I am no expert on finance. Therefore, I cannot tell whether George Soros' proposals for increased regulation of the financial system have merit or not. Soros has probably forgotten more about finance than I ever knew to begin with. However, Soros' position has at least one serious weakness that is common to many arguments for increased government intervention in society: it fails to give adequate consideration to the shortcomings of the political process. Strangely, Soros admits that government is likely to do an even worse job in this area than he believes the private sector has; yet he still ends up supporting increased regulation.
Soros argues that speculative bubbles are a form of market failure that can cause great harm to the economy when the bubbles pop. He therefore concludes that we need government intervention to prevent bubbles from forming. However, he concedes that government regulators are unlikely to do any better at predicting dangerous bubbles than the market does:
[S]ince markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually re-calibrate to correct their mistakes. [Emphasis added]
If, as Soros believes, government regulators will be just as bad or worse at predicting bubbles than market participants, it's not clear why he expects government intervention in this area to improve things. "Feedback from markets" certainly doesn't create any comparative advantage for government regulators; after all, the private sector can use feedback from markets as well.
Soros' argument could still work if government financial regulation were costless. If that were so, the regulators might occasionally prevent a dangerous bubble from forming, while not causing any harm in the many cases where they are "bound to be wrong." However, as Soros himself points out, government financial regulation isn't costless because "While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences." Unfortunately, he doesn't do enough to consider the likely impact of these "political influences." The rest of his argument for increased regulation proceeds as if government were a "benevolent despot," willing and able to implement the right kind of regulation so long as he gets the right advice from experts like Soros.
Common systematic shortcomings of government suggest that Soros' "political influences" might cause even more harm in the field of financial regulation than elsewhere. As I discussed in this post, government intervention typically suffers from three major shortcomings: inadequate knowledge on the part of government officials, widespread political ignorance among the electorate, and the power of interest groups who can "capture" the political process and use it to benefit themselves at the expense of the general public.
All three of these problems are likely to be especially severe in the field of financial regulation. Even those who worry less about political ignorance than I do would be hard-pressed to argue that the voters have a good understanding of complex finance policy issues. It's telling that some 25% of the public is so ignorant that they blame "the Jews" for the financial crisis. Such widespread ignorance suggests that voters will do a poor job of monitoring the performance of regulators, and also creates the danger that public ignorance will push the government to adopt severely flawed policies that seem attractive to voters with little understanding of the financial system.
It is also clear that there are interest groups in the finance industry who will lobby regulators to try to "capture" them and use government power to benefit themselves at the expense of the general public. Banks and large institutional investors are obvious examples. There are few other sectors of the economy with so many powerful, concentrated interest groups. The danger of special interest lobbying is, of course, exacerbated by widespread political ignorance. Ignorant voters can easily be fooled into believing that policies pushed by special interests will actually benefit the general public. This is especially likely in a crisis atmosphere like the present.
Finally, as Soros himself points out, government financial regulators suffer from inadequate knowledge and are likely to make mistakes as a result. The same complex nature of the financial system that ensures widespread public ignorance also makes it difficult for regulators to gather sufficient information to know when they should act. If regulators act on poor information, they might engage in interventions that create serious harm - as the Federal Reserve discovered on several occasions in its history, including the Great Depression.
Does all this necessarily prove that increased regulation of the financial system is undesirable? No, it doesn't. But it does suggest that justifying increased regulation requires a much stronger argument than that given by Soros. It isn't enough to prove that a market failure exists, even a very serious one. We also need proof that government regulators have the knowledge and incentives needed to improve on market outcomes without causing harm that outweighs any benefits they might create. Even if Soros is right about the alleged failures of the market, he hasn't shown that government intervention will be better. Indeed, for reasons he himself hints at, it might be much worse.
UPDATE: It's possible that Soros wants the new regulation to be conducted by experts insulated from the pressures of the democratic process. If so, that would partly (though by no means entirely) protect against the dangers of public ignorance and interest group lobbying. Unfortunately, the "rule of experts" solution to political ignorance has serious flaws of its own, which I discussed in detail here.
Related Posts (on one page):
- Global Governance or Governmental Network Coordination for Global Financial Regulation?
- A Flaw in George Soros' Case for Increased Government Regulation of the Financial System:
- Soros on Principles of Financial Regulation and Efficient Market Hypothesis:
- Thomas Sowell on Public Ignorance and the Financial Crisis:
- Political Ignorance and Blaming "the Jews" for the Economic Crisis:
Have you considered that for Soros this is a feature rather than a bug? It might be the whole point, he is himself a powerful interest group and is seeking to capture the political process.
It would be interesting to know which of the three problems I noted don't exist in "the real world." Is the public not ignorant of finance policy? Are there not powerful interest groups in the finance industry who will try to "capture" the regulatory process for their own benefit? Or is Soros wrong to believe that government regulators will often fail to accurately gauge bubbles because of limited information?
I think the argument would be that a regulator can have all the information of the market - and the incentive to keep the bubble from growing.
Of course, that doesn't answer the question of whether a regulator can actually do that, or whether even if it can the benefits outweigh the costs, but it is an argument as to why a regulator can act on market information when market participants will not.
1. Where wealth is being generated quickly (high rates of growth) across an industry (pick a reasonable percentage), and
2. Where such growth is tied almost entirely to the increased velocity of money, and
3. Where there is neither a) a physical commodity nor b) a profit that operates independently from a properly functioning original product.
4. We have a bubble.
This basically describes: dot com and housing.
The third step really describes "imaginary wealth."
It's a deadly serious concern. Over- or mistaken-regulation can be particularly insidious because inefficiently setting risk levels too low can stifle innovation, investment, all the stuff that will be needed if the next generation is to get out of the hole currently being dug. This something I was trying to convey to my now-suddenly-entirely-risk-averse students. Failures to take risks will cost us dearly, and the information gap between market players and officialdom not only raises questions as to officialdom's competence to make the calls, rather than setting baseline rules against fraud and for transparency and certainty of legal outcomes, it also raises questions about bureaucratic abilities to stay one step ahead of clever, motivated markets.
That is not to say that reform of financial regulation is a fool's errand - it's not, in my view, but instead a necessary undertaking by government at this juncture - but it has to be approached very cautiously, just as the efficiency of markets has to be approached more cautiously than we have done in the past couple of decades.
In what area does government have an advantage in information and control and motivation? Only one, so far as I can tell. That is in turning political influence into economic advantage, and finally back into greater political influence. There are innovations here, and there is risk-taking, too, but not ones that should make us very happy.
I do not think that Soros's principles give sufficient weight, to public choice theory and the malign effects of government, and not just its competency or incompetency, particularly when it comes to Congressional involvement in the private economy, whether via the banking system or anything else, such as Detroit.
The line in practice turns out to be a fine one between setting the underlying legal rules of the market system and its regulation, and simply preserving past winners who have leveraged economic success in the past into political control in the present. I don't think Soros's account gives sufficient weight to that problem of public choice.
That said, we should choose other forms of regulation to relieve regulators of responsibility to recognize bubbles. I don't believe regulators would ever really squelch a bubble even if they did recognize it-- considering that regulators' clients will always be bubble participants getting rich (on paper, until the bubble pops). I suggest we take other steps which would discourage the formation of bubbles in the first place, party by giving investors (including institutional investors) better information so they could avoid imprudent investments (such as housing-bubble MBS) which finance bubbles.
We should disestablish the NRSRO rating-agency oligopoly and forcing ratings users, not securities issuers, to pay for ratings. We have seen that the current setup, by which MBS and CDO wastepaper garnered AAA ratings, is useless as the current ratings agencies are insulated from competition and corrupt. We should require all CDS or similar paper to trade on a central exchange with publicly-reported prices and terms as well as identification of parties so other folks can estimate market-participants' exposures under various scenarios. We should also abolish the C.R.A. and regulate financial institutions of all kinds on financial criteria only. As the Countrywide and Fannie and Freddie debacles have shown us, a politically-correct fascination with pushing money at so-called "underserved" borrowers is no substitute for actuarially-sound loan underwriting.
Eric: is the parent-child form of divide and conquer part of your new book? It seems to me more vital than the game among nations ...
Except wasn't there some mention of "irrational exuberance" in the mid '90's, well before the bubble burst?
Soro's proposals seem to have a ring of truth to them. But it doesn't help his argument to assert that we will simply have to expect the impossible of our regulators.
I think calls for the Fed, or some other body, to look at problems of price bubbles in systemically important industries as falling under the latter category as opposed to a mere market failure. Any such directive, whether it is based on velocity magnitudes or some other measure would prove impossible to determine that a bubble exists. If market participants are unable to determine when a bubble occurs, especially when they do have skin in the game (contrary to the myth that MBS issuers did not have any), why would a poorly paid bureaucrat at the Federal Reserve be able to determine when a bubble exists?
Bernanke said as much in 2002 ("Understandably, as a society, we would like to find ways to mitigate the potential instabilities associated with asset-price booms and busts. Monetary policy is not a useful tool for achieving this objective, however. Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.
A far better approach, I believe, is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. I have already mentioned a variety of possible measures, including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed. Although eliminating volatility from the economy and the financial markets will never be possible, we should be able to moderate it without sacrificing the enormous strengths of our free-market system.")
Holman Jenkins' recent article in Policy Review was excellent in regards to similar matters:
Link
Also, what prevents a new body from becoming a source of systemic risk itself? There are more than first-order effects, and any effort to regulate derivatives will push trading to more unregulated, opague financial sectors. Any efforts to raise capital standards will give an incentive to financial firms to conduct more off-balance sheet transactions in the form of Credit Default Swaps, ABSs, etc.
How about at least requiring everyone to have a reasonable amount of "skin in the game", including the borrowers, the lenders, and the loan originators? That would certainly have kept the demand for real estate from radically outstripping the supply, and probably kept price increases of real estate at reasonable levels. It would have held down the profits of flipping, reducing that practice.
And of course, it would have also prevented millions who had no possibility of ever repaying the mortgages from getting one in the first place (unless the Ponzi game of re-financing on rapidly increasing and inflated real estate "values" continued unabated, that is). No down payment, no income, no job and get a mortgage anyway, on a massive scale, that was the rule of the day. Anyone should have been able to see that that would eventually lead to a huge dislocation in the residential real estate market somewhere not far down the line, but no one wanted to look. Everyone was making tons of money, and getting lots of votes for helping the poor and downtrodden get their own home.
What we actually had was massive regulatory intervention in the financial industry that forced lenders to disregard sound business practice that had prevented this in the past. And why? Because those perfectly sound business practices resulted in disparate impact on victim groups that made up big voting blocs in one party.
Glass-Steagall worked great and it didn't have any provisions for bubble forecasting.
June 18 (Bloomberg) -- Maybe it’s a sign of the times, or a manifestation of bailout fatigue, that news of lobbyists descending on the Federal Reserve creates little reaction and no outrage.
“Executives and lobbyists now flock to the Fed, providing elaborate presentations on why their niche industry should be eligible for Fed financing or easier lending terms,” writes the New York Times’s Edmund Andrews in a June 13 article.
Regulation that is crafted to help all citizens, broadcast so that all the people understand it, and then enforced by the government equally is different than the regulation proposed by Soros. His kind is ad hoc regulation by an opaque group with dubious claims of independence and who apparently holds court daily with influence peddlers.
In fact this crisis was so predictable it hurts to see how little was done to prevent it from happening.
FED even knew it at a very early stage too, but had a policy not to interfere with the market (unless it goes down- the so called Greenspan Put).
With this in mind we should no longer wonder why bubbles occur. Policies have been and still is assymetric, which encourage bubbles.
With the right people to overlook the economy at least people could have been warned, and warnings makes people in power take action.
I was one of the economists who in March 2006 in a Master Thesis foresaw the bust of the first international housing bubble and its consequence likely to be global recession.
Read more at: www.jensks.com
An ancillary assumption is that the value of things should always go up, but that they should go up in a slow orderly way -- in order to avoid the bubble / burst cycle.
I don't share these assumptions. I am an investor and trader, and I can tell you NOBODY ever talks about why the failure of bubbles are a good thing, so I will:
1) 'Capitalism without failure is like religion without sin' -- Failure, and the pain that it brings, is the best self regulatory cure to making dumb decisions. People tend to focus on reward, but it really is the risk / reward ratio that matters. Without failure, risk made tangible, you don't really have capitalism.
2) 'Peaks create troughs' -- An exuberance in one direction, upward, is called a bubble. But when it pops it tends to over react and it's value decreases well beyond what is reasonable, creating investment and asset acquisition opportunities. Does anybody really ever say 'hey the stock market is way undervalued, let's get the regulators in there so they can stop such madness'? Of course not, when such things occur the reward opportunity is so high nobody wants the government stepping in and messing it up.
3) 'Buy low and sell high, or sell high and buy low' -- there is plenty of money to be made in both directions. And unless you allow the market to make such trades on both sides all you are really doing unduly influencing the normal market. This is what happened when the 'regulators' came up with the bright idea to not allow people to sell short certain stocks. Well, by doing so they also took out the ONLY group that ever had to BUY the stock. That's why you saw stocks on the 'no short list' plummet, since a large number of the for sure buyers were taken out of the market, and only those who would invest or speculate on the stock to the upside would only step in at MUCH lower values.
4) 'Not all bubbles are equal' -- do you ever hear anybody complain about the commodity bubble being popped? I don't. Oil, Copper, Wheat, Cotton, Corn, Beef, etc. all fell 30-60% from their highs. Was that a bubble? Was popping it bad? How do you regulate the financial services in such a way to make sure that that bubble can pop but the stock / real estate bubble either doesn't happen or doesn't pop?
All I am saying is that there are some very good reasons to let bubbles develop (freedom of investment decisions) and for them to pop (not all bubbles are equal, and their popping can create opportunities).
No bureaucrat who doesn't have their livelihood at stake can make a better decision than an investor who does. What the real issue is is that since the government is so interventionist to clean up the mess (which it shouldn't be), then they should be responsible and control things so the mess never happens which is completely logical. Let's deal with the former issue and not the latter.
Why? Because in a bubble there is still lots of money to be made selling your bubble assets to the "greater fool." Indeed, the most informed players are the most likely to stay in until just before the end, because they are the most confident (not always accurately) that they will time the bust right.
In contrast, government regulators have less of an incentive to let the bubble ride, and can also design policies (like expanding capital requirements during periods of greater growth) that are bubble sensitive, even if they don't actually time the collapse of a bubble correctly.
Not even approximately true, as the case of He-3 proves.
The business cycle upsets the status quo and forces re-evaluation.
Without that variation, people tend to get intellectually lazy and do things just because that's how they've always been done.
On the other hand, other regulations Soros proposes can be implemented in a relatively transparent manner. For instance, requiring lenders to retain a certain portion of every loan they make is an easy to understand rule that can be implemented very broadly. I'm not convinced this is an important regulation -- Spain had such a rule but it apparently did not prevent troubles in the financial sector there -- but it seems easy to implement. Requiring derivatives to be "homogeneous, standardised and transparent" is also itself a relatively transparent regulation. This is done for many other kinds of contracts.
Finally, I would point out that in the U.S. even after the repeal of Glass-Steagal, you can still categorize most financial firms as either commercial banks, investment banks or insurance companies. Firms that stuck to traditional commercial banking or traditional insurance, with all the attendant regulations have managed to stay in business. The problems are largely concentrated among investment banks or among firms that chose to engage in the kinds of activities that investment banks engage in like AIG with its Financial Products division selling CDSs or Citigroup with its Structured Finance division packaging and selling CDOs. Loopholes that allow regulatory arbitrage should be closed.
Almost no one does.
That's why we have governments to rule us instead of markets.
Whther true or not, this point makes the case for government regulation. It's called "political economy" for a reason, the economy does not exist outside the realm of human politics and never has.
You mean Helium 3?
In looking at my text, I should have been more clear. Bureaucracies that don't have their livelihood at stake cannot make better decisions than investors who do. There will be some bureaucrats who are smarter and make better decisions than some investors, but not in total.
You are not answering the objection: bankruptcy does not provide compensation for most of the injured parties when an unregulated market collapses, which they all do.
Better than compensation, though, would be avoidance, which governments can manage. At least,the U.S. government did for 70 years until the free market maniacs took down the fences.
The idea that markets rule me is some kind of tortured parsing. How do you know what values I have or where they came from?
Avoidance is impossible. Any transaction requires some degree of risk. Usually, this risk is whether or not the product will work or if it will last until it's needed. Large monetary transactions always require large risks. It is impossible to have large businesses without large risks. Any transaction is a bet of some kind. Make enough bad bets and you go down. The ability to bet correctly consistently comes from the ability to gather data and the willingness to take risks.
The first values that your exposed to come from your parents. The next set is from your friends, past that is the reading or input from other media that you consumed. Your parents values will vary depending on the area you grew up in and the standard of living therein. Your friends values will be taken from their particular neighborhoods. What you read is first based off of your education. It branches off from there. I don't have to know your values to know the methods you came by them. I won't know the specifics of your case, but that is irrelevant here.
Bankruptcy isn't something that occurs in markets. It occurs in courts. A business in bankruptcy is simply unable to do business. The reason the business is in bankruptcy is because it ran out of money. Which means that the only way to fully compesate the injured parties is to injure another party, because the money available is not enough to cover losses and obligations sustained. If you've found a way to conjure money from thin air without devaluing it, you should present it.
I'd have to say I am not familiar with the HE3 issues you are bringing up, so I cannot comment either way.
What I can comment on is your issues:
1) You say with a blanket statement that bankruptcy does not provide compensation. And you base this on what? Bankruptcy of course offers SOME compensation, but what is you are really complaining about is that it doesn't provide what YOU think is enough. The UAW seemed to do quite well in the various car maker's bankruptcy. Further, the various creditors, investors, and other debt holders got a reward for taking the risks they extended. Hence that wonderful risk / reward ratio. Bankruptcy for many is the risk made tangible. Welcome to the real world.
2) You state that better than compensation is avoidance. Well, those harmed directly by a bankruptcy have a very easy way to avoid the problems of a bankruptcy. They don't have to invest in, lend to, or extend credit to the entity before it becomes bankrupt. You get what you want, avoidance, and I get what I want, limited government interventionism. It is a win win for everybody!
3)You state that, 'the idea that markets rule me is some kind of tortured parsing. How do you know what values I have or where they came from?' I don't know what values I have or where they come from. I believe that you should have the ability to express your values in the market by buy, not buy, investing in or not investing in, lending to or not lending to whatever and whoever you want. I don't want you spending my money just as much as you don't want me spending yours. Again a win win for us both.
4) This bubble certainly wasn't an unregulated one. The mere massive involvement of Freddie and Fannie as GSE's with mandated investment profiles at a minimum screwed up the normal market dynamics and at a maximum pushed the whole system over the edge.
This crisis was magnified by regulators, bureaucrats and the political class. The Fed juiced the money supply from 1997 - 2003 with ultra low interest rates and high levels of money supply expansion. The government encouraged banks to make loans to marginal borrowers. While I do not place sole blame on the government, they did nothing to prevent this crisis and everything to aid it.
Think about this. Citigroup expanded it's balance sheet by over US$1 trillion over a 5 year span while only growing its equity base approx US$150bn over that period. So that's 850bn of net new borrowing over that period. Remember for most of that time they were restricted from expanding by buying other financial institutions. That's about US$170bn per year in net new borrowing for a 5 year clip. How could that level of borrowing by a single institution get done if there weren't market distortions? I can remember the first billion dollar bond issue in the mid 80's and it was a big thing. Borrowing 170 billion in one year by one institution is staggering since it's only 20 years later.
Perhaps the Federal Reserve over that period has been inflating the money supply? So now that they've created bubble after bubble, should we give them more power to dominate the market? Should we give their brethren in the political class that power as well?
If we do, we're heading for an even bigger disaster down the road. Soros doesn't care, he thinks he'll be on top running things by then and won't suffer the pain.
We seem to be talking past each other on bankruptcy.
If a firm goes bankrupt because of bad management, tant pis. Each participant in the firm's activities gets a share of the bad news.
But if a firm fails because of a general market collapse, different story. I took the first post about bankruptcy to be arguing that bankruptcy was the mechanism by which market failures are addressed.
Not so. Only firm failures can be addressed by bankruptcy.
'Can you name one unregulated market that has failed?'
The idea that the current failure is due to a housing bubble is only partly correct -- credit default swaps were completely unregulated, so it is not true that unregulated markers do not exist, or that they do not fail.
The curse of knowing economic history is that I can name many unregulated markets that failed. The first collapse of Barings is a famous one.
'The mere massive involvement of Freddie and Fannie as GSE's with mandated investment profiles at a minimum screwed up the normal market dynamics and at a maximum pushed the whole system over the edge.'
Yeah, right. That explains Iceland. All those Icelandic bankers scrambling to comply with the CRA.
Don't you guys read newspapers?
As is happening right now.
I believe bankruptcy was brought up in this thread because of the belief of free market idolators that intervention in markets is always wrong and that markets are self-correcting.
My bad if that was not the original thought behind the thought. But this is a libertarian blog, right?
Will you at least acknowledge that if markets are allowed to self-correct to the extent of reducing market securities valuations by 90% (as happened under Hoover), some firms that did not 'take too many risks' will be brought down?
Many solvent businesses failed for lack of liquidity.
I like to say that knowing economic history is a curse because it prevents one from swallowing those simpleminded but comforting bromides about how wonderful markets are.
Eager reads a lot of "history" but he doesn't know history. Unfortunately for us, his misconceptions are common these days.
The '29 market crash and the '07 market crash were both caused by the same thing: Wall Street was being operated as a bucket shop.
Credit default swaps are thought to have reached around $55 trillion, about as much as the entire asset value of the earth. Obviously, they were completely divorced from reality.
Funny how the markets failed to notice that.
As I've observed a couple of times on other VC threads, the Great Depression started in 1922. It was not interfered with by government regulators (except at the state level, where they failed) nor did it self-correct.
Roosevelt ran for president in '32 on a platform of government stringency. He changed his mind when, almost within hours of taking the oath, the financial system collapsed.
We know how to ruin a functioning economy -- at least, I do -- but it is not clear how you come in and set things to rights after it's been done, as Obama is learning right now.
The '70s were hardly a market failure. The most important resource, after land and labor, was revalued to somewhere near its reasonable place in the economy, with adjustments as expected. The '70s were one of those painful market corrections that the market idolators are always advising us to accept with good grace because things will be better after we've taken our medicine.
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