The Fed and DC Celebrity Culture

One of the worst things about the ceaseless cable reality show of Washington is its tendency to lionize individuals as celebrity heroes, say, poor Alan Greenspan, not to mention all the other clowns down there who clamor for the role of Dear Leader, becoming experts in the end at only that. We seem addicted to an endless passing out of prizes and gold stars for which anyone and everyone are considered entitled, even Caligula’s horse, like Rome at the end. Jacques Barzun wrote the book entitled Dawn to Decadence—and he meant it. If you are in a habit of confusing excellence with personality, assuming your own conclusions and emulating past patterns, then you simply will make mistakes. Are the Hero’s confident assurances and future predictions correct? Do they persuade you that he is a “good man” and if he is, do you think his moral goodness in itself is enough? Is he a smart man?  Is he a roll up the sleeves and get under the hood man?  Does he understand how the nation and its markets work?  And, does he have a good team?  It seems to me that all of these questions must be asked, not only the first two.  And despite the conventional revulsion over Jimmy Carter’s supposed detail minded tendencies, there are times when you need just that.

Markets only function properly given certain conditions. The government has taken on, by law, the responsibility to encourage conditions that conduce to market integrity. These consist of things like diversity and competition in the specific industry; the existence of conditions for caveat emptor to operate, as opposed to conditions of subtle deceit, or follow the leader obfuscation through herding; the presence of full, fair disclosure of all material facts; the existence, in the proper sequence and structure, of arms’ length bargains (which are ethical purges); and absence of conflicts in each level of transaction. Care must also be taken with what the market climate is and the relationship between conditions of the past, conditions of the present, and conditions likely to be in force in the future. In short markets must not be rigged. And what does rigged mean? That depends on what market you are talking about, in what conditions, and when. Or grossly unfair. Grossly? Yes, because the law, spelled out in advance, can’t do everything. When people try, they are forced to resort to being confusingly vague.

The Fed is not tasked to be a regulator. Still less does it “run the economy.” (Most politicians seem wholly unacquainted even with this fact.) It is a central bank. If “the economy” is to be “run” at all (and mostly it should not be) that is what Congress and the President are supposed to do, and with all due caution—not the Fed. Only Congress and the President are democratically accountable in our constitutional system. In theory they are accountable for their mistakes, but I’ll Be Gone You’ll Be Gone (IBGYBG) is in full operation there as much or more than it is in investment banking. This is an inherent problem of agency anything—the third party (payor, or any other kind of person to whom the buck is passed) problem. Congress and the President try to evade even the very limited accountability they have to begin with, by delegating to agencies. Agencies have little accountability in part by design; they are tasked to execute details, to do a job handed to them like any diligent employee, not to tend to any big picture. Often they have life tenure job security, and this makes people sleepy eyed and to some extent negligent of anything except what they might get in trouble for, or what is personally inconvenient to them.

The Fed is basically a research institution. It is not an economic regulator. It is a macroeconomic reader of the economic State of the Nation. It is supposed to be a think tank, wholly separated from politics, that is, it is supposed to be completely apolitical and only gather and read data, then manage total money supply to smooth out historical bumps in the road. This cannot be mistaken for “running the US economy.” The US economy and the fairness of its society is a function of the well-calibration, or not, of its laws. The sheer bulk of the laws are out of control. This mindless bulk wreaks havoc with the underlying legal system. One way of dealing with this state of affairs is to develop an insouciant contempt for the very existence of laws or regulation. This is to be seen in today’s attitude of “so sue me,” or “you’re gonna make a federal case outta that?” followed by Wile Coyote-like evasion. Like the internet, the more there is of a thing, including laws, the easier and even the more necessary it is to just ignore it. Thus, the very status of law in society has declined with its increasing mass and lack of quality from remorseless efforts to mandate results no law can ever accomplish. One might say the same of physical books, which at least have a manufacturing cost barrier to overproduction, or once did. The mere word “book” or “law” still has some juice. Good branding.

We all enjoy seeing a Hero laid low. But Greenspan did not act alone. Greenspan is a victim of the economic assumption that all US markets — because we are America! — had all the legal components of integrity in place that had been reasonably well wrought for the common stock and bond markets of the 30s. The regulatory establishment, doubtless busy with many other important things, failed to notice that Fannie and Freddie’s securitization process was not a “market” process. It was a vast national insurance program, government guaranteed. When, in 1968, Fannie and Freddie were privatized, the regulators failed to apply the requirements of the securities law. They just assumed that whatever Fannie and Freddie had been doing was fine for Wall St. to just replicate, introducing “competition.” Securities law has at its root a structural economic analysis. These are minimum basics which HAD to apply to what self-interested private actors were now being enabled, by the government, to do. The regulators who should have been immediately alert to the national implications of creating a commons problem, from 1968 to the present, totally ignored it, and failed to put in place simple universal loan quality rules (in fact, the political pressure was all to do the opposite, remove and debase all rules of loan quality). The government process of national insurance packaging that banks were now being told they could, and should, emulate, as a mechanical matter of assembly and sales, was not a market at all. For banks to just imitate what Fannie and Freddie did eliminated a critical level of arms’ length transaction, in the analogy to securities sales. As every engineer knows, if you wipe out a level in your file path or circuitry, you might be switching a 1 to 0—producing, at the end of the line, the exact opposite result from what you expect. Everyone who might be considered to have been “in charge” in the country, most especially our national experts on this, the securities regulators, ignored these very large important considerations relating to the basic integrity of the nation’s markets. Charitably, they were mired in too many details to see the issues. Less charitably, all they cared for was to get back to their cozy, unchallenging 9 to 5 routines, or to posing for photo ops and taking meetings.

Hence, writ large, this regulatory establishment, and their alleged overseers Congress, are to blame. It is much more damaging to have veritable frauds pretending to regulate and so conning people into failing to take care for themselves, than to have no regulation at all. Presidents may not be to blame, because Congress strips them of managerial control over numerous agencies. The President is thus disabled from playing his check and balance role in the constitutional line up, for he can fire no one, nor manage their operations, a situation many consider to be flatly unconstitutional. The dogged effort of partisans to isolate blame to Alan Greenspan (or on the flip side, to Fannie and Freddie themselves) is just that. Partisan.

The regulatory establishment is, like the US military, just too large and too unaccountable. Too large and hence too incompetent. And ill managed. Yes of course I’m sure there are pockets of exception. If Congress exempts agencies from control by the President (thunder about an “Imperial Presidency” is usual here) and then gets back to campaigning, then all you have is a corporate entity managing itself in its own self-interest. The mish-mash of ill-conceived and ill-constructed laws with their resultant unsupervised regulatory tangles from Congress is today what we have most to fear, Obamacare being one possible awful example, whatever its benign intent. “Doing something” for the cameras, however destructive, has become the order of the day. Perhaps the solution (already rising in the land) is rising contempt for the law in itself. Its symptom is the rise of marketable sophistry. Hired gun lawyers are taking paid dog eat dog adversarialism to the status of a near religion. A “scientific” one. (This is why extremisms in the worship of “The Market” can indeed be plausibly compared to Marxism.)

I for example cannot really take any Hollywood film option/license or its net profits rider seriously. Any more seriously than I can the scribblings within a CDO squared.

It is getting to be true even of book publishing contracts, some of which have been rewritten into long, nonsensically hyper-regulatory instruments chock full of preposterous deconstructive reversals on prior custom, and other types of malicious mischief attempting to subvert the economics and law of publishing.

We have in this nation now an epidemic of the over-specialized. Economists are overspecialized when it comes to national policy-making. Policy is not supposed to be amateur hour, but an art governed first by good faith on behalf of the nation. Too many lawyers today do not understand core principles of how law supports economics, and how economics underlies law. They lose themselves in words and meretricious arguments that can be easily spun out of mere words.

The idea of the legislative, the executive, and the judicial branches was two things: a separation of powers in a division of labor, and their integration by way of check and balance among these distinct governmental corporate functions. Executive was supposed to mean management, and that has been disabled. Following FDR’s lead, we have created a counterproductive hyper-specialization that leaves no one in charge. The grown-ups are absent, and no one sees the forest for the trees. Seeing the forest, however, does not mean that Dear Leader commands it. American society wants to recharacterize itself as some kind of 100% no-fault, limited liability state for anyone in a CEO type role. No personal responsibility for anyone, no assumption of risk (with various legal instruments and “complicated” special devices used to accomplish this)—except for the poor. This is not capitalism. It is socialism in capitalist sheep’s clothing, limited to a particular class—the corporate and political elite.

The Conceit of Government, from FDR to Obama

(Initial Draft)

Peter Wallison of AEI has a good piece in the Wall Street Journal this weekend (How Regulators Herded Banks Into Trouble, 12.3.11, on how varying capital requirements between security types engineered the financial crisis—both the boom that enriched the bankers, and the bust we’re all now suffering. Politicians perennially forget that rules restructure economic results. Complex rules invite gaming, or even fraud, and can have unexpected effects. As in, “unintended consequences.”

Governments are in partnership with their banks inasmuch as they guarantee them as “lender of last resort.” So the Fed is the banks’ Daddy, meaning, when Junior gets into big trouble, Daddy pays. The rules are the “deal” between them, the terms and conditions of which basically grant banks their profits and in a host of ways can get tinkered up or down. Banks are now mostly very large, and/or very much alike. This lack of diversity or individuality is in large part because bank business models are dictated by government rules. Bank profits depend upon (a) on the state of the economy at any moment in time and (b) the rules.

Banks are also more consolidated than ever because the government let them get that way, waiving antitrust enforcement to permit merger en masse. Heavy government regulation means one behaves in rule-required ways that will be roughly identical to others in your peer group. (It’s what a “rule” means, in fact.) It can be likened to a legal way of creating a business monopoly or cartel. Banks’ job is to keep people’s money safe while reinvesting it at various levels of risk chosen by the depositor. Basic black letter law says that banks owe a fiduciary duty to their clients—of honesty, and to ensure investment decisions they make on their clients’ behalf will be reasonably sound and wise. This common law still applies, but heavy regulation complicates and partially replaces it. Wallison points out that Basel’s rules said banks needed to take only one-half (or one-thirtieth) of the care investing in mortgage-backed securities (MBS) and sovereign debt as they did with ordinary corporate debt (subject to an 8 to 1 capital ratio). This means the rules declared certain securities (and as it turned out later, quite risky ones) to be twice or 30 times more profitable and hence half (or one-thirtieth) as risky to the bank. The rule thus put a thumb on the scale saying, invest in this, not in that—so, not surprisingly, they did. It would seem that no other rules specifically required banks to do any due diligence to inspect the integrity of MBS or sovereign debt. Thus, the rules, in essence, presumed the integrity of these types of securities, even valuing them precisely, in relative terms.

Banks’ job is to diligently inspect the quality of all debt. In theory they know how to do this. Today however this is a premise that could use circumspection. A related question is whether governments do any due diligence (indeed, twice or thirty times as much!) on security types, when they decide to privilege them with differential capital requirements. Rulemakers apparently take decisions by the seat of the pants, perhaps in haste, or based on past habit, ballpark analogies, and lobbyist preferences. Because that is the politician’s way. Hairy complex sets of interlocking rules are a bad match with the typical political process.

Banks still might choose to protect their depositor/investors better, by shunning those same privileged security types despite the super-low capital requirements implying they are low risk. In the boom before the bust, plugging that rule and assumption into their “buy” algorithms brought banks easy profits. What’s more, in the nature of banks’ relationship to governments, the governments guaranteed it. With that set up, banks could hardly do other than what they did. Higher risk investing requires greater diligence and brings higher costs. By rule the costs can be made to disappear because the entire industry is being told they need not worry. Outliers will simply forego profits that will be sorely missed later if a disaster ensues.

All businesses acting uniformly in lockstep can come about either by the imposition of a government rule, or by copycatting, whether out of habit or industry custom, or by way of free-riding one’s competitor’s R&D. If the government makes a rule, as well as financially guarantees you, it would be insane to forego easy profits arising from that rule. You would not only appear to be fatally stupid to a market that takes high short term profits as proof of high competence (even if they the fact that following the herd may not be a mark of brains, only of absent-minded conformity), you in fact would be stupid, given that it is law. No one imagines a rule might be fatally ill-conceived, even if it might be, especially these days. The politicians and regulators may not understand what they are doing when they write the rules; this is the unpleasant reality everyone is far too embarrassed to admit now. The sheer number of the rules would seem to indicate that no one could possibly have traced all the possible consequential effects. Unwittingly, politicians manipulate markets when they rewrite rules. Had there been no rule privileging MBS and sovereign debt, banks would never have felt free to assume that those securities were categorically less risky than all others.

Of course it is also possible that the banks manipulated these rules themselves, as a safe harbor for profits. Perhaps it was a dastardly plot to shift responsibility to the rulemakers in advance. The rise of law and economics has indeed proliferated such knowledge to at least some crafty bank employees and their agents. Today we see in all the techniques of bank behavior how much they love their regulators—whom they can simultaneously use, then blame.

The recession and sidelined cash is just the market saying, we don’t trust the politicians to make the right rules. They are all thumbs. (Thumbs on the scale!) We’ll figure out what to do after we get through the period of investigation, recrimination and vengeance and see what the new rules to “fix” things are.  After the new distortions are assessed, the overall investment picture can become clearer and a sense of general safety can return.

Politicians seem such busy-beavers today, “doing things” “for” us. Why such whirling dervishes, generating laws in bulk? In its broadest outlines, law is mostly static. Politicians seek to appear to the public to be men of action “doing something.” This leads them to make too many economic and personal choices that they are not supposed to be making “for” us at all, picking winners and losers. It is now to the point where, famously, they no longer even read the laws they promulgate upon the body politic. Their process is finger in the wind (test the zeitgeist for what buzz evokes positives), then claim to be acting in name of the democratic will of the people—who, like banks to regulators, can later be blamed, should anything go wrong. As a republic, not a direct democracy, our representatives are supposed to be doing the right thing, in their best judgment. We rely on their decency, wisdom, and intelligence and vision for the long term. They have no way of knowing anything about their constituency anyway, because to pollsters, people only express self-interest, not the public interest. The public interest can only be assessed at a remove, which is the representative’s job. Pollsters get whatever they fish for. Responders also like to echo conventional wisdom. Implementing conventional wisdom is not politicians’ job.

Default politician behavior reduces to what they want to do. Unfortunately mere party-line fealty and personal nest-feathering gets superficial justification from misreadings of libertarianism. (Note to libertarians: The Fable of the Bees was not a libertarian manifesto. It was an exercise in wit. Wealth is not proof of God’s favor; this confusion, often observed in history, is a known pitfall of Calvinism.)

The lawyer class is often unconscious of the distinction between risk and uncertainty. They too tend to be rabid form followers. Lawyers after all can always blame their client for any substantive decision, after it goes wrong. Substitutes for thinking—by herding and copying—is habit forming. It is also sometimes perfectly reasonable to assume a thing is valid, safe, advisable, or legal if everyone else is doing it. Where there’s smoke, there may be fire.

Investment “risk” is inherently uncertain. By contrast, actuarial risks are insurable, giving rise to the insurance industry. But insurance risk is not the same as investment risk. Insurance law presumes the existence of competitive firms in the form of insurance firms—or at least, it used to, before the structural implications of the law and the conventional boundaries among previous types of firm got broken down. Insurance companies, as firms, are checked by market competition and creative destruction, ie, market forces. The quality of an insurance company can be determined by (a) state licensing and regulation (this however is a joke; market discipline is really the only protection here); (b) well done assessments of solid, longitudinal empirical data-sets about a risk within a population; (c) a limitation to specific, assessable types of risk. Investment risk is not the type of risk, like a casualty loss, that can be averaged, determined, and made static, and turned into a firm to compete on the market for avoiding that risk. Rather, investment risk is about predicting the future, which is (more or less) inherently “uncertain.” About the future, we are all free to speculate by buying stocks and bonds, which is a kind of betting game, with its integrity and presumed accuracy regulated by the government.

Politicians wrapped in soundbites simply may not be qualified to make all the rules they seek to impose on us in their show of “caring” for us. This, I think, is what Richard Posner is getting at when he speaks of The Crisis of Capitalist Democracy. We need systems engineers today who really do understand the system. Politicians are mostly not this, but marketing specialists. They dissolve always into futile calls for infinitely ethical global governmental forces (themselves) to abolish investment uncertainty in a complicated utopian merger with perfect empirical risk analysis, forgetting that the past is no divining rod of the future (nor of truth).

Deciding on capital requirement rules is a matter of what risks are banks’ responsibility and what government’s. The government is the lender of last resort and must referee, only, and avoid “playing” in the game. When it inflates the currency by expanding money supply, it is playing. In response to 2008 crisis, we did this, unjustly channelling funds to administration cronies (the banks). Regulators should not be in charge of setting the relative risks of MBS, sovereign, and corporate debt. All they are doing is trapping banks into a particular investment allocation, and turning the government into a “player” in the investing game.

Super-leverage allocated to specific privileged asset classes suggests that banks tampered with the rules, exploiting their role as “public-private partner.” If government is to be a player, then banks have politicians cornered, for it is banks who understand their business, not politicians or even the regulators (or, not all of them all the time). The banks have all the expertise. If you are a regulator, you must of course listen to the banks (be lobbied by them). While they know more, they will also from time to time tell the truth. But our regulators would seem to have abdicated their role of defender of the public interest who takes all this professionally with more than a grain of salt for cronyist mentality.

Super-leverage granted by law to one type of investment is just a government subsidy for that type of investment. Bank capital requirements relate to bank entity type. It should be flat as to that entity type. Bank type is also the fulcrum of choice (and competition) for bank customers and the unit of risk so far as they are concerned. The government should not be funneling bank customers into MBS or sovereign debt. Entity type shaped FDR’s original “deal” (i.e., the laws and regulations) as between thrifts, commercial banks, investment banks, brokers of stocks and bonds, insurance companies, brokers of commodities, casinos, etc. Rules by entity type recreated the economic field of play. Later, the politicians permitted these entity types to remerge back into one, while keeping other rules intact made now obsolete by those changes. Political “compromises” here, saying, okay, we’ll keep this rule in place here, but waive it there, are very perilous. The abolition of Glass Steagall at the turn of the millenium, for good or for ill, increased entity self insurance by entity diversification. But unseen it also increased the risk of lowered due diligence and failure to evaluate the quality of whatever was conventionally defined by existing rule as “non-risky.”

So what we got was regulatory supervision—not decreasing financial risk, but increasing it—by dictating investment choices and eliminating bank incentives to be duly diligent in evaluating securities like MBS and sovereign debt. If banks were still small and diffuse and free to fail, a few belly-ups might have taught lessons of risk and how to avoid it to everyone else. To reinstate competitive entities would require deconstructing banks from their current monopolistic size. But creative destruction in banks is frightening to us all, given the expectations we have built up about them based on the seemingly (though in fact not) stable models of the past. The S&L industry imploded in the 80s at taxpayer expense because those institutions were trapped into a narrow business model by old bank regulations. We all like and want FDR’s socialist promise of a taxpayer guarantee, at least for some things. That’s why politicians go about irresponsibly replicating it. But FDR not only offered it, he limited it, to those original things. Those conditions now no longer exist. But our politicians can’t bring themselves to end the endless guarantees—they just keep on spreading them into places it doesn’t belong.

Government needs to limit its guarantees. It has to take care to limit the nation’s upside liability as a whole. Right now, government is not bothering to understand these things well enough to get the rules right. Ideologues of left and right confuse the picture with partisan litmus tests (their own version of wooden rules with unexamined unintended consequences) and demands for heads to roll. (Satisfying, but mostly symbolic). No one can see the forest for the trees. The system has been turned into a chaos of inconsistent rules breeding only confusion and conflict.

Understanding a thing from the top down (as intellectuals do) is not the same as regulating from top down. Our legislators do not understand the integration of law with economics. We need a moratorium on more laws and regulations until they truly figure it out.

One rate per debt type was just the wrong way of devising the capital requirement rules. Newly merged banks are attempting to self-insure among entity types. But these firms may now be simply too big to understand, much less to manage. The rulemakers ignored the reasons for separating by entity type, not debt type—they simply had ceased to comprehend the logic of the system as a whole. The politicians are no longer expected to be able to do more than lip reading or mimicry. Lawyers play all sides of the aisle, and nimbly evade all lines of fire.

Superficially, it makes sense to assume that, if an 8% capital requirement is correct for corporate debt, then government guaranteed mortgage backed securities might, seat of the pants, be “half” as risky as corporate debt. But you can’t hold that figure true forever just because the number is now enshrined in a legal formbook. That would legal incompetence (or rather, business incompetence, meaning, a business lawyer might miss it while blaming the client). These numbers were set up when the economy was smaller, different types of investment entity were clearly separated from each other, and the way those industries functioned were well understood. That doesn’t mean they’re wrong to have merged. Perhaps entity consolidation and diversification does optimally alleviate pertinent risks. But there were also diseconomies of scale in the new entities being allowed to form. Were they accounted for in all the vast complex of rules?

The law is being asked to make business judgments law simply should not be making at all. Law is static. Markets are not. The market will adjust to any fixed rule, changing the “new normal.” Positive feedback loops (“positive” does not imply good) can ensue, at many unexpected levels. The media’s celebrity focus on political figure summiteering, however, follows an old trope, of suggesting to the public that our pseudo-gods and deities, through law, can command markets. These heroes then arrogantly begin to believe their press releases and to act accordingly.

Lawyers often go to law school precisely because they don’t like math or statistics. The type can quite easily ignore economic reality as they proceed to plug old forms and numbers into new contexts.

The lesson to be drawn from Wallison’s article is that the regulation has to be appropriate to the type of entity regulated and all surrounding circumstances. If the type of entity regulated is changing, the regulation must change accordingly. Some laws and regulations already incorporate change automatically by being general, and thus able to encompass change. The wise lawmaker has to be able to tell the difference between what a general rule encompasses, and what specifics can be dictated without being overly controlling. Too often, rules are simply ill considered and ill expressed: the legal academy calls it, unsurprisingly, “bad law.” Rules can proliferate that may seem neutral or general but serve only a special interest, tilting the field to an industry, or even a particular company. This accounts for the rise in constitutional and other challenges to the validity of laws, and other contentious litigation.

If you are a lawyer whose job is to draft and negotiate contracts you probably deal every day with irrationality and greed in a counterparty, some tolerable and excusable and resolvable, some less so. Many authors have touched on the decline of ethics in the culture, the rise of strange entitlement or rights claims, of illegitimate techniques of cherry picking, sophistry, or an ends justify all means however corrupt sensibility. Inexperienced and youthful soldiers are then used to execute orders in fealty to corporate “business models” so as to dissociate their bosses.

Where the left is correct, emotionally speaking, is in this: there has been an encroachment by a corporate mentality by which humans accept a status as drones in a hive, whose 10 commandments are presumed to be not God’s but only those of their (IPO sanctified) business model. This is not only an insight of the left’s but also of conservatives, eloquently expressed by such as Russell Kirk and Richard Weaver (Ideas Have Consequences).

The left is also right to sniff out the ratiocinations of the University of Chicago business school and its law and economics scholars as legitimizing a lot of nonsense, though it is grossly unfair to blame the original expositors of legal and economic truths for emboldening all their epigones’ ridiculous misinterpretations. Necessary changes and reforms to antique rules in the governing structure, have simply not been made properly in some cases. People will seek to exploit the discontinuities in an ill-understood, overlarge, and rickety system that isn’t rapidly adjustable, to rip other people’s faces off. That’s human nature. A system greased to permit so much to be done on distant auto-pilot, by rule or computerized aggregation model, leaches much of the humanity and personal or ethical restraint out of it, which is what corrects for errors in any rule.

Congress has set about to grease certain wheels at the urging of those who stand to profit from it, without doing the job of seeing that the checks and balances which once, more or less, worked to purge risk out of the system and elicit important information, via the very creakiness and slowness of the old ways, were being overrun.

These lawyers in Congress and all their “best and brightest,” could not get the rules right (which includes knowing what should not be subjected to rules). Instead they considered it to be their job to spin out as many of them as possible, mistaking campaign slogans for policy prescriptions, and the rewards behind the revolving door.

Do our legislators even know what “law” is any more? Basel was a collection of internationals, ie, a group less authorized than nationals. Their acts seemed plausible, and were not much scrutinized for systemic effects as opposed to self-interested ones. An endless stream of meetings and the image of “power” on a world stage does not guarantee legitimacy, authority or coherence. We’ve had an abdication of true law, and many self indulgent shows of “control” by so-called “leaders.” The law is made to seem a mere question of what the polls say from day to day, manipulable in the future perhaps by everyone clicking on their remotes.

If that ever becomes so, then there will be no law. It will be nothing but semantics, to argue about unto exhaustion.