Sunday, October 19, 2008

New Regulation, same as the old Regulation

Now that various governments are backstopping all financial activity, it's time for new Regulation to be added to the warehouses of old Regulation that already exist. The excellent Steve Waldman has a good list of some guidance for these additional rules:
Dani Rodrik has asked for examples of good innovations. Here are a few on my list:

* Exchange-traded funds
* The growth of venture capital and angel investing
* The democratization of access to financial information (e.g. Yahoo! finance)
* The democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).

No list of good innovations is complete without a list of bad innovations. Obviously at the top of the list go CDOs, CPDOs, OTC credit-default swaps, the general alphabet soup of the structured finance revolution. (I would not, however, put all mortgage or asset-backed securities on the list. Well-constructed asset-backed securities, those that are transparent and not overdiversified, are very much like ETFs, and if they were more widely accessible I'd place them directly in the "good" column.) But there are many, many more bad innovations that we have yet to come to terms with:

* 401-K plans with limited investment menus
* The conventional wisdom that long-term savings ought by default be placed in passive stock funds
* The conflation of ordinary saving and financial return seeking
* The tolerance, advocacy, and subsidy of financial leverage throughout the economy
* The move towards large-scale, delegated, and professionalized of money management
* The growth of investment vehicles accessible primarily or solely to professional and institutional investors
It's well worth reading the entire post. My disagreement with Steve is that he seems to be trying to eliminate bubbles entirely, and I think that's impossible. We should be able to eliminate credit bubbles -- eliminate self-created risk from the financial system -- but human beings are prone to periods of irrational exuberance and it will always be that way. 

I also think that, in a society where Engineering Wizards keep creating new marvels like Google and the iPhone, we should be able to sit on our duffs and get richer even if we don't buy the new marvels. The money supply should deflate, gently, making money in safes worth slightly more over time. So while I agree that we should separate savings from investment, I don't think that every investor should be active, nor do I believe that savings should lose value. 

Arnold agrees that bubbles are inevitable, and does not like the degree to which the Government can direct investment in this new era. But in a world where there is maturity transformation (MT: short term deposits backing long term loans) the Government must provide FDIC insurance because there will be a systematic bank run. And if Government is essentially backing all loans, it will have a say in where those loans get deployed.

I see no recommendations that say we should just keep MT off, and build a stable system on those new foundations.


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