market price reflects its actual value (that’s good) or whether its market price includes some assumption of future value (that’s bad.)
The real value of oil will probably increase indefinitely in the future. But of course bubbles will be inflated and deflated in that time – just because something increases in value doesn’t mean it can’t be wildly overvalued at any given point.
November 19th, 2008 at 10:23 am
The trick, if you can pull it off, isn’t to prevent a repeat of the current crisis, but to prevent (or mitigate) the next crisis…
You mean, like the New Deal did when it set up all those regulatory programs and agencies designed to prevent another economic collapse? Y’know, the same programs and agencies we’ve been sytematically eliminating for the last 28 years?
Of course it’s just a coincidence that we got rid of the things designed to prevent a collapse of the economy and then the economy collapsed. It’s almost certainly Bill Ayres’s fault.
November 19th, 2008 at 10:27 am
Max,
Financial bubbles are always and everywhere caused by excessive leverage. You are entirely correct in saying that unless the last crisis is dealt with on a regulatory level, aspiring goldman partners will simply create a slightly different product with a new name and sell it to a group of newly wealthy people.
Matt has been talking about this a little, but really bubbles cause lots of wealth to be transfered to relatively few people and then the costs are socialized at the end. What this does is mis-allocate human resources to bubble activities when they could be doing real work. Right now, we have PHD physicists thinking about new financial products instead of green energy. Which to me is as criminal as spending several trillion dollars to clean up the mess they created.
November 19th, 2008 at 10:29 am
So, if that’s right, Matt, then why didn’t this latest financial catastrophe occur until AFTER the repeal of Glass-Steagall? Do you really think they’re unrelated?
The point is to look at the problem, and inductively determine root causes, and then address the root causes. That’s what Glass-Steagall did.
November 19th, 2008 at 11:26 am
The trick, if you can pull it off, isn’t to prevent a repeat of the current crisis, but to prevent (or mitigate) the next crisis…
There is no ‘trick’ to identifying the sound of snake oil being sold. There’s no trick to predicting basic human behavior, either.
Greed rules where sales take place. Transparency in publicly traded companies is essential to avoid fraud and deceit. Innovation in defining new accounting terms and methods should always be suspect until proven otherwise. And Santayana was correct about those who neglect history.
There’s no trick to preventing financial crisises if you understand these basics and can outsell the messages of the greedy who’ll try to cast you as a Socialist or Luddite. Oh yeah, and money always trickles uphill.
There is one other trick to master that you apparently have forgotten. While seeking to prevent crisises, one must also figure out how to sustain the lives of millions who’ll be hurt in the current crisis. FDR didn’t figure out how to end the Depression but alleviating misery he was okay at. And while the real misery – not just tight credit cardsn – has yet to seep into the front pages, it’s already there and will be multiplied considerably in the next year.
And if that effort’s sidelined too long by regulation-minded wonks or ideologues, there’ll be far worse national problems afoot than whether to bail out Chrysler again.
Prevention’s not the best cure. Psych 101, consideration and compassion are. And there’s nothing new to that trick at all.
November 19th, 2008 at 11:28 am
But America’s economy always has to have a bubble going to function.
Without one, our rich people will just blow their money on fun things.
November 19th, 2008 at 12:29 pm
Capital gains income should be taxed at the same rate as wages. Capital losses should not be deductible. There should be additional tax brackets of 50% for all income above $1 million and 75% for all income above $5 million. The one exception should be domestic manufacturing profits, which should be tax privileged the way capital gains are now.
Those simple changes would realign the incentives such that people who want to get rich would actually try to build something useful. It would deflate a lot of enthusiasm for financial bubble making without a lot of complicated new rules.
November 19th, 2008 at 1:29 pm
Not that hard. Leverage is the problem. All that changes is the ways of hiding excessive leverage from accountants, regulators and … perhaps most significantly … from yourself.
The reason to regulate bank leverage is very simple. It’s an arms race. You have to regulate it because otherwise all the players have to outrun each other towards the precipice. We need a SALT treaty among banks and only the state can broker the deal.
November 19th, 2008 at 3:50 pm
So, if that’s right, Matt, then why didn’t this latest financial catastrophe occur until AFTER the repeal of Glass-Steagall? Do you really think they’re unrelated?
I’m open to the theory that Glass-Steagel may have helped cause this. Walk me through how that worked, if you don’t mind.
November 19th, 2008 at 4:12 pm
Two months ago I said don’t worry too much about new regulation because it’s going to be a generation before there is even a slight chance that people are going to trust other people with their money. In 1932 stock brokers and bankers were considered leapers, the scum of the earth. So it will be again.
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