Summers Highlights Dilemma

At the Bretton Woods conference over the weekend, sponsored by the Institute for New Economic Thinking, Larry Summers had this little nugget on regulators:

Speaking at length about the competing ideologies surrounding regulation, Summers distinguished between one side worrying that regulators will become “co-opted” by a conflict of interest, and the other afraid regulators are simply “ignorant” of the institutions they are charged with controlling. “There is hardly anyone,” Summers said, “that is both knowledgeable and [sic] unco-opted.”

It’s an insoluble problem in the public sector because anyone really knowledgeable is more valuable within one of the firms he regulates rather than outside it, creating a constant brain drain. There are exceptions to be sure, but the talent will always disproportionately on the inside. Financial entities make money in very complex ways, making an outsiders job very difficult even if able and motivated. When I have seen regulators, invariably they are focusing on some check list developed in Washington that is so irrelevant.

The key to managing government this century has been to remove individual authority. The abuses of the spoils system of a century ago are far more vivid in the modern mind than the bureaucratic inertia that slowly drains our national vitality. Bureaucrats have discovered one best way to avoid blame: by creating systems in which no one has the ability to do anything not in a rulebook created years ago by bureaucrats who haven’t been on the front line.

Effective regulators, when they exist, are free to make the countless judgments needed to make something good happen, as when an analyst decides that a bank is a ‘sell’. Yet this now only happens to firms so weak they are already almost dead, protecting us only after the damage has been done.

For over a hundred years we have been erecting regulatory systems designed to add licensing and other criteria that supposedly make things safe. But no system of licensing, nor any regulatory system, no matter how brilliantly conceived, will function as intended unless humans have primacy over ultimate judgments ant every level of responsibility. When people focus on compliance instead of making sense of the situation, you get irrelevancy.

Holding people and companies responsible for their actions is the most important way of enforcing genuine ethical and efficient behavior, and I don’t see how government regulators can do this. Remember, the best regulator ever invented is competition, which involves breaking down barriers to entry, and expediting the failure process that is an essential part of competition (including defaults with loss of principal, foreclosures), is the exact opposite of what most regulations actually do.

It’s naive to think a checklist in Washington will be effective, as any explicit process invites its circumvention. After all, for years Washington wanted more housing loans, and when the hucksters started gaming the system with NINJA loans, it was Fannie Mae software that really institutionalized it, and then they acted shocked that such loans were commonplace.

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About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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