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It's not clear that regulations are inherently futile. The financial sector has put a great deal of effort into evading regulatory requirements and has indeed been quite successful at flouting both the spirit and letter of the law. This is not, however, a reason to throw up our hands and conclude that regulation is futile. Rather, it is a reason to strengthen regulatory enforcement so the financial sector cannot flout the spirit and letter of the law without meaningful consequences.

Consider, as a comparative example, the 'regulations' (laws) on the books defining and prohibiting murder. A rising murder rate is a cue to spend more on law enforcement and/or toughen sentencing rather than a cue to throw up our hands and remove killing from the criminal code.

Just because the financial sector has become very adept at evading laws does not mean they should be given a free pass to do whatever it wants any more than a high murder rate should be solved by legalizing murder.

Curmudgeon: Fair enough. If we couldn't find a better solution, then regulations on leverage etc. should stay in place, perhaps changed, and be better enforced. But murder is bad, and we want to stop it. Leverage is good, and we don't want to stop it; except it sometimes has bad consequences. There *has* to be a better way, where we can allow leverage, but stop the bad consequences.

In 2006 BIS said there was 6-7 years worth of GDP in derivatives outstanding. I'm worried the next time this happens, there will be decade's worth outstanding, and for example, traders will cause a four digit barrel price of oil and a three digit bushel price of wheat. The reaction would be roiling nationalization and some martial law to ensure functioning of some basic services like utilities.
Beyond not electing Republicans still free-market fighting the Cold War, I think the key is to determine how much trading liquidity is necessary to keep real economy derivative hedges working. If a farmer forward sells grain, some liquidity is good. Too much and the farmer is lost in the noise. Too little and the farmer is stuck with grain or bankrupt. Same with the currencies of honest Central Banks servicing debt and funding education, etc.
IDK how to determine what level of trading is parasitic or what regulations prevent pyramiding, but a Tobin Tax solves the problem. When derivative plays are too high, Tobin Tax (or restrictions). On the recession side the revenue from the tax could be used as negative tax for stimulus or just plain FDR job creation (nursing/teachers not depression-era parks cleaners).

I don't think you want to kill bubbles because some are real. Internet bubble created real wealth via network effects that just happened to be given away instead of dot.com captured. Columbus exploration too. Small pox and slavery sucked but Africa and Americas in no geographic position to ever get mechanical power from steam engine.

Bankruptcy without economic cost is a lot like jumping off a cliff without pain. It doesn't happen and, if it did, that would mean there would be no penalty for doing something really STUPID!

Sorry, pain and cost are are the downside of the process that allows euphoria and gain (even "irrational exuberance") on the other side.

You gotta be prepared to take the bad with the good.

Phillip Huggan: A Tobin tax would tax all financial transactions; I don't see how it could prevent the 'bad' ones and not prevent the 'good' ones. Same for any restriction on leverage or duration mismatch. If you allow *any* leverage or mismatch, there will always be some risk of a financial crisis (regardless of who is in government). Only a 100% equity financial system (zero debt and so zero leverage) would prevent insolvency (and it worked well in handling the crash of the tech bubble in 2001, which was mostly equity-financed). But people don't always want to invest all their wealth in the stock market, and firms and people don't always want 100% equity-finance (for good reason). The sort of restrictions you propose are just tinkering around the edges with the existing medicines. There has to be a better, more radical solution.

Terry: there is individual cost (wealth transferred) and there is social cost (real wealth destroyed). If a firm defaults on its debt, the original owners of the firm lose the firm, and the holder of the debt gets back less than 100%. This is sufficient disincentive. We don't need to prevent the workers and machines continuing to produce output as well, which is the destruction of real wealth. Actually, my proposal would give individuals a bigger incentive to avoid risky loans than would government bailouts, where the government subsidises some of the losses.

"(Forget all those derivatives; they are just a fancy way to get more leverage, or to get around regulations limiting leverage.)"

Thank God you said this. I've been saying this as well, and it's great to find someone who agrees with me.

On the Soros testimony the other day:

"Take for example credit default swaps (CDSs), instruments intended to insure
against the possibility of bonds and other forms of debt going into default, and whose price
captures the perceived risk of such a possibility occurring. These instruments grew like Topsy
because they required much less capital than owning or shorting the underlying bonds.
Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of
the underlying bonds and five times the entire US national debt. Yet the market in credit default
swaps has remained entirely unregulated."

( Agree: but he misses the point. CDS's filled the need, which were investments with less capital. Something else would have worked if they didn't. It wasn't the investment, it was the need which created the investment )

Yeah Nick I shouldn't have said Tobin Tax. What I meant was an instrument like a Tobin Tax (which itself doesn't seem politically popular) that comes into enforcement as traders crowd out real economy hedges and which increases in severity, like ibncome taxes, as derivative euphoria takes off.
Pareto effects cause the rich to get richer. Whatever initial allocation of capital existed, land ownership or invention or skilled labour, without steep enough taxes you get a society where having money becomes the prerequisite for income. This is happening in Canada and has happened in USA. But derivatives have the incidious potential to speed this up greatly; whoever is exploiting credit loopholes or controlling a dishonest treasury can monopolize the future world's real economy, potentially.
An alternative to the "phased in and graduated" Tobin Tax would be to modify the daily trading price limits already in place for grain contracts. They are limited to a daily price movement (which was doubled recently). For example, as it becomes clear (IDK how) a contract has been taken over by speculation, the daily price limit could be lowered. On the converse, assuming too much contraction someday, you could raise limit. Many alternatives. Could impose tax after a certain volume breached, certain number of traders, for certain financial contracts that could potentially compete with central banks...
the level of derivatives needs to be limited, somehow, else it locks the world's economy into too many dumb investments (big USA homes is minor).


Without leverage, we would have to pay cash for our homes, or else use equity-finance, and with equity-finance the bank, as part-landlord, would want to stop us painting the walls orange.

is surely silly.

The bank wouldn't have the resources to micro-manage like that if everybody was doing their financing that way. I haven't thought it fully through, but I don't think it is obviously as bad as you are painting it.

Don: I was pleased to see Arnold Kling giving a specific example of how CDS's are a response to regulation: http://econlog.econlib.org/archives/2008/11/why_credit_defa.html#more

Phillip: If policymakers were able to identify bubbles, and were able to keep their heads, and yet for some reason couldn't persuade people that they were paying too much for something, (big 'ifs'), then I think the best policy lever would be to restrict leverage on bubble assets. For example, if a 10% downpayment is required for houses in 'normal' times, this could be raised to 20% if house prices look 10% overvalued, etc. Simple and direct, and lets safe trades continue. (For 'houses' read 'whatever asset is in a speculative bubble'.)

reason: My "painting the walls orange" was a flip (OK, I admit, a silly) example, but of a real and important difficulty with equity finance. Suppose I lend you money to buy a house, and you have (say) a 50% downpayment. If we use debt-finance (like a standard mortgage), all I have to worry about is that the house is worth more than 1/2 what you paid for it, and that it is insured against fire etc., and I can be almost sure I will get my money back. But if instead I use equity-finance, I am going to need to check that the house is worth every dollar you paid for it, and that you don't do anything that detracts from the value of the house, and that I get half of any benefits from the house (how would we even measure that?). As you say, this micro-management would indeed take a lot of my resources, but it would be necessary under equity-finance, which is why we very rarely see equity finance of owner-occupied houses. The same is true (perhaps to a lesser extent) for other assets, not just houses.

Nick, but sometimes assets that appear to be bubbles aren't. My specific example was the internet bubble. Dot-com mania led to the laying down of new communications infrastructure along with the IPO frenzy. In the future investments in windturbines or some materials science advances may appear to be bubbles. We'd be at internet 2000 if not for switchers and fibre optics companies (esp asbestos ones) getting their market caps. In the long run this would be a cap on computer hardware as semicondutor lasers turn into substrate materials science. Biotech is another. I'd say take the bubbles and sock away some windfall revenue. Microfinance could go bubble (yeah right).

One thing that ought to be looked at very seriously is the moral hazard that comes with limited liability. Because of limited liability, senior management in the financial sector is in the privileged position of being able to earn unlimited rewards from making good bets without also being exposed to the downside risks of making bad bets. As a result, managers have every incentive to take extreme risks as they'll never suffer any consequences if things go badly.

Imagine the risks you'd take in a casino if you got to keep 50% of your winnings and somebody else covered all your losses.

Encouraging extreme risk taking is acceptable on the margins of the economy, but it's fundamentally wrong when the downside risk of bad bets by systemically important firms can effect the lives of every human being on the face of the planet.

I can't agree because the occupier also loses if he does something silly, not just the bank. Why wouldn't the bank assume self-interest was sufficient?

But we didn’t know how to design a financial system which is robust enough to cope with people making bad decisions.

Since we don't know what the bad decisions are until too late, the only way you can minimize the damage done by bad decisions is to minimize the damage done by *all* decisions. We can only minimize risk at the cost of minimizing innovation or reward. And, of course, the only way you can bring the risk down to zero is to remove all possible reward.

Instead, we just have to decide how much risk we're willing to tolerate. If we want the rewards of a reasonably innovative and profitable financial system, we're just going to have to accept that there's some risk of catastrophe.

We Canadians might be patting ourselves on the back for not allowing them to take risks, but we're deceiving ourselves if we think we're immune. Our catastrophe may be a 1 in 200 year problem rather than a 1 in 50 year problem, but there's not doubt there's some financial crisis that we haven't thought of that's just waiting to take us down.

One other problem is that eventually the innovators will destroy the risk-averse if catastrophe doesn't happen fast enough. I don't know how many more years Canada's banks would have survived in their current form if the current crisis hadn't occurred - they'd have been bought out or merged with the far more successful risk-taking US banks.

Phillip: the tech bubbles caused more investment in tech (which seems good) but less investment in something else (which is bad). On net, the distortion of investment into tech and away from something else was presumably bad, since those decisions were made based on expectations of future profitability which turned out to be wrong. But if that were the only bad consequence of a bubble (if it didn't bring the rest of the financial system crashing down when it burst), I wouldn't worry too much.

Curmudgeon: yes, limited liability creates a moral hazard (or principal-agent) problem. But some de facto limits on liability are inevitable anyway (debtors' prisons can't get cash out of a pauper). And without legal limited liability, I would be extremely nervous of holding shares, and wouldn't want to be manager of a corporation unless I could be perfectly sure I could control everything. With no externalities, limited liability looks like an efficient compromise between moral hazard and risk-sharing. But maybe if there are externalities, as you say?

reason: self-interest tells me to default if my house price falls too much. Self-interest also tells me to take out a loan if my expected gain when house prices rise exceed my expected losses from default. let me try my argument another way. Suppose we had a policy that the government would set fire to factories where the loan defaulted (after warning the occupants of course!). That would reduce the owner's incentive to default, and/or reduce the bank's incentive to make risky loans, because the net proceeds from a bankrupt business would be lower. But it would be bad policy nevertheless. But that is effectively what happens (only not as extreme) if the bankruptcy law lets the factory sit idle, or sells the assets at fire-sale prices.

Tom: I agree with everything you say. I just refuse to accept it! There must be a way to shift that risk-reward trade-off to get more safety and more reward, not just move along the trade-off curve. I think that changing contract law would be a way to shift the trade-off. I think it was Laffer who said something like "No such thing as a free lunch? Nonsense! Our job is to find them and eat them."

I think the dot.com bubble had the potential for global slowdown if not for US deficit spending (which has merely paid the recession forward). You can regulate away obvious financial parasitic behaviours but you could still have legal recessions. I read a news headline that said UK MPs are now being given some science education. Maybe large players whether crown, private, or legal, should be forced to learn some macroeconomics and accounting?

"There must be a way to shift that risk-reward trade-off to get more safety and more reward, not just move along the trade-off curve"

It is quite possible that regulation prevents us from choosing solutions along the efficient frontier.

Andrew: the way I think of it is that each particular set of regulations defines one point in {risk, reward} space. Join up the dots (or find the envelope/frontier of those dots) and you draw the trade-off. The government/regulator then chooses a point on that trade-off. A bad set of regulations would be a point off the frontier. But just tinkering with leverage and mismatch regulations seems, at best, to just move us along the frontier, getting less risk but less reward if we tighten up, and vice versa if we loosen.

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