Thoughts on Wall Street

Crossposted at the Square Deal:

I’m not very good when it comes to things like money, my partner (who is the Democrat in the family) is better at those things than I am. So I will venture into this whole talk about what is going on with Wall Street with some fear and trepidation.

As we stumble through this crisis, I have seen much ink spilled not as much on how to correct this, but on who is to blame. For liberals, this is a wonderful time, a time of vindication. In their eyes, 30 years of free market ideology now stands in ruins. We drifted away from Roosevelt-style regulation and look at what happens: we are teetering on the Great Depression, Part Two. Here is Robert Kuttner’s take:

Government, under Franklin Roosevelt, got serious about regulating financial markets after the first cycle of financial bubble and economic ruin in the 1920s. Then, as now, the abuses were complex in their detail but very simple in their essence. They included the sale of complex securities packaged in deceptive and misleading ways; far too much borrowing to finance speculative investments; and gross conflicts of interest on the part of insiders who stood to profit from flim-flams. When the speculative bubble burst in 1929, sellers overwhelmed buyers, many investors were wiped out, and the system of credit contracted, choking the rest of the economy.

In the 1930s, the Roosevelt administration acted to prevent a repetition of the ruinous 1920s. Commercial banks were separated from investment banks, so that bankers could not prosper by underwriting bogus securities and foisting them on retail customers. Leverage was limited in order to rein in speculation with borrowed money. Investment banks, stock exchanges, and companies that publicly traded stocks were required to disclose more information to investors. Pyramid schemes and conflicts of interest were limited. The system worked very nicely until the 1970s — when financial innovators devised end-runs around the regulated system, and regulators stopped keeping up with them.

Libertarian(?) Megan McArdle thinks that while there is some need for regulation it will not necessarily create the halcyon days Kuttner longs for. She thinks the regulatory regime is a relic of the New Deal days and needs an overhaul:

America’s financial regulatory structure is badly outdated, and in need of a massive overhaul. Its overlapping agencies seem to work at cross-purposes as often as they cooperate, and the fuzzy lines of authority can exacerbate panic because of a lack of any clear procedure for wrapping up big insolvencies. And its inertia in the face of changing markets has left it ill-prepared to deal with the current crisis. The SEC, for example, continued the process of forcing securities issuers to use a few government-sanctioned ratings agencies to certify their securities, despite mounting evidence that this cozy oligopoly was falling down on the job. As with most regulations, the quality floor quickly became a ceiling, as issuers did just enough to get approval.

More broadly, all of the regulatory bodies failed to realize, or react to, the fact that an increasingly complex array of financial instruments had introduced new risks into the financial system. It is far from clear that these risks should have been avoided by banning the more exotic derivative structures, as some commentators have urged. But the risks should have been known.

America’s entire approach to regulation is a relic of the New Deal, when optimistic Keynesians still believed that they might tame the economy by getting bright technocrats to run it. Seventy-five years later, we know that an economy of 300 million people is too complex to be controlled by any institutions, no matter how well-intentioned or well-managed. But our regulatory bodies still function on the dream that we can find bright public servants to wring all of the risk out of the system by carefully inspecting each product and certifying its quality.

For McArdle, regulation is not about trying to get rid of risk, but managing the risk:

A better approach would be to focus less on eliminating risk, and more on managing it. This means not only greater transparency, but encouraging alternate ratings systems to help make investors aware of risk. It also means developing procedures to cope with the inevitable failures, rather than scrambling to put together ad-hoc solutions when the market, shockingly, once again fails to behave.

I’m not going to pretend that I don’t have a dog in this. I do tend to lean towards McArdle’s viewpoint than Kuttner’s. But I don’t know if going back to the Roosevelt era is the answer to the current mess. I do think we need reform; too much of what has gone on has been shrouded in secrecy and needs to be brought out into the open. But I don’t know if the solution is to go back to what he had 70 years ago. For one, do we know if what worked then would work now?

I’m not advocating for no change or for no regulation. Clearly there needs to be some. What I am concerned about is that we have a solution that fits the times, not just something that is dusted off because it worked so well circa 1945.

It would be nice for partisans to be willing to look at what works now, and not think that some solution offered decades past will solve something today.