Boom and boom

The search for the culprit in the current financial crisis continues. The Washington Post has an article which appears to put the blame on the Clinton Administration for failing to extend regulation into the burgeoning field of derivatives -- but really puts the onus not on the Clintons but on financial industry lobbyists and the misguided spirit of a Republican deregulatory mania who led his administration astray. The basic storyline is that a lonely bureaucrat -- Brooksley E. Born of the Commodity Futures Trading Commission -- wanted to regulate derivatives but was forced back by the 'Wall Street legends' Alan Greenspan, Robert E. Rubin and Arthur Levitt Jr. Treachery overcame good intentions and here we are.

Efforts to establish the opposite narrative are made by the WSJ, which boldly makes the claim that "the only banking 'deregulation' in recent years was that of Fan and Fred." In this version of events, things were under control until the knaves tricked the Republicans into letting them have a try at the stick, whereupon they flew the entire aircraft into the terrain.

In each of the first two presidential debates, Barack Obama claimed that "Republican deregulation" is responsible for the financial crisis. Most viewers probably accepted this idea, especially because Republicans generally do favor deregulation. But one essential fact was missing from the senator's narrative: While there has been significant deregulation in the U.S. economy during the last 30 years, none of it has occurred in the financial sector. Indeed, the only significant legislation with any effect on financial risk-taking was the Federal Deposit Insurance Corporation Improvement Act of 1991, adopted during the first Bush administration in the wake of the collapse of the savings and loans (S&Ls).

The WaPo and the WSJ articles don't technically contradict each other. The WaPo article claims that goverment failed to extend regulation into the Wild West of derivatives, while the WSJ claims that the only regulatory retreat was in the face of Fan and Fred. The arguments are like ships passing in the night. Either way the thesis is that more regulation might have stopped the problem from developing. But would it?

Tigerhawk probably has it right in his post, "Who deregulated what and when, and does it matter? " when he argues that politicians rarely shut the barn door before the horse gets loose, though they typically install a 20 inch thick armored steel door after the fact. But the steel door is more to exculpate themselves in the historical record than to keep the next Black Swan from making its appearance, because they typically haven't a clue what it will look like and so it will probably come in the back way. Tigerhawk writes:

I hold this truth to be self-evident: No government of men can design a regulatory system that will prevent the next bubble and ensuing panic. Only the collective memory of the last bubble prevents the next one, and when that fades with the turning of the generational wheel the lesson must be learned all over again. The reason is obvious: Bull markets -- whether in stocks, tulip bulbs, railroads, or real estate -- are fun, and nobody, and especially no politician, wants to stop the party before its natural end.

This panic will affect many people, especially the young traders, portfolio managers, and bankers who are losing their jobs or seeing their well-heeled friends fall back into the middle class. Those who stay in the business will remember it for the rest of their lives. Today's twenty and thirty year-olds will indemnify the American and European economies against excessive debt and asset inflation for the better part of their careers. Schedule the next big melt-down in 40-60 years, when these people are long-retired and the generation born around 2025 deludes itself into thinking that it is "different this time."

I think Tigerhawk really hits the mark when he argues that no real world regulator ever wants to be a party-pooper. Money making schemes, while they last, are essentially unstoppable. The Y2K bug and Carbon Trading will probably be regarded by future generations as examples of head-scratching foolishness. But their chief attraction, like the subprime mortgages, wasn't that they made sense, but that you could make money off of them. Nobody stands in the path of the gravy train.

But there is another theory of why collapses occur that bears thinking about. It is rooted in the somewhat kooky discipline of "ponerology", which defines itself as the science of evil. The basic idea is that while about 5% of the human population is psychopathic they tend to collect over time in the upper echelons of organizations. According to this theory, an inordinate number of really bad people are at the very top of society. Eventually they take it over and pervert it. Although most of "ponerology" sounds hokey and there is no rigorous reason to believe that scum rises to the social surface, I think it may be true that over time psychopaths learn to game the system simply because these are precisely the types of people who are obsessively looking for a way to gratify their socially prohibited desires.

So the same effect predicted by "ponerology" takes place but for a different reason. The psychos cluster around the lever they want to pull and eventually they get their hands on it. In time they find the way and turn a healthy system on its head. Perhaps bubbles and social catastrophes coincide in part with the discovery and rapid diffusion of a loophole which is rapidly exploited by evil people.

Two possible examples which come to mind are the phenomenon of pedophila and Islamic terrorism. "It was a bold man who first et an oyster," a wag once wrote. But many a timid man followed the bold.  Once the first pedophile discovered holidays in Thailand or a perverted clergyman spread the word that children trusted men of the cloth it was only a matter of time before a kind of bubble blew up which created a whole new category of tourist industry and very nearly collapsed institutions which had lasted for millenia. When radical Islamists discovered that Western civilization made cars, airplanes, the Internet and biological science available to the common man it wasn't long before mass terror attacks using these implements were under way. One day evil people make a business process or technological breakthrough and for a time, they have a boom which to us looks like a catastrophe. Imagine the excitement with which real scammers must have regarded Fan and Fred, or the derivative market, as you prefer. Seek and you shall find.

It's interesting to speculate about what bad guys may be looking for next. An amusing story is told about Kurt Godel, one of the greatest mathematicians of the 20th century. It seems that Godel applied for US citizenship and proceeded to his examination in company with Albert Einstein and Oskar Morgenstern when it occurred to him to tell the judge about a logical loophole he had discovered in the US Constitution through which America could be turned into a tyranny.

Einstein and Morgenstern coached Gödel for his U.S. citizenship exam, concerned that their friend's unpredictable behavior might jeopardize his chances. When the Nazi regime was briefly mentioned, Gödel informed the presiding judge that he had discovered a way in which a dictatorship could be legally installed in the United States, through a logical contradiction in the U.S. Constitution. Neither the judge, nor Einstein or Morgenstern allowed Gödel to finish his line of thought and he was awarded citizenship.

It's amusing until one realizes how often we discover, at intervals of 50 or so years, how a cohort of people more or less simultaneously learn to game a system until it crashes. I really do wish the judge had let Godel finish, though the 5% of men in the world would have been listening to his words more intently than all the rest.