The following is in response to last week’s exchange between Guy Cumbie and Michael Edesess, which concerned Edesess’ article two weeks ago, Letter to the Editor On the Wikileaks of the Economics Profession.
Dear Editor,
I’d like to respond to Dr. Edesess’ letter last week, and in particular to his position that investors and consumers stand to benefit from more regulation of the financial markets, analogous to the way all Americans benefited from the warning labels that were placed on cigarette cartons.
The fear and greed aspects of our imperfect human market participant nature, when left largely unchecked by our enlarged frontal cortexes, indeed can render us frighteningly vulnerable to the too-good-to-be-true and ultimately calamitously harmful siren song allure of Enron, Madoff, and yes, even Fannie/Freddie investment stories. History and behavioral finance theory both make that perfectly clear: Left to our own devices, we are indeed undoubtedly capable of harming ourselves. That I will stipulate.
Irrespective of the usual role of fear and greed in the process, permanent impairment of one’s institutional or personal nest egg is certainly not fun and can be the source of very serious life change and grief. Having said that, economically equivocating such a bad result in the financial markets with thousands of nicotine addicted smokers' deaths by lung cancer, or planes full of unsuspecting passengers being killed by poorly maintained aircraft crashing, is far short of meaningful.
Put differently, having dinner downgraded from prime steak to burger because Madoff made off with your money is just not quite the same as going from alive-and-well to dead-and-disintegrated because some airline operator was slack on maintenance. The steak-to-burger downgrade might be painful, perhaps, and more so to some than others, but is not even close to being killed by improper aircraft maintenance.
While regulatory-mandated disclosure of investment risks and conflicts and timely prosecution of frauds makes sense, neither of those will preclude certain investors from acting out of fear and greed and occasionally getting whacked, and sometimes badly, for having done so. Further, I do not believe (nor I'm sure, does Dr. Edesess) that a regulatory prohibition against allowing fear and greed to enter into one's investment decision making (i.e., the root causality of most investment calamity I've seen of in my near-30 years in the field) is constitutional, much less desirable.
Constitutionally-limited government means just that. It doesn't mean look for reasons to create an ever-increasingly more complex regulatory maze of OSHA-like safety regulations in a marketplace wherein personal physical safety is not generally directly threatened.
Should there be regulatory limits placed on the financial leverage of individuals' and financial institutions' portfolios? Perhaps. Should the SEC's Bill Donaldson have agreed to relax their 1975 net capital rules/leverage limits for the largest broker-dealer holding companies when he was implored to do so in 2004 by Goldman Sachs' chief and former Donaldson Wall Street pal Hank Paulson? I don't think so.
To contemplate further layers of intentionally market-distorting bureaucratic regulation as the antidote or prophylactic for further supposed "market failures" in the sometimes dangerous, yet very seldom fatal investment markets, when we so recently unwound existing reasonable leverage constraints and failed to timely enforce against massive frauds (Enron, Madoff, etc.) is masochistic. Jeffrey Friedman's work on the causality of the global financial crisis is, if nothing else, a very well put together indictment of governmental actions and policies, from the aforementioned net-cap rules relaxation, to Basel-accords adoption, to Fed-rate tinkering, to the CRA of 1977, to implicit full-faith and credit guarantees of virtually infinitely leveraged mortgage-backed securities, to ad hoc aborting of established bankruptcy law, to not-so-tacit prohibitions of normal loan underwriting rigor. These government policies and actions exacerbated problems instead of inhibiting them. Many of them, especially in concert with each other, were downright root causal in nature...a classic cluster of unintended consequences gone completely to seed, and on an unexpected scale. It was all because someone in power became convinced of the presence of some intolerable imperfections, i.e., that markets were not functioning precisely as they wished, and certainly not quickly or tidily enough.
