Streetwise Professor

May 3, 2010

“Reform” in Haste, Repent at Leisure

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 6:18 pm

A constant theme here at SWP, in my public speaking, and in my academic work has been the lack of serious thought underlying the financial bills currently slouching through Congress.  These markets are complex (in the usual sense of the word, and the more technical meaning of complex systems characterized by emergent orders and rich feedbacks).  Any major changes will have effects that are almost impossible to predict: and it is quite likely that the legislative effects will be quite different from those intended by its framers.  Or, as I put it in a policy paper for Cato that I just finished (first draft, anyways):

There is a “fire, ready, aim!” feel to many of the policy proposals emanating from Capitol Hill and the administration.  Prescription precedes understanding.  To evaluate the costs and benefits of clearing mandates, this order must be reversed.

The implicit judgment underlying the regulation is that the received structure is fundamentally defective, but there is no explanation as to why that is so.  There is no stepping back to ask: “Could there be an economic rationale for the arrangements that have emerged from the decisions of myriad economic agents?”  There is no grappling with the Coase question: no serious attempt to identify the source of transactions costs that could lead to the massive “market failure” that the advocates of major changes believe exists.

As I’ve said before: fools rush in where angels fear to tread.  Without understanding what is broke, and what isn’t, how can you fix it?

I am reminded of the time I was helping my grandfather fix a tractor.  I had the wrenches out and was ready to just start unbolting stuff.  He said: “Wait just a God damn minute.  Why don’t we try to figure out why it isn’t working first?  If you just take the damned thing apart it will be well and truly broken.”

Is it too much to ask the denizens of the 202 area code to wait a God damn minute and figure out what in the financial system didn’t work and why, before they well and truly break it in ill-considered efforts to “fix” it?

Well at least I have some company in my misery.  Today’s New York Times, of all things, has an article that highlights the foreboding of several other finance scholars:

Others simply argue that it is premature to pass sweeping legislation while so much about the crisis remains unclear and so many inquiries are in progress.

“Until we understand what the causes were, we may be implementing ineffective and even counterproductive reforms,” said Andrew W. Lo, a finance professor at the Massachusetts Institute of Technology. “I understand the need for action. I understand the need for something to be done. But what I expect from political leaders is for them to demonstrate leadership in telling the public that we need to proceed about this in a much more deliberate and rational and thoughtful way.”

. . . .

The most basic critique comes from Professor Lo and others who say that Congress is moving too quickly. The origins of the crisis remain a subject of intense controversy. Investigations continue to unearth surprising information. The Financial Crisis Inquiry Commission, a bipartisan panel created by Congress, is not scheduled to report until December. Why not wait, they ask, until the targets are clearer?

Exactly.  The article quotes others, including Lawrence White of NYU who almost sputters with indignation at the failure of any of the bills to address Fannie Mae and Freddie Mac at all.  But what would you expect from Barney Mae and Chrissy Mac?  Or is it Fannie Frank and Freddie Dodd?  Regardless, addressing that issue would raise the most embarrassing questions, like: WTF are the people who bear tremendous personal responsibility for one of the most costly aspects of the crisis–and what is arguably a key underlying cause of the crisis–doing in charge of “fixing” the system instead of donning sackcloth and squatting on a pile of ashes, begging abjectly for forgiveness?

In another misery-loves-company moment, from a truly unexpected source, Sheila Bair and the FDIC have come out against the derivatives spinoff provision of the Lincoln bill:

Federal Deposit Insurance Corp. Chairman Sheila Bair is opposing a Senate measure that could cut off privileges to banks like Goldman Sachs Group Inc. and JPMorgan Chase & Co.that don’t segregate swaps trading units.

Bair, in an April 30 letter to Senate Banking Chairman Christopher Dodd and Agriculture Committee Chairman Blanche Lincoln, said the proposal championed by Lincoln would create “weakened, not strengthened, protection of the insured bank.”

“If all derivatives market-making activities were moved outside of bank holding companies, most of the activity would no doubt continue, but in less-regulated and more highly leveraged venues,” Bair wrote. “Even pushing the activity into a bank holding company affiliate would reduce the amount and quality of capital required to be held against this activity.”

Not that Bair has gone the SWP full monty: she still favors the Volcker rule and mandatory clearing.  But at least she recognizes the completely insane and ill-considered, unlike Shapiro and Gensler.

But will any of these Cassandra-esque warnings, from Bair or from academics, make a difference?  Sadly, almost certainly not.  This whole endeavor is operating on a strictly political timetable, and is driven by a strictly political considerations.  It is the centerpiece of the Democrats’ attempt to salvage something from the upcoming elections.  And as such, thoughts about the economic rationale or consequences are irrelevancies.

Print Friendly, PDF & Email


  1. I think that different things require different regulation. For example, I have argued hard for ending payment for order flow, internalization etc-and that might work very well in the cash equity, cash options, futures, and prime brokerage currency markets-probably even the corporate and muni bond market-but it isn’t great for all markets.

    Lincoln’s bill will either kill OTC; or cause another crisis.

    Comment by Jeffrey Carter — May 4, 2010 @ 7:24 pm

  2. Or both.

    The ProfessorComment by The Professor — May 4, 2010 @ 7:45 pm


    Here is the CME chairman

    Comment by Jeffrey Carter — May 5, 2010 @ 4:37 pm

  4. Thanks, JC. Talking his book. No surprise there. I just find it very funny to see him on such good behavior.

    The ProfessorComment by The Professor — May 5, 2010 @ 8:18 pm

  5. […] doubly reckless to be a primary architect of a wholesale reengineering of the financial markets.  So this holds true too: WTF are the people who bear tremendous personal responsibility for one of the most costly aspects […]

    Pingback by Streetwise Professor » Sorry Don’t Feed the Bulldog — August 24, 2010 @ 8:41 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress