Ms. Watkins, why does Charlie have lit dynamite?

You are a teacher at a local primary school. Each school day you and some of your colleagues watch over the children at the school playground to make sure all of the children follow the rules and keep their hands to themselves. Your role is to keep the children safe. Mind you, this is a Montessori School where the philosophy is to let children explore within set boundaries.  But, if a child hurts another or a child’s behavior poses an immediate risk to others, you always step in.

In fact, one child, Charlie has been a bit of a problem recently. Charlie is one of the biggest kids at the school, a boisterous sixth grader who likes to push and play with matches. Last July 4th, it seems he got a hold of a video on the Internet blog Credit Writedowns on how not to use fireworks.  Contrary to the video’s intention, he rather liked seeing things blow up and courting danger. You see Charlie is a bit of a pyromaniac. You have repeatedly had to stop Charlie from bringing matches to the playground and lighting things on fire. But, recently you have had to confiscate firecrackers and suspend him from school.

But, one day a new headmaster comes to the school. He doesn’t believe much in the need for teachers to monitor the children. The children can monitor themselves. Unfortunately, Charlie has a bit of a following at school and before you know a lot of the kids are lighting firecrackers on the schoolyard. No one gets seriously hurt – just a few minor burns here and there. So Charlie ups the ante to M-80s like he saw in the video. There was a serious close call when he put the frog in a jar with the M-80, but self-monitoring has worked pretty well and there have still been no major casualties.

That’s when little John comes up to you and asks, “Ms. Watkins, why does Charlie have lit dynamite?”

In case it’s not obvious:

• Charlie is a too big to fail bank.
• The matches are debt, the firecrackers are derivatives, the M-80s are asset-backed securities and the dynamite is OTC derivatives.
• You (Ms. Watkins) are Brooksley Born
• The headmaster is Alan Greenspan
• Little John is another smaller community bank
• The other children are banks and citizens of the broader economy
• The frog-glass incident was LTCM’s collapse
• The lit dynamite incident was Lehman Brothers

In the past, I have likened regulators to referees or playground monitors to illustrate why the concept that markets are self-regulating is absurd. In the last post, “Frontline – The Warning: Who Knew About the Looming Financial Crisis?” Alan Greenspan was at war with regulator Brooksley Born over this concept of self-regulation. Born believed that regulation was a necessity in any financial market. Greenspan believed that markets are inherently self-regulating. Even fraud was self-regulating through market discipline in his view. I believe he has now repudiated this. However, Born lost that battle with ugly consequences when the market she wanted regulated, OTC derivatives, blew up via AIG.

Self-regulation is to regulation as self-importance is to importance.

Note: Even though, I am pointing to Buiter’s piece here, I am not a believer in regulation-heavy in the least. Nevertheless, his ideas do merit consideration.