I am not terribly convinced by this:
“…after decades and decades of instability in the 1800s and early 1900s, followed by the massive bank failures of the early 1930s, regulations were imposed to stabilize the banking system. The result was sixty years of calm in the financial sector. That’s hardly a failure of regulation. It wasn’t until the shadow banking system began growing outside of the regulatory umbrella that problems began to re-emerge. A central theme of the posts this week has been that bringing about another decades long period of relative stability will require the regulatory umbrella to be extended to cover all firms within both the traditional and non-traditional (or shadow) banking system, hedge funds included.”
That does rather ignore the fact that, in the early 1970s – in the period of “calm” that this writer talks about, we had stagflation, the collapse of the Bretton Woods banking system, etc. Hardly very calm. And if the system was calm, as claimed, how come it collapsed? (Hint: it was not the fault of evil private bankers or tax havens).
In the absence of a return to sound money and an end to fiat monetary systems, there may be something to be said for rules to at least limit some of the damage that monetary mistakes can cause. This is a second-best solution, I would say. I have heard it argued, even by some pretty ardent free market types, that there is a case for splitting the roles of risk-taking investment banks from those of more utility-like retail banks, as under the old US Glass-Stegall rules in the US. But had Glass-Stegall been in force today – it was abolished in the late 1990s – it would not have been possible for investment firms such as Morgan Stanley and Goldman Sachs to remodel their businesses as full-service banks, as happened in the autumn of last year when those firms were partly bailed out by the taxpayer. The ironies abound.
On this issue of the “shadow banking” system, the author and others need to understand how the business of securitising debt and selling it off to investors started, as well as why hedge funds and other non-bank institutions developed. This market, and the fiendishly complex derivative products that drove it, was given much of its early impetus by a banking regulation system, known as the Basel system, that told banks they had to set aside a certain portion of capital to one side to protect against risk.
It was, if you like, a partial acceptance that fractional reserve banking, if it is allowed without any “safeguards”, is dangerous. But what happened? Banks took out tradable insurance policies, such as credit default swaps, and used this insurance to get a better credit rating, and hence, reduce the amount of capital they set aside. The “shadow” banking system, then, and the derivatives market that gets so much heat, was partly driven by regulations, as well as by the application of sophisticated – if flawed – mathematical and scientific techniques to the business of finance.
The article does at least, in a backhanded sort of way, recognise that not everyone is signed up to the narrative that “unregulated capitalism” has failed. I am glad that has been noted. After all, it is a myth that supporters of capitalism, such as yours truly, oppose regulations per se: what I oppose is state-imposed, one-size-fits-all regulations. For example, if a privately run stock market wants to create its own listing rules to build and develop a reputation for high standards, it will be in its self interest to do so, since a track record for honesty, transparency and efficiency reduces the costs of capital because investors are more willing to hold equities traded in honest places rather than dodgy ones, and so on.
If the state has a role, it is that of going after thieves and fraudsters. And as we have seen in the case of US Ponzi scheme conman Bernard Madoff, the powerful US Securities & Exchange Commission did not act, despite certain suspicions about him, for years. By focusing on the basics, rather than trying to regulate everything under the sun, the state might even do some good.
Soviet Union was also very calm. Except when it failed.
I find it curious that lefties are all talking about sustainability except when they go to economic maters and expenses…
Perverse incentives.
Billings MT races to install traffic cameras
I love the comboxes. The sassy sensus fidelium is against this, obviously.
The writer is correct, sound money is primary. Regulation is a weak substitute but better than nothing.
When the private sector can create or otherwise obtain money without limit these crashes will follow.
It wasn’t regulation that caused the problem. Nor was it unfettered capitalism.
It was the dereliction of regulators. And of Congress. And of corrupt and lax governments here and in many other nations.
Madoff would have been caught if the regulators had done their job.
There was no sound reason to give hedge funds freedoms denied to mutuals.
There was no reason to allow partial reserve banking to leverage as far as it went. Or for lenders to regard a promise – insurance – as actual money.
Real estate lending went out of control both because the government encouraged it as social policy and the Federal Reserve, partly as social policy, kept rates too low.
The government itself, using the Fannies, was the great enabler of mortgage lending. And through various agencies it was also a huge direct lender.
Fannie and Freddy were governed only by the Three Monkeys.
Regulators and Congress were so unconcerned that they did not even measure these new and worrying trends. Easier not to be bothered.
The one truth. Government gains from these matters. Perhaps a politician loses office here and there but government grows and fattens.
There’s another, broader, implication here in terms of human nature.
If you are told that a regulator is in place and doing fierce things to bad people, you will act on the basis that it is indeed doing so. Where people are told clearly “caveat emptor”, that’s what they do. The regulatory regime suggests that “caveat emptor” is not necessary, because the regulator is supposed to be doing that. THAT’s why regulatory failure is so dangerous – it allows dangerous situations to become much bigger and hence more dangerous.
It’s similar to the inevitable effect of the welfare state: if the state raids your wallet in taxes, individuals feel no further duty to their fellow man. That’s the really corrosive effect.
I thought you might like this. Well, I liked it.
I’m totally lost with all this banking/ macroeconomics thing (university education, enough said).
Anybody suggest any good reading to give me a grip of the basics. Thanks.
The banking industry was “calm” over all those decades only when seen from a great distance. Up close, it was as turbulent as any other human institution. The thrift industry basically collapsed twice (once in the early 80’s and again in the early 90’s); stagflation took an immense toll in the 70’s, when Penn Square and Continental bank both failed; sovereign defaults (notably in South America) nearly sank Citibank and many other large banks in the late 50’s; need I go on? So the fundamental premise of this article (as well as many of its conclusions) is nonsensical.
As has already been noted here, governmental interference in the market (ever-more intrusive and detailed regulations in an inevitably futile attempt to manage away all risk, the politicization of Fannie & Freddie, etc., etc.) are the real villain in this story, but of course that meme doesn’t serve to expand the role and power of government or its sycophants so it gets no play.
Derivatives, securitization, hedge funds, etc., have been and continue to be excoriated, but in my opinion that is almost completely unfair. Most people don’t even know what these things are, but the mob is out with its torches and pitchforks and wants blood. Derivatives and securitization are extremely useful financial tools, which add significant value to the capital markets and, indirectly, benefit the rest of us. It is probably inevitable that some were misused; that is the nature of humans and is only a problem because (again) of governmental intrusion which prevented the market from correcting itself. If counterparty risk is a problem for regulated and insured banks, the solution is for the banks (and their regulators) to better monitor counterparty exposure, not prohibit the use of these instruments. We shouldn’t throw out the baby with the bathwater.
A word about hedge funds, also depicted these days as wearing black hats. The reason they arose at all is a reaction against (unnecessary) regulation. Simply put, some investors (extremely wealthy individuals and large institutions) do not require the “benefit” (if such it is) of SEC oversight; they can do a fine job on their own, thank you very much. Such investors want the flexibility to move quickly, into new forms of investment, without the glare of publicity or the cost (financial and otherwise) of government bureaucrats looking over their shoulder. There is nothing wrong with that. But the flip side is that if they guess wrong they should be permitted to fail and wipe out their investors. Indeed, that is what generally happens (google “Long-Term Capital Management” to see the reward of hedge fund hubris; the Wikipedia article is pretty good), and to my knowledge no large hedge fund (other than those run by fraud, c.f. Bernie Madoff) have failed in the current banking collapse. But if you’re concerned about the systemic risk presented by huge hedge funds see my previous paragraph about managing counterparty risk.
This is a huge issue, far too large to adequately discuss here. But the solution to the current financial crisis won’t be found in shoddy historical analysis, nor will it come about through increased reliance on inevitably flawed and ineffective regulation (Cleanthes’ observation about the moral hazard that creates is quite valid). Ignorant and venal politicians are the last people to whom we should be looking for solutions to problems which are largely of their own making.
Laird,
While you’re right that no major hedge funds have collapsed in the current banking crisis, many, many of the big names have been bloodied and have suffered huge redemptions.
The principal cause of this was the ban on short-selling that was introduced in the shadow of Bailout I, which put a short squeeze on the whole alternative investing industry. This event exacerbated the liquidity crisis at precisely the time that you wanted liquidity, and for the market to discover a proper value for those banks.
As you indicate yourself, if you want prima facie evidence that governments should be kept as far away from the economy as possible, you have it right there.
Cid the Cidious:
I recommend almost anything by the so-called Austrian economists. The Ludwig von Mises Institute website(Link) has a fantastic collection of literature, much of it in free pdfs or articles.
Where to start is the problem. I suggest George Reisman(Link), especially “The Myth that Laissez Faire Is Responsible for our Present Crisis(Link)“, and the series that started with Falling Prices are the Antidote to Deflation(Link) (followed by Part 2(Link) and Part 3(Link)); and Bob Murphy(Link), (see his Mises archive here(Link)).
Bod, being “bloodied and suffer[ing] huge redemptions” is precisely how the market is supposed to operate when improvident investment decisions are made (or when you’re just unlucky enough to be long when the market collapses). But (as I think you were implying) hedge funds weren’t the cause of the collapse, merely among its victims, so they should not be made scapegoats for it.
As to the short sale ban, I don’t think this is the place to get into a technical discussion about that (and I’m not really competent to do so anyway), but I will note that the SEC’s abolition of the “uptick” rule several years ago greatly increased market volatility and arguably exacerbated the collapse. More illustrations of the Law of Unintended Consequences.
Great tips in these comments. I know this is a long shot, since there are so many texts out there, but I was wondering if you wizards could give me some feedback.
I have this ancient (OK copyright 1992) Economics textbook sitting on the shelf, and was wondering if its credentials are positive or negative. A quick glance at it seems that it presents a balanced view and isn’t skewed towards Keynesism.
The book is “Econimics”, by Alan E. Dillingham, Neil T. Skaggs, and J. Lon Carlson. Any clues?
Thanks
As some of you might remember, I’m employed in the hedge fund industry (just to declare my biases).
re: Laird’s comments, the worst of the redemptions seem to be over for my firm, although we expect to bleed assets for the forseeable future; but he’s right, bloodied and suffering it is exactly how the market should leave us if we do a lousy job – except we had the added complication of a bunch of imbeciles in DC manipulating the market.
Laird also managed to tease out the message I should have articulated much more clearly hedge funds (and the whole alternative investing industry) really are one of the victims here, with the added problem that for hedge strategies such as pairs traders and arbitrageurs in general cannot pursue their strategies without taking some kind of short position. When one leg of a pairs trade gets frozen out (which happend to us in 3 or 4 deals), you have no recourse but to sit it out and just hope you can execute efficiently when you’re permitted to unwind the position.
Needless to say, the long side of the market continues on its merry way while you’re paralyzed on the short side, so any hope of being able to manage risk is out of the window, even assuming you could speculate on the value of the short exposure.
Actually everything was regulated.
Even the bonus structure is mandated by Federal regulations.
This “unregulated entities caused the problem” thesis is what is called a “big lie”.
In propaganda one can either try and distort and twist detials – or one can go for broke and just tell a huge lie.
Tell a story blaming one’s enemies for what has been done by one’s self.
Take one example.
Barney Frank does more than get involved with underage male prostitutes (simply to help the poor boy of course), or engage with sexual practices with the C.E.O. of Fannie Mae.
He is also a serious political power – who puts his sexual antics to the front so that he scream “homophobe” at anyone who opposes him.
Congressman Frank has been a leader of the “affordable housing policy” for many years.
Demanding that Fannie Mae and so on serve this political agenda.
And that the Federal Reserve system support it to.
Yes he is a man with a funny voice and who is proud of being a “Jew” who is not really a follower of the Jewish faith, and a “representative of the working class” who has never worked a day in his life.
But this is a only a tiny part of what he (and others) are – if only they were just the corrupt, workshy, sexual adventurers they present themselves as.
By the way, in a “deregulated” financial system there would have been no Fannie Mae or Freddie Mac (supposedly privately owned or not) and none of the other endless govenment entities and interventions.
People like Chairman Frank would not have been important.
And people could have carried on voting for them (in order to show how tolerant they were) without destroying the economy