Joseph Stiglitz: Unfettered Markets Do Not Lead to Societal Well-Being

Joseph Stiglitz says deregulation has not worked:

Central banks need to act pre-emptively, not reactively, by Joseph E Stiglitz, Project Syndicate: Not surprisingly, the atmosphere at this year’s World Economic Forum was grim. Those who think that globalisation, technology, and the market economy will solve the world’s problems seemed subdued. Most chastened of all were the bankers. ... And it was not just the bankers who were in the Davos doghouse this year, but also their regulators – the central bankers.

Anyone who goes to international conferences is used to hearing Americans lecture everyone else about transparency. There was still some of that... I heard the usual suspects – including a former treasury secretary who had been particularly vociferous in such admonishments during the East Asia crisis -– bang on about the need for transparency at sovereign wealth funds (though not at American or European hedge funds).

But this time, developing countries could not resist commenting on the hypocrisy of it all. ... Had America really told others to bring in American banks to teach them about how to run their business? Had America really boasted about its superior risk management systems, going so far as to develop a new regulatory system (called Basle II)? Basle II is dead...

Bankers – and the rating agencies – believed in financial alchemy. They thought that financial innovations could somehow turn bad mortgages into good securities, meriting AAA ratings. But one lesson of modern finance theory is that, in well functioning financial markets, repackaging risks should not make much difference. ...

There might be some money in repackaging, but not the billions that banks made by slicing and dicing sub-prime mortgages into packages whose value was much greater than their contents. It seemed too good to be true – and it was.

Worse, banks failed to understand the first principle of risk management: diversification only works when risks are not correlated, and macro-shocks (such as those that affect housing prices or borrowers’ ability to repay) affect the probability of default for all mortgages.

I argued at Davos that central bankers also got it wrong by misjudging the threat of a downturn and failing to provide sufficient regulation. They waited too long to take action. Because it normally takes a year or more for the full effects of monetary policy to be felt, central banks need to act preemptively, not reactively.

Worse, the US Federal Reserve and its previous chairman, Alan Greenspan, may have helped create the problem, encouraging households to take on risky variable-rate mortgages by reassuring those who worried ... that there was at most a little “froth” in the market.

Normally, a Davos audience would rally to the support of the central bankers. This time, a vote ... supported my view by a margin of three to one. ...

It was interesting to see the different cultural attitudes to the crisis on display. In Japan, the CEO of a major bank would have apologised..., and would have refused his pension and bonus so that those who suffered as a result of corporate failures could share the money. He would have resigned.

In America, the only questions are whether a board will force a CEO to leave and, if so, how big his severance package will be. ...

This is the third US crisis in the past 20 years, after the Savings & Loan crisis of 1989 and the Enron/WorldCom crisis in 2002.

Deregulation has not worked. Unfettered markets may produce big bonuses for CEOs, but they do not lead, as if by an invisible hand, to societal well-being. Until we achieve a better balance between markets and government, the world will continue to pay a high price.

Comments

[Bruce Webb]

I suppose I should be embarrassed at insisting on taking a historico-politico data infused approach to some of these economic programs while ignoring the rock solid logic of the neo-classicists, after all if we had granted them every single naive view of how humans actual psychology operates and ignored history as it actually played out they had a good case. Kind of like the one my parents sold me about Santa Claus. My older brothers clued me in at a pretty young age, why does the U of Chi GSB still try to convince us that the Easter Bunny is still delivering eggs and that the Tooth Fairy is just a manly, manly spirit that has an odd attraction for small childrens' teeth.

St Ronnie is not coming back and he would not recognize the totality of the message no being delivered in his name. Not that he would disagree on the substance necessarily it is just that he couldn't have Imagined they would have been able to sell this with a straight face

[yamada]

So, what has to be done from now on, under the situation?
I think market should fail, so there must be a remedy.
Even though "the world will continue to pay a high price", we must think the remedy to minimize "a high price".

[Bruce Wilder]

At the heart of the present crisis was a huge expansion in irresponsible, high-risk lending, at the height of a housing bubble, apparently driven by what bankers seem to have thought was an opportunity to disintermediate the risks through securitization: slice, dice, get it off the books, slap a AAA credit rating on it, and send it on its way to a greater fool.

Stiglitz seems to think it clever rhetoric to assert "banks failed to understand the first principle of risk management", but, somehow, I doubt that explanation, even if I could forgive the comical reification. Yes, if only we could enroll more young bankers at the Stiglitz School for Wayward Youth, where they could learn finance theory and risk management, and finally understand, understand, understand.

At the Wilder School for Delinquent MBAs, we have a phrase for what went on; we call it, "Take the Money and Run". When you see a character like Angelo Mozilo stuffing his pockets and putting on his track shoes . . . well, you don't wonder if he knows the first principles of risk managment. He does, and he's putting them into practice.

[hari]

JS - repeats the arguments we've made here (since last Aug)
when the credit crunch index started showing in Feds assessments, and media frenzy started.

In hindsight, I suppose there's not much more to do now but to allow the market to bottom out...with a recession that smells more like a stagflation.

[pgl]

Something tells me that Milton Friedman might have agreed with one aspect of what Stiglitz wrote. Stiglitz suggests that all this fancy repackaging would not increase efficiency because financial markets had already rung out most of the inefficiencies from not having diversifiable risk diversified. Yet the architects of all this financial engineering want to make megabucks anyway. Making megabucks in an already efficient market requires some sort of wealth transfer which can be accomplished by sleight of hand risk transfers. Of course Friedman might also wonder why the sleight of hand does not already become transparent in a free market.

[paine]

bwilder
perfect comment

the nub :

"dearest sheep faced joey s
for the love of allah
call em all looters bandits and beasts
and walk ...away "

i wonder if joe needs to feel
he 's in a north world
dominated globe
chock full
of noodle head bankers
in charge of it all
instead of board room thieves
or
he's trying to remain both
"right "
and "comfortable"

as in ...just looking
to be polite enough
to get invited back next year

[save_the_rustbelt]

For a little balance, deregulation has led to valuable innovation, more options for consumers and lower prices for services.

Regulation tends to protect large corporations from competition by entrepreneurs (remember when ITT and IBM were going to rule the world?).

So let's not throw the baby out with the bath water.

And besides, we do not have a deregulated economy, we have a less regulated economy.

[ken melvin]

I ask you, what's wrong with a little innovation? Skimming you say? Ah but you didn't catch on whilst we were stirring the pot. And look, can you tell the difference twixt mine and the sucker's who worked for his? Money's all the same no matter how you make it.

[bakho]

Great post.

Monopolies (Enron for instance) can form just as well under "dereg".
ATT and IBM are in a different market position because of technology changes. We no longer rely on wires and mainframes.

[zinc]

The deregulation movement has been a disaster for Americans, leading to inefficient markets, increased risk, wealth polarization, bubbles, destruction of personal savings, unsustainable leverage, industrial concentration, weakening of US competitiveness, fascism in the political sphere and militarism, inter-generational debt transfers, legalized loan sharking. With each repeal of post-depression regulation, we retrace the the path to the great depression.

Methinks that deregulation is not the only problem. The lack of enforcement has resulted in de-facto repeal of all regulatory protections. All the written laws in the world will not help when an out of control executive branch of government refuses to perform their constitutional duty to enforce the laws of the land.

On "cops" last night, I watched three squad cars take down a pathetic drug addict who had stolen a wallet. The victim didn't want to press charges so they hauled the guy to jail on a warrant for lieing in the middle of the street. He should have been an investment banker where there are no cops.

[barry payne - economist]

the internet is a good example of fusing extensive government regulation of efficient network monopolies with the private sector to allow "unfettered" vibrant competition among the end users of content that takes place across the surface of these networks

the primary reason the U.S. lags so far behind globally in internet bandwidth and penetration is open, hostile aggression by the private sector, which intends to privatize and strip free of regulation the provision of facility-based networks as they roll over the pols to do it

"Whiticare tiering" refers to intentions by the prior CEO of AT&T, Ed Whiticare, to assess additional charges to parties that provide "content", claimed by Whiticare to use "our pipes for free" ...

it's a form of content discrimination that could never occur under effective competition, and if it succeeds, it will suppress extensively the existing competition on the internet

individual intentions versus ... constraints? failed outcomes for lack of understanding? systemic failure?

the fundamental objective is to undermine competition at the outset, shut down the transparency and replace it with a MSM PR machine that barks in an audio loop "private success - government failure" in Orwellian fashion exactly as it exploits government means towards private ends

when serious competition appears despite efforts to design it out of the structure, like among end users on the internet with near zero cost of entry and exit, it can't be left alone as a success of combined government and private sector effort, to be expanded as is ... instead, it becomes another opportunity to segment the market and generate more revenue ...

the hell with competition and efficiency, isn't everyone a "content provider" on welfare using "our" system for free?

Angilo Mozilo and Ed Whiticare, two peas in a pod

[johnchx]

Perhaps this is just a language nit, but does anybody have any idea what "deregulation" Stiglitz has in mind? Specifically, what part of the mortgage securitization process (which is where he seems to focus) does Stiglitz think used to be illegal, but isn't illegal anymore?

More generally, of the three crises Stiglitz talks about, only the S&L crisis would seem to be the direct result of a specific act of deregulation. Enron didn't collapse because it was allowed to trade natural gas futures, and WorldCom's fraud didn't arise from the fact that the company was allowed to sell local phone service. And, off the top of my head, I don't know of any significant regulatory change that contributed very much to the sub-prime crisis.

I suppose one could point to the repeal of Glass-Steagall (signed by Bill Clinton in 1999), which allowed commercial banking under the same corporate umbrella as investment banking. But so far, that aspect of deregulation appears to have performed more or less as intended: diversified financial companies like Citibank can remain profitable even in the face of significant losses in one or two of their lines of business.

Not that there aren't some increases in regulation that would have been helpful. Personally, I favor two: (a) rules to effectively eliminate off-but-not-really-off balance sheet SIVs "sponsored" by commercial banks and (b) "suitability" requirements for mortgage originators, similar to the rules that apply to securities dealers. And I'd favor eliminating anything that links regulation to the work of the ratings agencies; ratings agencies aren't bank-examiners-on-the-cheap, they're like the op-ed page of the Wall Street Journal: for entertainment purposes only.

But I think it's a mistake to characterize the sub-prime crisis as a result of "deregulation." Am I missing something?

[mort_fin]

johnchx - I think that you're right, but I understand the semantic shorthand that Stiglitz is using. In the Enron case, some of the lack of transparency arose from the growth of an unregulated OTC derivatives market at the expense of the regulated exchange market, and in the mortgage lending case much of the trouble traces to the growth of unregulated mortgage banking at the expense of regulated depositories / GSEs. It isn't literally deregulation, but to the extent that an unregulated substitute grows (possibly because of the regulation in the traditional sector) and the regulatory authorities don't expand to account for the growth of the substitute market, you have a decrease in the percent of the market regulated.

[Darren]

paine, I'd just like to say that your comments in the form of poems are a delight. (and they would be even if I didn't agree with them 99% of the time). Keep it up!

[anne]

The mortgage crisis, or rather the subprime mortgage crisis is not a result of financial deregulation or a result of conglomeration. The Federal Reserve always had an understanding of how the subprime market worked, and always was able to immediately limit the issuing and packaging of these high priced products.

Where the problem resided was in not paying attention to the incentive of lenders to use subprime mortgages excessively because they were so profitable. High cost mortgages are highly profitable when paid or wne packaged and sold to investors. There was then reason for abuse from lender to packager.

But, as I have often written the abuse was written about in the New York Times as early as 1999 and several time after on the basis of studies extending from as early as 1994. The abuse was especially clear from the perspective of African Americans and mortgage abuse of African Americans however long understood has simply been ignored by financial companies and regulators.

[ScentOfViolets]

At what point does stability become more important than growth? I'd much rather have reliable investments that accrue three percent interest year after year than an environment where swings from one hundred percent plus to minus five hundred aren't uncommon. Sure, the latter might result in a net average growth of, say, four percent, rather than three. But is that the only relevant number? This seems to be the position of many free-market ideologues these days.

[James Kroeger]

yamada:So, what has to be done from now on, under the situation?
I think market should fail, so there must be a remedy.
Even though "the world will continue to pay a high price", we must think the remedy to minimize "a high price".

I agree that the bankers need to fail and pay a very, very steep price. That would happen if a snowball of bankruptcies was allowed to occur. Of course, if we let that happen without government intervention, all of the money in the economy would immediately dry up and the Next Great Depression would be on. Unfortunately, that isn't an acceptable choice.

At the same time, I am adamantly opposed to any kind of taxpayer bailout, whatsoever. What is left? I think that each bank should be allowed to fail utterly, and at just the right time, Congress should buy up as many banks as it can at firesale prices, effectively nationalizing most of the industry. These banks would then be immediately re-capitalized by the taxpayers and the money-lending spigot would be turned on, only this time the Bad Guys would not win and the taxpayer would at least get something for contributing some of her resources to saving the economy.

Is there any other alternative that would force the financial industry to pay the severest price imaginable while still not allowing the economy to collapse in a heap?

[calmo]

So many good comments (to follow Darren's spot light with a flood light...and extend bakho's remark about Mark's post to all these responders), tis inspirational to wake up to you people Sunday morning [Yes, that is the low-ball cash-in of "good comments": gets calmo's ass in gear.]
Let me connect ScentO's note about stability/growth and zinc's what is this thing called deregulation, honey?.
That was easy.
But showed no growth, and was bereft of any regulation or process by which we might learn the nature of the connection however fragile and tentative non-existent it might appear.
So what is required is more than the PR that a connection exists? This could be trouble, --actually defending some proposition rather than merely pastin it out there...but it can be a joy too, just sorting ideas out no matter whether they add to your financial position...or detract from it (like this, for those who could be in hot pursuit of a shorting strategy). [This is the definition of an academic, yes? wastrels thinking for no gainful employment...luckily harnessed by institutions.]
It is said (ok, writ vicariously) that HFs need more regulation, but what is meant (turbo vicariously) is that we need more accountability --they themselves need to respect the rules and regs to make the trades they do, so they are not short of rules. It's just that they (writers of the regs!) draw the distinction between themselves and the inhabitants of the economy who have no business (other than the people's money) meddling in their financial affairs...which are only for the economy's well being...starting with HF managers and those bargain $1.7B "earnings".

[bob]

A predatory system having troubles ?

Gee who ever woulda thunk.

[anne]

"For a little balance, deregulation has led to valuable innovation, more options for consumers and lower prices for services."

Seriously, where when how which? What am I missing? What valuable innovation came of financial company deregulation since 1980? More so, what low prices, where? Financial company prices are high to the point of mockery. The thought of retail banking or investing with a Bank of America or Merrill or Chase or Morgan Stanley is absurd.

[Winslow R.]

Nice post and comments.

BTW we have been posting on this for a least 2 years (when I started) and one of the reasons I stayed.

James K wrote: "Is there any other alternative that would force the financial industry to pay the severest price imaginable while still not allowing the economy to collapse in a heap?"

Give citizens access to the Fed.

Citizens would lend to other citizens by trading citizen loans (home, car, student) for fed funds.

Corporate banks would lend to corporations by allow banks to trade corporate loans for fed funds.

Cut banks down to size. Corporate entities have no one to hold accountable. Citizens are unable to escape their identity.

[anne]

"For a little balance, deregulation has led to valuable innovation, more options for consumers and lower prices for services."

Financial companies were allowed to compete more since 1980, but never did; while there is as much ability to regulated financial products now as in 1980, only regulation has carried no meaningful monitoring to limit financial crises these 25 years.

Please, please, please, show me where John Bogle and David Swenson are wrong when they complain of the astonishing failure of financial companies to compete in terms of prices or correspondingly innovative products?

[anne]

The mortgage crisis has nothing at all to do with innovate products or low products, but quite the reverse. Mortgage bond packages have been there dor decades, and the mortgage crisis is a crisis of absurdly high priced products. The vibrance of the subprime mortgage market where African Americans in particular were needlessly sold overpriced mortgages for years and years, shows hoew little competition there is among financial companies.

[anne]

Warren Buffett was taught decades ago, and later taught in turn, just how little effective competition there was in the insurance industry, as Berkshire Hathaway much to the surprise of many became a monster insurance company by being among the very few to actually compete. In 1980, the mutual fund industry was dominated by insurance companies (really). The startling lack of meaningful competition among insurance company in mutual funds, led to the funds becoming a lost industry by 1990, simply because Fidelity became less outrageously expensive and always competitive Vanguard simply grew to all sorts of financial industry surprise.

[Winslow R.]

For what its worth, I have much easier access to funds than I did in the 1990's even after the latest round of credit restrictions. I'm not sure if today's 25 year olds have easier access than I did.

When I was 25, if I had been able to access money from banks, I could have done more as only a 25 year old could do. To a 25 year old, it doesn't matter if you can only access funds at 3% higher than the banker pays as no 'old' banker could compete with me.

What really mattered was I had access through friends and family.

Now that I am older/wiser/more cautious, I have a harder time competing with that 'old' banker. Now that 3% difference is too much to make me move, though now I have access I don't have the youthful energy to make marginal enterprises happen.

This is not to say I now sit idly by ..... I post.

[NLS]

Could we please get some libertarian nonsense?

[donna]

"Could we please get some libertarian nonsense?"

JP Morgan, Citibank, et al: "And I would have gotten away with it, if it wasn't for you pesky kids!"

[George F. Smith]

The one thing we don't have and have never had is an unfettered market. Not even close. To blame any outcome on an unfettered market plays to the politicians. Deregulation is not the same as no regulation.

[Bruce Wilder]

johnchx: "Perhaps this is just a language nit, but does anybody have any idea what "deregulation" Stiglitz has in mind?"

I wondered about this, as well. It's not just a language nit.

Stiglitz seems to be engaged in the same kind of superficial gloss I am prone to in writing blog comments. I am too lazy to go look something up, or spend an afternoon writing down equations, or really puzzling over how to translate a mass of detail into accurate generalization. So, I reach for the already famous quote or event that seems to me to be likely to arouse in the reader the desired reaction, and I kid myself into thinking that the result will be a shared insight. Economists, who teach, call this communication process, "hand-waving" and it is a large part of what makes lectures effective.

Bereft of the emotional clues of an in-person lecture, written on the page, and restricted to the too few words of a blog post or newspaper column, it is far less effective, I think, than in the classroom (and it is not all that effective in the classroom; lectures are a primitive technology, and "hand-waving" a crude craft skill at best).

I don't think you, Johnchx have missed anything. But, "regulation" and "deregulation" have assumed a conceptual generality in Stiglitz's mind, which differs from that in your mind. As mort-fin comments, Stiglitz is using a short-hand, and I can only guess at what the original text might be. I suspect that, for Stiglitz, WorldCom and Enron got into trouble, because the executives thought they would not get caught, because the watchdogs were no longer watching.

For Stiglitz, the elaborate apparatus of financial reporting and auditing, that flows from the SEC through the professions of law, accounting and auditing, constitutes "regulation". There was no formal de-regulation, but there was a marked trend of many subtle changes, culminating in the election of George W. Bush, which many in business took as a signal of a further stepdown in scrutiny. (That this was true among the players at Enron and WorldCom has been documented. Both these companies took fatal turns immediately after Bush's inauguration.) Now, the immediate agents of ill-advised permissiveness were auditors and banks, not government regulators, per se. And, as it turned out, the agents of legal retribution -- government lawyers -- had not all retired, after all.

Conceptually, for many people, litigation is not regulation, but an alternative to regulation. And, the elaborate, but private apparatus of, say, the Financial Accounting Standards Board, or the AICPA's GAAS is not regulation -- or at least not government regulation, even if the SEC lurks somewhere in the shadows. And, changing the SEC chair from Arthur Leavitt to Harvey Pitt does not constitute de-regulation of any kind.

But, perhaps I construe Stiglitz's use of "deregulation" too narrowly, by focusing on the financial and accounting frauds. Stiglitz is engaged in a lazy rhetorical tactic -- using the notorious as a symbol, without specifying what "thing" is, he wishes to symbolize.

For Stiglitz, Enron and WorldCom may also be associated with the deregulation of power and telephone service, respectively. Deregulation of those broad markets made the high-flying of these companies possible. WorldCom's financial reporting fraud was possible, in part, because it aligned with a popular story about the increased efficiency of a deregulated industry; the corrosive effect on the then, still-honest AT&T is less well-known. Enron, famously, made stole a lot of money, courtesy of George W. Bush's FERC, in the partially deregulated California electricity market. But, it was only one instance of one company, in an industry whose de-regulation over the course of a dozen years was marked by much criminal conduct.

There was a Star Trek: Next Generation episode, "Darmok", where the universal translator fails, and Picard and crew must struggle uncharacteristically to communicate with alien Tamarians, who say things, like, Rai and Jiri at Lungha. Rai of Lowani. Lowani under two moons. Jiri of Ubaya. Ubaya of crossroads, at Lungha. Lungha, her sky gray.

The problem turns out to be that the Children of Tama (Tamarians) communicate entirely through allusions to their shared mythology.

Stiglitz is making an allusion to his mythology of deregulation, without bothering to acknowledge that political competition has introduced a struggle between contradictory mythologies.

Deregulation was introduced as a meritorious technical reform backed by economic theory and a model of calculated risk, but quickly became a magical policy backed by an ideological mythology. This was because technical errors in implementation -- the "bugs" -- became the most attractive features of deregulation policies for politically interested parties.

If you want technically-flawed policy, if your job is to advocate for technically-flawed and therefore, bad policy, you have to have a good cover story and a ruthless streak, and you need an audience of fools and worse. You need Karl Rove and Jack Abramoff and Larry Kudlow and Greg Mankiw, and Save-the-Rustbelt.

I am not sure Joe Stiglitz, with his own mythology, is much of an antidote.

Where's Glinda and her snow, when we are asleep in the field of poppies?

[Cynthia]

Well said, Bruce (Webb and Wilder)...well said (as usual).

[gordon]

Bruce Wilder: "There was no formal de-regulation...". What about repeal of Glass-Steagall?

[Peter Schaeffer]

All,

Was Enron brought down by a lack of regulation? In a very simple sense, of course not. Enron was crashed by a combination of a liquidity crisis triggered by a crisis of confidence and a solvency crisis brought on by failed investments (Dabhol, Azurix, broadband, etc.). To this day it doesn’t appear to be clear how important liquidity versus solvency was.

Enron’s energy trading business appears to have been profitable until the end. Indeed, Enron’s top traders have done quite well post-Enron. While Enron’s trading businesses consumed the last bits of cash the company had in the final days, it is hard to blame profitable divisions for the failure of any company.

Conversely, Enron’s energy projects business (expanded in water and telecoms) consumed vast amounts of capital and led to large losses. Enron tried to hide these losses via SPE’s. Eventually, the SPE’s started to fail bringing down the parent company.

Was a lack of regulation responsible for any this? Not directly. However, it can be broadly argued that the overall deregulatory climate of the times gave license to executives and accountants to do things that in a more straight laced time would not have been contemplated.

This applies to the inner workings of Enron as well. The energy projects business was riddled with poor practices, conflicts of interest, and fraud that would never have been tolerated in a more disciplined climate.

If that sounds like the dot com bubble of the 1990s or the housing bubble of 2006/2007, it should.

[gordon]

I think Zinc ("The lack of enforcement has resulted in de-facto repeal of all regulatory protections"...) is definitely on to a major aspect of what "deregulation" means in practice. Public Citizen has an interesting paper (May 2007)(.pdf) on deregulation of electric power. A quote:

“For the last 10 years, the Federal Energy Regulatory Commission (FERC) has embarked on an experiment in elctricity deregulation, replacing 100 years of cost-of –service regulated rates with prices in many parts of the country now set by market-based prices, thereby treating an essential service – electricity – as a commodity. Deregulation meant breaking up vertically-integrated companies and allowing newly deregulated power plants to sell power at the highest price they can charge, compared to the original model where prices were directly died to costs, plus a reasonable, regulated profit. As a result, prices in deregulated States are higher and are climbing faster than in those States that remain regulated, as wholesale competition has failed to materialize…

The crux of the problem lies with FERC’s failure to regulat wholesale markets by refusing to review rates charged by power sellers. FERC allows power marketers and other suppliers to charge market-based rates without any regular review to ensure that such rates comply with the Federal Power Act’s mandate that all rates be ‘just and reasonable’…” (my emphasis).

There are probably several aspects to "deregulation", including repeal of regulatory laws (Glass-Steagall), removal of powers (like State electricity-price fixing powers) and refusal of regulators to enforce. There are probably trade-related aspects too, as when a free trade agreement allows entry to products (Chinese toys) which couldn't have been sourced in the US at such low standards. Maybe others?

[Farrar]

John chx
"But I think it's a mistake to characterize the sub-prime crisis as a result of "deregulation." Am I missing something?"

Yes, you (and others) are missing the obvious. It's the philosophy, or rather the mythology of deregulation which has led to a progressive refusal to enforce regulations and laws on the books. If anyone at the Fed or the treasury really wanted to - assuming they had the budget - they could easily have stopped the sub prime fiasco before it ever got started. Stiglitz's criticism may have been technically inaccurate, but essentially he was right on the mark.

[James Killus]

Let's see if I understand what Bruce Wilder has said: There is no such thing as "deregulation"; there are only differing forms of regulation, with regulators also having great leeway in what regulations are to work for whose benefit. With the coronation of G.W. Bush as the Regulator in Chief, all regulations were at last understood to work in favor of concentrating wealth to the greatest extent possible. (Earlier, there was occasionally some confusion on that point).

Of course I may have misinterpreted BW's position as being almost exactly my own. Either way, I believe it's spot on.

[Winslow R.]

Farrar wrote: "Yes, you (and others) are missing the obvious. It's the philosophy, or rather the mythology of deregulation which has led to a progressive refusal to enforce regulations and laws on the books."

While I sympathize, I believe the philosophy/mythology of regulation/deregulation doesn't matter, when it comes to banking. My intuition says the power that emanates from money creation can resist containment by the state as it is on an equally if not more powerful footing. The structure of global finance is more highly developed than the structure of global government (hence Stiglitz's disgust with Basel II).

Only the market cycles of boom and bust, feast and famine, war and peace have tamed/shamed the financiers.

Stiglitz is finding the idea that the state could optimally regulate banks, laughable.

There has yet to be 'optimal' banking.

[Bruce Wilder]

Peter Schaeffer says...

"Was Enron brought down by a lack of regulation? . . . it can be broadly argued that the overall deregulatory climate of the times gave license to executives and accountants to do things that in a more straight laced time would not have been contemplated."

I think that could be narrowly argued, as well. And, was so argued, quite convincingly in courts of law.

Let's not forget that Arthur Anderson met its demise along with Enron, because Enron was only the last in a series of cases in which Arthur Anderson had failed to do the auditor's job on behalf of the public interest.

And, the major reform to come out of Enron/WorldCom was Sarbanes-Oxley, which transferred primary responsibility for certifying the accuracy of financial statements from auditors to executives.

A lot turns, here, on whether you think "regulation" includes these basic institutions for assuring the integrity of public companies. In my mind, it does.

[Peter Schaeffer]

Bruce Wilder,

Your narrow argument fails because Enron was convicted under existing law, not SOX or any other post-Enron act. Taken literally, you appear to claiming that there was nothing wrong with the legal and regulatory structure Enron operated under (or more correctly violated), because Enron’s executives were readily convicted.

Really? There actually wasn’t something seriously wrong with the business climate that produced Enron and Worldcom? After all Bernie Ebbers went to jail.

As for Anderson, the Supreme Court overturned Anderson’s conviction. The decision was unanimous.

[Lafayette]

Basel II will be back

Article: Basle II is dead...

So, George has converted himself to the forensic sciences?

Does this look like Basel II is "dead"? (Look at the "Latest News" caption, below on the page linked.)

Basel II is on the back burner, perhaps. The times being what they are, with too much of a financial mess about, it may not be called upon as the Saviour of International Financial Risk Taking in the immediate.

But, once the losses are fully purged from the banking system -- as is happening when banks declare losses on sub-prime debt (a process that will take at least a year). Then, and only then, will a sense of rational take the place of frenzied fear.

And, governments start looking for longer-term solutions. Basel II will be back as Basel III. Derivatives traders beware ...

[Lafayette]

Ditto, the accrediting agencies

BW: A lot turns, here, on whether you think "regulation" includes these basic institutions for assuring the integrity of public companies. In my mind, it does.

Agreed. Ditto, the accrediting agents, this time around.

Finance is rife with management that can't seem to get a handle on the notion, "Enough is enough". They just look ravenously at the year-end bonus; meaning the Ferrari, the house in the Hamptons, the summer villa in St. Tropez and/or year-round apartment in Paris XVIeme. (Tell me what you worship and I'll tell you who your god is ...)

Picked up on the D&B site:

About D&B

D&B (NYSE:DNB) is the world’s leading source of commercial information and insight on businesses, enabling companies to Decide with Confidence for over 165 years. D&B’s global commercial database contains more than 125 million business records. The database is enhanced by D&B’s proprietary DUNSRight’ Quality Process, which provides our customers with quality business information. This quality information is the foundation of our global solutions that customers rely on to make critical business decisions.

Yeah, right, Decide with Confidence -- note the capital letters. So, how did they get the sub-prime business sooooooo wrong? Talk about Marketing hype ...

[Lafayette]

PS: As for Anderson, the Supreme Court overturned Anderson’s conviction.

Right, just like Microsoft, after having been convicted for "Abuse of dominant market position", was let off with a slap on the wrist. Was abuse proven by the lower court, yes. Did anyone go to jail for bilking the public on Window's sales? No. Was MS fined for abuse? No.

Not until the European High Court condemned them first for Abuse I, along the same lines as the lower US court, a few years ago. And again recently for Abuse II. So, what does this mean? (Total value of fines: About three/four days of MS revenues.)

It means that the regard to BigBusiness is far different from Europe to the US. Which courts has the more objective POV?

I leave the answer to your imagination.

[Lafayette]

Right, Virginia, there IS a Santa Clause

PS: As for Anderson, the Supreme Court overturned Anderson’s conviction.

Yes, they are also experts in dimpled ballots and punch-card holes that were not pushed hard enough to make the chad fall off.

Which tells us what? That THIS Supreme Court is objective?

Yeah, right, Virginia, there IS a Santa Clause ... nine, in fact, in dark robes sitting on a High Court bench. For which, Father Christmas was a tad early with lead-head's Christmas present in December of 2000.

And, aren't we all soooooooooooo pleased with the consequences!

[prostratedragon]

"Innovation" would have to include the restructuring of the lending process from both the borrower and lender perspectives, I should think. Ditto the partially related nationalization of the mortgage lending process and the relaxation rules under which banking entitites could tap the funds of the Federal Home Loan Banks. And the repeal of Glass-Steagell already mentioned must have had some effect in changing the costs and regulatory burdens of engaging in various activities.

Of course, I have no idea whether Stiglitz would know or care about such things.

[reason]

I feel people here are generally on the right track, that it was more a failure of supervision that of regulation as such. But I think the problems with the financial system are more basic than that. The problem lies with a system that incentivises inherently risky behaviour and lacks automatic rebalancing forces. I'm sure part of the problem lies in the combination of the ability to electronically create credit (and hence money) combined with limited liability status (so that you can take one-sided leveraged bets without risking your solvency). Financial returns have lost all connection to underlying value because leverage is no longer constrained. Please tell me why I'm wrong.

[reason]

Just to be clear
... without risking your PERSONAL solvency ...

[Peter Schaeffer]

Lafayette,

In the American legal system a unanimous Supreme Court decision represents a very clear consensus as to the issues at hand. Note that Bush vs Gore was a 7-2 and 5-4 case by contrast.

[Winslow R.]

reason wrote"The problem lies with a system that incentivises inherently risky behaviour and lacks automatic rebalancing forces. I'm sure part of the problem lies in the combination of the ability to electronically create credit (and hence money) combined with limited liability status (so that you can take one-sided leveraged bets without risking your solvency)"

I remember a time Mark discussed the dissonance between government creating or regulating markets.

Automobiles are not created by government but they are regulated by them.

Money is created by government/banks and regulated by government/banks.

See the problem?

A unfettered market allows a 'promise to pay' to be manufactured by anyone not just government/banks.

Until the 'real world' money creation process and its resulting regulation recognizes this reality, we will not move forward. Technology has now advanced to where citizen money creation at the Fed can become a market reality.

[Lafayette]

The fit finally hit the shan

reason: I'm sure part of the problem lies in the combination of the ability to electronically create credit (and hence money) combined with limited liability status (so that you can take one-sided leveraged bets without risking your solvency).

OK.

No one "creates money electronically". One borrows or loans money. One may even sell or buy financial instruments (that contain intrinsic monetary value). But the electronics are there to conduct the transaction, not create the money (out of thin air). (Unless, of course, a trader commits fraud.)

Banks/Investment houses have operating funds that have been accumulated over the years, that are put to work everyday buying and selling, thereby arbitraging and making a profit -- which enhances profits. The pool gets larger and leverages further profits.

The traders who do this are not terribly brilliant people. The Frenchman who busted SocGen had a good Finance degree, but the Englishman who broke Barings did not. Most are just gamblers, playing the numbers. But, it's not exactly a lottery.

And, the gains are highly enticing. SocGen, arbitraging derivatives, was earning more than 50% of its net profit from such trading. All the rest was fairly normal banking business, such as bank accounts, credit/mortgages, etc., etc. So, to get the best traders they had to pay the best commissions.

However, I quite agree with you. A bank can make perfectly honorable profits from arbitraging and offering a modestly well salary. Giving 5% of net profits to the Golden Boys is asking for trouble. Some will be prompted inevitably to take short cuts. It happens time and time again.

It is not by calling upon an industry to reduce commissions that any change can occur. It is by confiscatory taxation above a maximum limit that such can be accomplished.

NB: And at SocGen, due to fraudulent trading, the fit finally hit the shan. At Goldman Sachs, however, the bonus pool was in billions of dollars. The difference being that GS had compliance mechanisms that proved to be faulty at SocGen. I can assure you that SocGen will go out of its way to make sure the honest traders get their commissions. Or, these people will be out the door in a nanosecond, working at some competing bank.

[Worker]

As close to libertarian nonsense as I can muster.

The US has too much regulation generally, but too little effective regulation of the biggest banks. What we need is additional regulation targeted at the largest banks, who have demonstrated time and again their propensity for creating bubbles.

I like Stiglitz' point that preemptive moves against asset bubbles by the Fed and regulatory authorities would be a first step to taking back control of the economy.

In generally, however, the big banks (eg. Citi) love regulation. Regulation creates barriers to entry and economies of scale (compliance costs). Compliance with existing regulation rarely protects investors from their latest schemes. But compliance costs do help the big banks squeeze out any small/ mid-sized competitors (eg. AG Edwards).

There is oodles of regulation governing the US financial sector. Unfortunately, most of these regs are burdensome without benefit, and in-fact counterproductive in that it promotes the too-big-too fail money center banks and their various socialize-the-costs bubble blowing schemes.

[anne]

"There are oodles of regulation governing the US financial sector."

Agreed; which is what makes 25 years of saving and loan crisis, and commercial bank Latin America crisis, and commercial bank domestic crisis, and mutual fund Mexican crisis, and investment bank bond derivative crisis, and hedge fund bond derivative crisis, and mortgage banking crisis so interesting.

I could easily add more to the list with minimal thought.

[Worker]

Look at the previous bubble scam perpetrated by the big banks prior to junk mortgages- dot com.

Enron and World-Con were big-bank modelled frauds built in the mold of Wall Street itself. But these frauds couldn't have existed without the financial oxygen provided by the big banks for big fees.

Yet instead of serious regulation of the banks, we hoisted Sarbanes Oxley on US businesses, 98% of whom were not engaged in fraud and bubble speculation. ~$1 trillion USD was spent by companies complying with largely non-sensical rules with little or no value to investors.

One result- the cost of going public is sufficiently high that capital raising below $250mm is pushed into the private market. Guess what? Only the biggest banks can underwrite IPO's this size. So the perpetrator benefits from protective legislation at the expense of US businesses, investors and consumers.

At a cost of $1trillion, the prescribed regulatory solution did nothing to deter their next recent bubble fraud.

Now they will rinse and repeat. Sickening.

[Worker]

Citibank seems to be front and center of every crisis.

Amazing how they stay in business.

[anne]

Interestingly, Citigroup was among the largest of international bankers in Argentina through the period of the Peso-dollar peg but Citigroup was not adversely effected by the currency crisis. The reason is that the currency peg was kept long after it was evident to all that Argentina's domestic economy was beyond recession. Citigroup's invesment in Argentina was basically short-term capital that as long as the peg was kept meant Peso assets could be sold for dollars with no currency loss. There was massive selling of Peso's well before devaluation.

The international investors in Argentina who were hurt were curiously retail investors who had bought long-term Argentine bonds.

[Winslow R.]

Laff wrote: "No one "creates money electronically". One borrows or loans money."

You are mistaken as banks do create money electronically.

When a bank creates a loan, it creates a loan and a deposit at the same bank. That 'electronic' money need never move from that bank. Not ever.

Money can be electronically credited from the deposit account to the loan account as the months go by until the deposit account has been drained. If the bank charges more interest on the loan then it pays on the deposit, the borrower will never be able to pay the loan with just the money at the bank. A paradox that can be remedied by the borrower doing some work for the bank.

If that deposit account is a money market account no reserves are required.

[Winslow R.]

"There is oodles of regulation governing the US financial sector. Unfortunately, most of these regs are burdensome without benefit, and in-fact counterproductive in that it promotes the too-big-too fail money center banks and their various socialize-the-costs bubble blowing schemes. "

Very well put. The oodles of regulations are required to try and plug all the holes created by this unnatural monopoly. Most banking regulations could be removed if money creation were made more naturally, by those that actually need the money.

[Winslow R.]

"Banks/Investment houses have operating funds that have been accumulated over the years, that are put to work everyday buying and selling, thereby arbitraging and making a profit -- which enhances profits. The pool gets larger and leverages further profits."

Not always, as we have seen recently the leverage can work the other direction and shrink bank tier 1 capital.

This bank capital is not used internally, only externally to meet capital requiremnts and only then if someone bothers/is capable of checking. How to find the 'true' value of securities when there is no market?

[Lafayette]

WR: You are mistaken as banks do create money electronically.

Well, then, you had better tell the Fed that Monetary Policy is no longer under their control.

It will come as a great surprise to them, I should think.

[reason]

Lafayette...
I doubt it - that is why they concentrate on controlling short term interest rates rather than the money supply these days.

[Lafayette]

The Virtual Monetary Multiplier Effect

reason: ... that is why they concentrate on controlling short term interest rates rather than the money supply these days

Agreed.

My point is that what banks do is have a virtual monetary multiplier effect when seemingly they "create credit".

As the sub-prime mess indicates, they are writing their Toxic Waste off the books. Does this mean they are "destroying money". I don't think so.

So, where did it go? It went to the builders who were paid to build the housing (who paid the labor and material). They retained the profits and are sitting pretty on a pile of cash, wondering when this present crunch will be over.

Till then, it's off to the beach in Hawaii ... ;^)

[Winslow R.]

"As the sub-prime mess indicates, they are writing their Toxic Waste off the books. Does this mean they are "destroying money". I don't think so.

So, where did it go? "

Bank money is 'destroyed' by loans being paid off.

If home loans are foreclosed on, they are paid off not with financial assets (deposits) but rather a nonfinancial asset (a foreclosed house). The loan (bank asset) is 'destroyed' and is replaced by a nonfinancial asset which may have no value. The bank deposit (bank liability) remains.

I think it is pretty clear 'cash' is being held by offshore entities, Saudi Arabia, China, etc. not by home developers.

[STS]

Winslow R:

"Most banking regulations could be removed if money creation were made more naturally, by those that actually need the money."

This sentence puzzles me. How do you distinguish it from: "the rules *could* be eliminated if the rules *were* eliminated"?

It seems to me that the banking system keeps running amok precisely *because* it gets too free with creating whatever amount of money it thinks it needs. What is a "liar loan" but the creation of money by somebody who finds it convenient to have more money than they can scrape together by more conventionally respectable means?

I guess I'll need to consult von Hayek on this subject. But it sure looks to me like his theory has been implemented and found wanting.