The Tacit Admissions of the Political Class, Part 2

Continuing the discussion from the last post about what politicians really mean when they say (and fail to say) things, I have come to the news item that initially sparked my thought process.  It involves an old friend of ours.  Welcome back Timmay!

Financial Regulation

With all the sound and fury lately regarding financial regulation and “systemic risk,” it is interesting to see Tim “Timmmmay!” Geithner urging “global minimum standards” for derivatives regulation.  In the same breath he urges against a “race to the bottom.”  By now, we should all know where I am going with this.

By positing a “race to the bottom,” Geithner implicitly admits that investors, traders, and various other market actors would prefer less regulation.  If the derivatives trading market found the regulations proposed by the SEC useful, they would gladly submit.  Given the choice, they simply would not.

I am sure that I would be accused of unwarranted simplicity here, but I disagree.  I concede that it is entirely true that poor risk management on the part of purely private-sector actors is a recipe for crisis, and I know for a fact that in the absence of regulation, there would be many a company bankrupted in the blink of an eye.  (Note, however, that regulation did not prevent these bankruptcies either; see AIG, Fannie, Freddie, Lehman, Wachovia, Washington Mutual, etc.)

So what’s wrong with Geithner’s proposal?  Let’s read between the lines.

Geithner’s tacit admission that people would prefer less regulation in spite of overwhelming risks indicates that derivatives market actors do not take seriously the idea that companies will be allowed to fail or investors allowed to lose much money. In other words, market actors do not view the dangers of poor risk management – whether in the presence or absence of regulation – as a credible threat.

If they did, massive and blatant risks would have to be accounted for, and quite frankly, that would affect a huge financial company’s bottom line, and not in a good way.  Why would such a company want to give up the ability to take massive risks and possibly reap massive profits if the only downside to massive losses is having the government cut you a check?

Of course the big banks have no desire to regulate themselves, but it is a problem that stems entirely from the “solution” to the last financial crisis, i.e. bailouts, and it is precisely the problem with Geithner’s proposal now.  The only real solution is erasing the errors of the last faux-”solution.”  What is needed is not more regulation, but healthy incentives, beginning with complete, total, and unambiguous disavowal of “Too Big to Fail.”

Remove regulation concurrently with removing the possibility of bailouts, and before the regulators could even catch their breath, financial institutions would be self-regulating their own risks.  They would respond to the disciplined incentives presented them, just as they responded to the perverted incentives presented to them last time.

By claiming that only one option is available – broad-reaching, top-down, command-and-control, global regulation – Geithner tacitly backs up the current assumption that the bailout incentive has not changed.  The way the market sees it, Geither is “threatening” to keep bailing companies out unless he is given godlike powers over the economy.  After all, he has never once seemed to consider that market actors could possibly be responsible for their own profits and losses.   Is it any wonder the big financial companies are so much happier with the status quo?

Heads, Geithner wins.  Tails, you lose.  It looks to me like “Too Big to Fail” is here to stay for a while.

Bernie Madoff Calls the Whole Government a Ponzi Scheme. He Ought to Know.

This just in, straight from the horse’s mouth – Bernie Madoff was quoted calling the whole government a Ponzi scheme.  And if there’s anybody who knows a thing or two about Ponzi schemes…

Wall Street swindler Bernard Madoff said in a magazine interview published Sunday that new regulatory reform enacted after the recent national financial crisis is laughable and that the federal government is a Ponzi scheme.

“The whole new regulatory reform is a joke,” Madoff said during a telephone interview with New York magazine in which he discussed his disdain for the financial industry and for its regulators.

The interview was published on the magazine’s website Sunday night.

Madoff did an earlier New York Times interview in which he accused banks and hedge funds of being “complicit” in his Ponzi scheme to fleece people out of billions of dollars. He said they failed to scrutinize the discrepancies between his regulatory filings and other information. 

He said in the New York magazine interview the Securities and Exchange Commission “looks terrible in this thing,” and he said the “whole government is a Ponzi scheme.”

Now, I’m sure there are some people out there who will write this off as the rantings of a common criminal, but I happen to think he makes some interesting points. 

First, his contention that banks and hedge funds were complicit is almost beyond question. 

I would also add that regulators were “complicit” to the extent that they wilfully ignored the warning signs and, in several cases, actual written warnings from concerned parties. 

After all, if you look the other way when your job is to scrutinize, you might as well make your sanction of criminal activity explicit.  And as for the banks and hedge funds, their focus was on short-term gain, secure in the knowledge that bailouts were available to anyone who messed up badly enough.  And even if it cost some individuals their jobs, the pay packages they got in the interim would keep most people comfortable for the rest of their lives.

As for the government being a Ponzi scheme, that’s almost beyond question too.  The definition of a Ponzi scheme is an investment vehicle whereby early investors are paid “returns” from the subsequent capital payments of later investors.  Look at Social Security – that is quite literally the business model.  Medicare – same thing.  Medicaid – same thing, but at a quicker pace.  Together those three programs make up the majority of yearly government spending, and they all involve payments to early “investors” coming straight out of the pockets of later “investors.” 

And look at the other core functions of government, even beyond these obviously flawed entities.  I’ve previously referenced how unions (in their current form) cannot be viable without the full backing of government.  The system involves legislators bestowing favors on a chosen group of people, and in return those people ensure that their benefactors are popularly elected.  How is this any less circular?  And how does the story change when inevitably the music stops and some people are left without chairs?

And what of the new regulatory “reform”?  Well, I have personal knowledge about this, and I can assure you Madoff is absolutely right when he says it’s a joke.  Regulators could have – no should have - looked at the DTC transaction log to ensure that Madoff was not running a multi-billion dollar Ponzi scheme, but nobody bothered.  How is this problem corrected by, in essence, shuffling the pieces of the regulatory regime around? 

So some agencies will be consolidated.  Other agencies will come under the purview of the Fed.  A new agency will be set up to “oversee” all the old agencies.  The fact is, smart people will always be one step ahead of the regulators, and it does not matter even a little bit how the regulatory pieces fit together.  Do you think Madoff would have reconsidered embarking on a Ponzi scheme just because thrifts are now regulated by the OCC instead of the OTS?  Do you think Madoff would have thought twice about stealing people’s money if only the Fed had had an Office of Minority and Women Inclusion before this totally-not-wasteful-at-all reform?

Public choice theory merely gets another underscore.  Of course, beyond all the implications of regulatory capture, etc., we see the pure spoils system at work.  The more regulators fail, the more power regulators get.  And of course, the more people who derive their power from Washington, the more power is concentrated there.  One last question – do you think the legislators mind?