Think Economically


Maximum understanding, minimum average total cost.

The *real* real problem with financial regulatory reform: closing our model

“How come good people do bad things?”

So people are thinking and talking about this and there are two glaring problems in the discussion. First, “the structure of regulation” will never be done, complete, finished–it’s a game we make up as we go along. Second, the question “How come good people do bad things?” is the wrong question.

Jim Surowiecki argues that regulators need to focus more on “preventing malfeasance from happening.” John Kay argues that we need “a structure of regulation” that fixes perverse incentives and makes people–or financial institutions–more trustworthy.

Felix Salmon shoots holes in both of them, basically saying “yeah, good luck with that.” Which I’d like to reinterpret: for real, good luck.

The answer: people do things, and smart people do creative things, and there is no fix–there is managing society, and if everyone does what people do, it’ll never end. There is no regulation to solve it–but we have to put up a dam and pile up the levees or the torrent of human intention will go places we don’t want it.

Tunnel under the embankment - - 1154526

Economists treat people as though they are greedy and untrustworthy, in our models, and then most economists have trouble bringing that into real life without it complicating interpersonal relationships. And then they become regulators or consultants or what-have-you and they say “sure, Jamie Dimon or Lloyd Blankfein or whoever  is greedy, but who isn’t?” and it becomes difficult to carry that picture in your head, that idea that the person you’re at lunch with would gladly screw a lot of people out of a lot of money, given the opportunity–hell, may even feel morally obligated to do so.

And now economists and economically-minded individuals continue the paradigm of financial scandal as moral failing. This may well be the case, but I think it is, perhaps, not useful. A few of the sources of these thoughts I remember: One is Felix Salmon’s post today about how better regulation won’t work. One is Matt Yglesias’s post on the real problem with private equity.

These discussions seem to revolve around trust:

Yglesias recapitulates Summers and Schleifer’s argument that as a firm goes from start-up to an established concern, there are numerous unspoken bargains between ownership, which usually represents capital, and labor, and that the fact that those unspoken bargains are unspoken means they are not contractually obligatory, just kind of the decent thing to do, and so private equity can engage in the perfectly legal although perhaps morally repugnant activity of pissing on people’s notions of fairness, thus saving money on bathroom facilities. Trust (which in this case seems to stem from history or camaraderie, but again, maybe mutual interest once upon a time) declines. Yglesias notes: “I don’t know that there’s an ironclad policy remedy to this.”

Salmon basically argues that the game slowly transforms from a positive-sum game when there are lots of little firms to a zero-sum game once vertical integration has taken place. Trust (which stems, he implies, from mutual interest) declines. He punches holes in arguments from Jim Surowiecki and John Kay, saying that Surowiecki is too vague, and that Kay is missing the existence of important constraints.

In my opinion, the useful model is one that gets away from good people doing bad things and just looks at it as a lot of people doing a lot of things. If they work hard, they do many more things with higher value and higher leverage than most people. If they’re smart, they get creative–and smart, creative, hard-working people have a tendency to just do stuff to see if they can, because, hey, it might work.

If you’re like me and you find a word document or an excel spreadsheet online, you check to see if you can access the directory. Why? Because you might find something cool. It’s like finding a giant rain runoff pipe and walking through to the other side–maybe it’s just a gully, maybe it’s someone’s property, but maybe it’s The Lost World. How could you be content not knowing?

Sometimes you follow that unknown path and find out that you can make a crap-ton of money. It happens. And Salmon is right, it’ll keep happening. But I know that you can trust people to be people, and that means that there is regulation that helps. Some of it is putting people in prison for going where they oughtn’t. Some of it is letting creditors twist in the wind if they make bad decisions. A lot of it is keeping up with smart people and figuring out where they think they’re going and whether that’s such a good idea after all.

The myth that economists fall for, though, comes from our models: in our models, we hit equilibrium and that’s it. Design a mechanism that gets your typical agents to the desired equilibrium and you’re done. And then people in real life get all fancy and regulators feel bad after they have a couple drinks or get invited to a bris or baptism or wedding or something. What we need is to stop pretending that there are good people and bad people, and stop pretending that an incentive-compatible mechanism will solve the problem.

The first steps?

First, drill into every regulator that your friend, the investment banker, when he’s on the job, is not your friend. He’s not a good person or a bad person, he’s just a profit-motivated dude and your job is keep him in line. Treat them like addicts–it’s nothing personal, it’s just the nature of the business. Cops deal with confidential informants all the time on made-up TV shows I watch, but they never forget they’re cops, and those other dudes, they’re CIs. But they still have Internal Affairs or whatever to catch rogue cops, and presumably internal affairs has their own whatever.

Second, find a way to keep it all manageable–some activity that might be efficiency-enhancing will have to be forgone, because the costs of hidden action are too high and the technical hurdles for enforcement are too high and so there’s no way to create separation.

Third, keep regulation contingent and fluid. We need a stable regulatory environment, and much of that is already there. But there should be some straightforward ground rules regarding financial innovations–probationary periods or what-have-you in which regulators can be brought up to speed. Mostly regulation needs to change in its paradigm–it is not the rules of the game maybe so much as the rules of the rules? I’m just spinning stuff here, but there must be some way to acknowledge the disequilibrium nature of innovation.


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July 2012
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