Tuesday, June 23, 2009

Crisis for dummies: Regulation/Deregulation

Markets exist in a regulated medium. Regulation is necessary for markets to function. The question is how much regulation. Lately regulation has lagged innovation. For a bit of perspective there is this interesting chart from the NYT, describing the different agencies and what they oversee.

The Great Depression saw a rash of new regulation coming out. Most importantly, money levels were regulated by the Glass-Steagal act. Besides the separation of investment banks and commercial banks, the fact that debt holding were a regulated multiple of reserves set money levels in the economy. "innovation" such as securitization was developed to bypass said regulation. By selling the debt in the form of MBS and CDO thereof, banks were able to recycle cash, keeping regulatory levels in line but blowing up the credit bubble in the greater economy.

Deregulation takes a big part in the narrative of the financial breakdown. It starts in earnest with Reagan and the whole "laissez faire" movement. People voted with their feet. There is a wave of euphoria that takes over markets and economies when monetary levels start to rise. The economy grows in earnest and inflation of assets, kicks in. That is just the way it is. Deregulating the flow of money ensures one thing: it grows exponentially.

So we are seeing a rash of legislation coming back. Some of it is good: There is talk of CDS regulation (BAN NAKED CDS!). Clearing houses for OTC products. Some of it seems irrelevant to me, like the new impositions on levels of debt holding in MBS markets. Some just wrong headed, like the salary limitations that sound like filthy jealousy to me.

But the main thrust is to re-establish trust in markets. When MBS markets are on life support by the government, meaning that the US buys MBS in large quantities to try and revive the patient from cardiac arrest, a revived secondary market would get the flow of credit going. That isn't happening right now. Who is going to have trust in a system that has been proven to emit silly levels of debt, to people who couldn't afford it, stamped AAA by the rating agencies while everyone was feeding at the trough of fees. Yuck, talk of organized crime. I don't trust it, won't for a long time. Until a batch of MBS performs at advertised levels really. And this will not happen until 1/ the housing market stabilizes 2/ legislation makes sure there is transparency in the process of manufacturing securitized debt.

Much of the coverage I read about regulations is intensely technical, by necessity. But the only legislation I am looking out for would be the one that limits the total amount of debt in the system. In the short time I have spent learning about finance, the one thing that stands out is money levels. These need regulation that is outside of the reach of politicians and their time-lines of 4 years. Of course what I just said makes no sense, there is no regulation outside the political system and it is a shame when it gets to money. As you can see I am an naive optimist disguised as a bear.


Celal Birader said...

Except the Chinese politicians have no such timelines and in my opinion they have been the best at managing their economy. It's a shame that democracy and sensible economic governance don't seem to work well in these days.

Marcf said...

Celal, I think this is due to ignorance more than malice. When you read stuff like the declaration of the official from the bank of japan, you have to choke. Do not assume malice where incompetence will do.