About Those Virgins

I don’t buy the arguments David Galland gives about the shamans and the virgins when talking about financial reform. He says:

dancing around open fires bedecked in certain animal skins or allowing shamans to sacrifice virgins were seen as effective methods for controlling the natural chaos of things.

He’s talking about policy makers in Washington of course. They are the shamans dancing around the open fires ready to sacrifice the ‘free market’ virgins in order to control the chaos that markets sometimes bring with them.

The thrust of his post – that over-regulation is poison – is something I agree with wholeheartedly. Moreover, I think David and I probably agree on a number of other things as well. One of them is that we never had free markets. In this sense I see the shaman and virgin analogy as a nice tale but a straw man argument that doesn’t really fit the bill. In my post "A more in-depth description of how elites maintain status quo ante" the virgins being sacrificed by the free-market poseur shamans dancing around the fire of crony capitalism are American citizens. What has really happened over the past quarter century is that special interests have gained so much sway over policy that even this financial reform bill crafted after a spectacular systemic failure is inadequate to deal with them.

But should we expect any different? Another point where David and I agree is where he says:

Most prevalent among the modern belief systems is that shamans of government and high finance can, by virtue of their Harvard degrees and clearly advanced intellects, effectively manage large economies. The fallacy in this notion should be evident to everyone – here in the U.S., it’s as simple as noting how everyone from the Fed chairman to almost all of the nation’s political leaders and the best and brightest on Wall Street failed to anticipate the current crisis. Any way you slice it, the lot of them were caught as flatfooted as the crew and passengers on the last voyage of the Morro Castle.

One minute, big party… the next, diving over the side of a ship to an uncertain future in mountainous, storm-tossed waves.

Clearly, the best and the brightest failed to foresee this once in a lifetime crisis. Why should we trust them to craft legislation to deal with the next crisis? We shouldn’t.

The question is what should we do then. David suggests we throw up our hands in disgust and allow the chips to fall where they may; that is the clear implication of his opening ship junket story. Give up, he says.

I take a different tack that hearkens back to my days in the technology and telecom industry. In the Internet world, any large business platform must deal with the complexity of millions of users with myriad different ways of interfacing with its service. This creates a mind-boggling complexity which can lead to catastrophic failures that result in hours of downtime or data loss and millions of lost dollars in revenue for the company and its users. We have seen these nightmares again and again. The first example that springs to mind is of AOL’s "America On Hold" fiasco when it switched to unlimited dial up Internet plans in the 1990s. We saw this type of service failure with Research in Motion’s Blackberry service going down, Google’s Gmail service going out out. EBay and Amazon have had these problems as well. And in some cases, like an infamous T-Mobile outage there was serious and permanent data loss.

Redundancy. That’s the word one learns from these scenarios. What any complex system needs is redundancy. David is replacing an all-consuming belief in the elite shaman policy maker for undying faith the free market shamans who tell us all will be well if we let the chips fall where they may. Both scenarios are not redundant. When failure strikes, it is catastrophic.

A better approach to regulatory reform is to build natural redundancy into the financial system. No system is fool-proof. But having multiple checks on system failure is better than having one.

Here’s how I would go about it:

1. Assume an unlevel playing field: if we assume that some actors in business are naturally advantaged and will use these advantages to tilt the playing field in their favour, we must assume these actors will overreach, take on too much risk and subject us all to a catastrophic failure. Therefore, we must devise rules of fair play which are both monitored and enforced through sanctions to prevent this. This necessarily means we have to have regulations and regulators. Assuming that markets are self-regulating is folly which invites bad behaviour. Do I want law makers dictating how private enterprises should structure their compensation schemes as the Europeans want to do? No, that is what I call regulation-heavy. But, I do want consumer protections (think seat belts or child labour laws), anti-trust laws (think cases against Standard Oil or AT&T) to be robust and enforced. To me this is the first line of defence against market failure.
2. Assume regulations are inadequate: I think the European proposals to regulate financial services compensation schemes are wrong. It’s over-regulation. And when there is bad regulation or over-regulation, one thing results: people devise (legal and illegal) schemes to get around the regulations. That’s certainly what has happened in the financial services sector. The profit motive is too large to prevent this sort of thing. And what invariably happens is that the market becomes distorted and more fragile as a result. This, in turn leads to unexpected and catastrophic failures.
3. Assume markets fail. We should assume that markets fail – and catastrophically. That means that we often reach a critical state where panic is the order of the day and where smooth bell curve mathematical functions don’t work. The likely outcome of these situations without a lender of last resort is catastrophic business failure and economic dead weight loss. This naturally leads to political chaos, economic depression and military adventurism. Allowing markets to fail and sitting idly by is not an option. This means we must create market structures, institutions, rules and safeguards to prevent liquidity crises from becoming solvency crises. This is a primary reason the Federal Reserve exists – to act as a provider of liquidity.
4. Assume regulators will be captured: But we should assume that these regulators will be captured by industry and fail. How else would you explain the sanctioning of increased leverage in the investment banking sector early last decade?  At one point in time, net capital rules which governed the amount of leverage investment banks could use limited them to 12:1 ratios. Policymakers changed the rule in 2004 to allow 30:1 leverage and the gross increase in balance sheets which ensued. Had Lehman been limited to 12:1 leverage, its failure would have been less problematic. How do we make this regulatory failure redundant? By creating a market structure that can handle failure. And that means, first and foremost, banks must be limited in size as a share of assets. Too big to fail is too big. Full stop.

My view is that systems fail and we need to be prepared for that failure. Throwing up your hands and acting like you can just give up and let things take their course is an invitation for anarchy and its necessary successor, despotism. What we should do is structure a system that sets basic mechanisms in place to prevent market failure but that is redundant enough so that it can deal with market failure. Moreover, one flaw need not bring down the whole system if it is redundant. We shouldn’t trust the shamans who counsel absolute faith in the infallibility of the policy illuminati. But neither should we trust the shamans who counsel absolute adherence to a non-existent free market.