From the first posting on this blog, excerpted from a paper I wrote in 1977:

“An example closer to home was the surprising preference of the local powers in some unreconstructed rural Southern counties for the food stamp program over the old commodities distribution program. Most people in the North thought the food stamps far more liberal and humane.

In 1968, while travelling in upstate Louisiana for the Office of Economic Opportunity, I found out that the food stamp program (a) enriched the local storekeepers, (b) permitted both the hiring of white clerks and the firing of Black warehousemen, and (c) was driving the poorest of the poor out of the state. They could not afford the minimum cost of the food stamps, and their source of commodities was shut off.

I dare say that few of these consequences were uppermost in the minds of the major sponsors of the food stamp legislation.”

If Wall Street is going to run the economy into the ditch every once in a while, then government is going to have to impose speed limits or hire some more cops. The Administration’s plan is to hire more cops. I’m for more speed limits.
Even Alan Greenspan is in “a state of shocked disbelief” at the consequences of “the self-interest of lending institutions.”  So once again the debate is about the speed limits and the cops. We’re not hearing so much about the glories of the open road.

There are both theoretical and practical problems with just hiring some cops. There are several practical problems.  Some of the cops just hang around fruit stands eating the apples (see: Bernie Madoff and the SEC). Sometimes the word from headquarters is to spend more time polishing the patrol cars (see: Christopher Cox and the SEC). And sometimes budget cutbacks reduce the cops to invisibility (see: CPSC and Chinese toys).
The theoretical problems are far more serious. They stem from Ashby’s Law of Requisite Variety, a fundamental proposition in cybernetics and systems theory. Ashby’s law states that “only variety can absorb variety.” More simply stated, three basketball players will never be able to outscore five players. Just ain’t gonna happen.

Regulations and regulatory agencies are the cops in this story, and Ashby’s Law applies in both (1) space and (2) time. First, there are a lot more folks on Wall Street (read: the financial sector writ large) than regulators, and ‘twill be ever thus. The regulators can’t be everywhere.

Second, regulation as a ‘tool of government’ is effective only until the regulated evolve enough to evade the regulations. This happens quickly. In today’s world of instant information, we’ve even seen the financial markets evolve ahead of our imaginations. So today’s regulations can never prevent tomorrow’s problems. A recent Tom Toles’ cartoon captures this well.

This would be true even if we truly understood either (a) the financial system or (b) the governments’ interactions with it. Only a certified system dynamics simulation model would show we understand the financial system itself. And even though the Clinger-Cohen Act of 1996 mandated enterprise architecture for federal programs, there’s been no attempt to apply this form of systems analysis to the many and varied governmental agencies, taken together, that touch the financial system.

So that leaves “speed limits,” defined as any controls built into the system that don’t require cops (regulators) for enforcement.

All the attention has been on “executive pay caps” and whether these will destroy the motivation of the Masters of the Universe, and on and on. This is a wrong-headed approach.

Back to the highway analogy. Imposing executive pay caps is like putting a governor on a rental car driven by a teenager. It’s not his car, and he’s still out looking for thrills.

We need to have bankers act like a new father out driving with his baby daughter in a car seat in the back. We need them to have some ‘skin in the game.’ We need them to retain substantial personal liability so they act (drive) more cautiously. We need to add some fear; reducing greed alone won’t cut it.

Joe Nocera’s entrancing New York Times Magazine article, “Mismanaging Risk,” goes on for 7500 words about investors’ risks and firms’ risks but never imagines that risk might apply to the people running the firms.

Corporations are creations of governmental laws and regulations. So are partnerships, limited liability companies , and limited liability limited partnerships. It would not take “rocket surgery” to create and mandate a form of entity for firms capable of causing “systemic risk” that would retain personal liability for managers whose actions could put either their firms or the economy at risk.

Median annual household income in America was $50,223 in 2007. I think someone gunning for one hundred times that should be willing to put his Manhattan apartment, his house in the Hamptons, and both yachts at risk until he’s been out of the game for, say, ten (10) years.

Give me my choice of three Harvard professors, throw in one from MIT, and I’ll have a solid draft for you in a weekend.

Letter to the Washington Post:

Max Stier (June 8th: “The Flow-Chart Fallacy”) is half right. We don’t need to reorganize and layer the regulatory communities around food safety and the financial system. We’ve had our Katrina on Wall Street. Building a bigger financial regulatory structure won’t prevent another dangerous recession, just as creating the Department of Homeland Security certainly didn’t help with hurricane recovery.

But improving the leadership of the regulatory community won’t help if a future Administration’s policy is to turn a blind eye to abuses, or if agency budgets are continually reduced. And useful measurement tools won’t correct the fundamental flaw of regulation: Regulations are great for controlling old problems, but they seldom if ever prevent new problems from emerging or control them when they do.

We need some fundamental changes to “the way the game is played” in capitalism, akin to those that restrained monopolies a century ago. Surely the maintaining the health of the financial system today is at least as important as restraining Standard Oil was then.

I have two suggestions for starters. First, I would limit the market share of any bank, hedge fund, etc., so that individual failures would not threaten the overall system. We’ve had banks get bigger, not smaller, since last year. And of course I’d reinstate Glass-Steagall (1933) in a Wall Street minute!

Second, I would mandate that large financial entities be licensed and managed as “limited liability partnerships” rather than corporations. (A hybrid form to include shareholders is not beyond the imagination of policy-makers and law school professors.)

Such an entity would require that the senior staff, those making more than, say, $1 million per year in salary and bonus combined, would be personally liable for any losses and any damages and remain so for a period of perhaps ten years after leaving the firm.

Rather than fight a losing battle over executive pay caps, I’d like to see the Masters of the Universe have some “skin in the game.” A lot of skin.

One of my father’s favorite stories – meant to instruct as well as entertain – was about the Irish lord interviewing candidates for coach driver. He asked each, “And if the English were coming, and you had my family in the coach and had to hurry down the mountain, how close to the edge of the road would you drive?”

The first man said he’d drive as close as a yard to the drop-off below. The second man, wanting the job, said he’d drive to within a foot. The third man said, “Sure, and I’d be drivin’ as close to the mountain side of the road as I could, yr Lordship!”

The third man got the job.

This came to mind yesterday when listening to Marketplace on NPR. Tess Vigeland said, “Three hundred and forty-five thousand people lost their jobs last month. Now the pace of layoffs is slowing, but the Labor Department reports the unemployment rate now stands at 9.4 percent. Want to hear the scary part? Well remember those bank stress tests? The unemployment rate used in their so-called “Worst Case Scenario” was a mere 8.9 percent. Oops.”

That raised a flag for me, because for months unemployment has been predicted to rise to over 10 percent in 2009.

Then I read a story on Bloomberg News, Bank Profits From Accounting Rules Masking Looming Loan Losses, that included the following:

“Treasury Secretary Timothy Geithner, after “stress testing” 19 banks on their ability to withstand a worsening economy, declared in early May that Americans can be confident in the banks’ stability and resilience. Wells Fargo & Co. and Morgan Stanley were among banks raising $43 billion in new capital since then through share sales…

“… Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago, says the government stress scenarios underestimate how bad the economy may get…

“The Federal Reserve, which designed the stress tests, used a 21 percent to 28 percent loss rate for subprime mortgages as a worst-case assumption. Already, almost 40 percent of such loans are 30 days or more overdue, according to Tavakoli, who is the author of three primers on structured debt. Defaults might reach 55 percent, she predicts.”

The last “stress test” that I had involved a treadmill and a lot of heavy breathing. I was wired up with a heart monitor and under the close supervision of several folks in white coats.

It’s beginning to look like the “stress tests” those nineteen banks passed were more like a walk in the park!

How can the government claim it’s measured something – say the safety of banks – if the yardstick isn’t both (a) clearly marked and (b) open to inspection?

Almost as troubling but more obscure are some of the rules of the (banking) game that the Feds have changed recently. I remember the discussion of “mark-to-market,” but some are far more arcane. The Bloomberg article includes this:

“Along with that change [mark-to-market], FASB also let companies recognize losses on the value of some debt securities on their balance sheets without counting the writedowns against earnings. If banks plan to hold the debt until maturity, they can avoid hurting the bottom line.

“Another $2.7 billion before taxes came from an accounting rule that lets a company record income when the value of its own debt falls. That reflects the possibility a company could buy back bonds at a discount, generating a profit. In reality, when a bank can’t fund such a transaction, the gain is an accounting quirk, Weiss says.”

Such rules raise two ‘governance’ issues. First, and foremost, what are the possible unintended consequences of hurried rulemaking? Second, what is the likelihood that such rules, of obvious benefit to the industry, will ever be rescinded?

Aren’t we getting closer and closer to the edge of the mountain?

Daniel Boone was America’s first Libertarian. Whenever he saw smoke rising from a neighbor’s cabin, he moved his family west. Government wasn’t the problem, government wasn’t the solution – at least until the Indians came a’callin’. Oliver Wendell Holmes, Jr., appointed to the Supreme Court at age 62, once said “In the law, an ounce of history is worth a pound of logic.”

Today’s problems are far too complex, critical, and urgent to be solved by either Libertarians or logic – or even lawyers. We need to use the best science available to design and test government’s moves against present and emerging societal (and planetary) problems. And those sciences aren’t biology and physics. They’re systems theory, systems dynamics, and computer simulation, among others – the whole lot of the sciences developed since World War II. Names like Norbert Weiner,  John von Neumann, Stafford Beer, and Jay Forrester are not familiar to the lawyers who make up the vast majority of legislators and staff on Capitol Hill. Such subjects don’t come up in law school – ever!

Take global climate change (Please!). Last week Steven Pearlstein of the Post wrote a column about the complexity of the Waxman-Markey bill. In it he says:

“There remains a robust argument over whether the American Clean Energy and Security Act of 2009 represents a crucial step in preserving life as we know it. But there is no question that there are few pieces of legislation that are likely to have a more profound effect on the U.S. economy. It would bring about dramatic changes in the relative prices of energy and goods produced by energy-hungry industries. It would redistribute trillions of dollars in business sales and household income and generate hundreds of billions in government revenue. And it would represent the most dramatic extension of government’s regulatory powers into the workings of the economy since the early days of the New Deal.
“For all that, there are probably not more than a few hundred people who really understand what’s in this legislation, how it would work and what its impact is likely to be. As it moves through the legislative process, it’s worthy of closer attention.
“The other thing to say about it is that it is a badly flawed piece of public policy. It is so broad in its reach and complex in its details that it would be difficult to implement even in Sweden, let alone in a diverse and contentious country like the United States. It would create dozens of new government agencies with broad powers to set standards, dole out rebates and tax subsidies, and pick winning and losing technologies, even as it relies on newly created markets with newly created regulators to set prices and allocate resources. Its elaborate allocation of pollution allowances and offsets reads like a parody of industrial policy authored by the editorial page writers of the Wall Street Journal. The opportunities for waste, fraud and regulatory screwup look enormous.”

(Another article in the Post, well worth reading, says “The proposal is far more complex than anything tried before in this country, and a close parallel in Europe turned out to be seriously flawed.”)

I like Pearlstein; I don’t find him an ideologue at all. When he’s nervous, I’m nervous. And the entire column is worth reading – twice. But there’s one sentence that’s entirely wrong: “For all that, there are probably not more than a few hundred people who really understand what’s in this legislation, how it would work and what its impact is likely to be.”

Unless and until someone tells me that there’s a very good simulation model of the US economy, and that Waxman-Markey has been plugged into it under a broad variety of assumptions, I don’t think that there’s ANYONE who understands how it would work and what its impact is likely to be!

Wanna bet? Wanna bet the economy or the planet?

An article in Friday’s Post reports that “The board in charge of sanctioning mortgage lenders who violate Federal Housing Administration policies is ineffective and slow at a time when the volume of loans backed by the agency is exploding, according to an inspector general’s report scheduled for release today.” This board has ruled on only 94 cases since October, although 12,641 lenders do business with FHA.

I began to wonder if ANYONE had “the big picture” of how the Federal Government interacts with the financial sector’s myriad actors. While I’d love to see a serious attempt at simulating the overall system, at minimum we need an Enterprise Architecture for the government side. And we know how to do that!

The article continues: “The concern is that some lenders may be using the same abusive tactics that contributed to the collapse of the subprime market and that the FHA may not have the resources or policies to stop them and protect itself against losses. The agency insures lenders against defaults.” So here we go again!

An “Enterprise Architecture” is a set of models of the enterprise showing the relationships between its people, processes, and information. That’s a simple definition – the topic gets into the weeds quickly, as you’d expect from a discipline developed at the Pentagon.

But EA is spreading: the Clinger-Cohen Act of 1996 mandated EA programs at each agency, sponsored by the local Chief Information Officer (CIO). There’s a Federal Enterprise Architecture Framework (FEA) issued by the CIO Council in 1999 to standardize it across agencies. And now OMB requires an EA for funding approval and oversight. And once OMB requires something, it’s really in!

That means we have a language, and a community of those who speak it, that can accurately describe “the people, processes, and information” involved in the oversight of the financial system. With luck, EA might also describe the financial system itself!

And if we had common understandings of how the system works, and graphic displays of the parts and their interactions, and maybe even color coded indications of the competence of the regulators (the Mortgage Review Board would be RED), maybe we’d have a better handle on how to fix it. What a concept!

Just google “enterprise architecture for beginners” for starters.

There are many good reasons to do what it takes to come up with a financial system that’s “fail-safe.” One of the best is that then maybe China will keep investing in America.

A recent article in the New York Times magazine, The China Puzzle by David Leonhardt, talks about how intertwined America’s economy is with that of China. I find it really scary, even though it ends on a hopeful note.

Some selected quotes:

“Over the past decade, China and the United States have developed a deeply symbiotic, and dangerous, relationship. China discovered that an economy built on cheap exports would allow it to grow faster than it ever had and to create enough jobs to mollify its impoverished population. American consumers snapped up these cheap exports — shoes, toys, electronics and the like — and China soon found itself owning a huge pile of American dollars. Governments don’t like to hold too much cash, because it pays no return, so the Chinese bought many, many Treasury bonds with their dollars. This additional demand for Treasuries was one big reason (though not the only reason) that interest rates fell so low in recent years. Thanks to those low interest rates, Americans were able to go on a shopping spree and buy some things, like houses, they couldn’t really afford. China kept lending and exporting, and we kept borrowing and consuming. It all worked very nicely, until it didn’t… The most obviously worrisome part of the situation today is that the Chinese could decide that they no longer want to buy Treasury bonds.” [Emphasis nervously added]

“Were China to cut back sharply on its purchase of Treasury bonds, it would send the value of the bonds plummeting, hurting the Chinese, who already own hundreds of billions of dollars’ worth. Yet Wen’s comments, which made headlines around the world, did highlight an underlying truth. The relationship between the United States and China can’t continue on its current path.” [Emphasis added]

“Throughout most of the 1990s, China’s current account surplus — the value of exports minus the value of imports — equaled less than 2 percent of its gross domestic product. As late as 2001, this surplus was only 1.3 percent of G.D.P. But then it began soaring. Last year, it was 10 percent of G.D.P., according to the World Bank. In more concrete terms, China sold $338 billion worth of goods to American consumers and business, more than the combined annual revenue of Microsoft, Apple, Coca-Cola, Boeing, Johnson & Johnson and Goldman Sachs. [Emphasis added!] American businesses sold only $71 billion to the Chinese.”

“At the end of a discussion with Lardy [Nicholas Lardy, a China expert at the Peterson Institute for International Economics in Washington] about the imbalances between the U.S. and China, I asked him what forms of leverage he thought the Obama administration had. ‘We have no leverage,’ he replied.”

A recent story in The Business Times says that China is still buying, and as of March had $767.9 Billion in Treasuries. That may not sound like a lot of money to you these days, but I’m still working on my first $1 million!

Leonhardt’s concern is that inflation caused by our stimulus packages will bring a decline in the value, and thus the desirability, of the Treasuries. Might happen.

MY concern is that the Chinese might also recognize that the American economic system is inherently unstable, since we’re still allowing (and indeed encouraging the growth of) financial institutions that are “Too Big To Fail.”

And have you read The Black Swan about unlikely events that aren’t planned for? And do you know about chaos theory, how sometimes things don’t end with a whimper, but with a bang?

And so if AMERICA remains “Too Big To Fail,” then a sensible policy by the Chinese would be to pull out, slowly if possible, more rapidly if necessary.

I’m for a “fail-safe” financial system. Now.

On May 9th, a Bloomberg News headline read: “Obama Administration Said to Favor Fed as Systemic Risk Agency.”

The article says that one candidate for Systemic Risk Agency (or SRA) is the Federal Reserve Bank. Others in the Administration favor a council of regulators. That would be an SRC, or Systemic Risk Council. This will take awhile to sort out.

And the article goes on to quote Senator Dodd (D, CT): “Senate Banking Committee Chairman Christopher Dodd said in a May 6 hearing that ‘It is my preference that authority not lie in any one body; we cannot afford to replace Citi-sized financial institutions with Citi-sized regulators,’ referring to Citigroup Inc., one of the largest U.S. financial firms.”

Barney Frank talked about systemic risk regulators several months ago. A Systemic Risk Regulator would be designed to assure that all those financial entities that are “too big to fail” wouldn’t even get CLOSE to failing, ever again.

MY problem is that any reasonable person would want to get rid of the systemic risk to the financial system, not regulate or oversee it. That reasonable person would want to break up any entity that was “too big to fail.” Is that rocket surgery?

Another Bloomberg article purports to report back from 2088 about our financial crisis and its aftermath. Deeply suspicious of government action, the article lists several unintended consequences, and starts with this truism: “The U.S. Congress, which excels at preventing the last crisis from recurring, enacted new rules and regulations before the last bank had extricated itself from the government’s grip.” [Emphasis added]

We shouldn’t settle for a good faith effort to try to create ways to restrain firms that are Too Big To Fail. We don’t just want to avoid repeating this financial meltdown. We need to avoid such failures no matter what. We need a financial system that’s fail-safe. “Fail-Safe” is not a new idea.
And has America ever before faced this issue of keeping corporate entities from becoming too large and too powerful? Why, yes. We called the issue “monopoly” and the laws “antitrust laws.” The Wikipedia entry for the Sherman Antitrust Act tells you more than you want to know.

The (several) antitrust laws were designed to keep large businesses from harming consumers by monopolizing trade and thereby becoming able to set prices without competition. Before it atrophied, there used to be an Antitrust Division within the Justice Department, believe it or not!

And if America decided a century ago to set limits to corporate power in order to protect consumers, why can’t we do so today to protect the entire financial system?

Why can’t we aim for a financial system that’s fail-safe? Shouldn’t that be our design goal?