Monday, March 17, 2008

To Quote Warren G, We Need to Regulate (JM)

It's a busy day, so working through my usually lunch blogothon I haven't been able to churn out my thoughts on Bear Stearns and the impending economic doom waiting to hit us all. I am sure Dennis will have some good thoughts on this this evening as well. However, I do want to discuss a post from Megan McArdle over at The Atlantic. Megan is yet another crazy Marketeer, but is generally somewhat reasonable and totally interesting, but today's thoughts from her were a bit silly. She points out the obvious, that just because there's a problem doesn't mean that there's a regulatory solution.

This is a totally agreeable argument, the existence of a problem does not automatically call for an interventionist solution. However, in this case her assessment of regulation presumes that its purpose would be to forestall risky investment vehicles, which would have a negative cost to the economy. This may be true and would require some real cost-benefit analysis. But I think that's only one small part of the real regulatory problem: transparency.

The real issue that this crisis (and several other major economic and business debacles of the last ten years) brings to the fore is that our financial network has become something of a Rube Goldberg machine. In this case, low-grade loans and investments were marked as AAA quality because of the bizarreness of the system (and desire for profitability). Derivatives have become so complex that it's increasingly difficult to understand their relationships in the market. More often than not, instead aggregating risk they hide risk. This can lead to a market boom, because more deals get made, but when the market turns sour it hits us much harder. I think regulatory bodies clearly have an obligation to work towards a greater transparency, which could only serve to boon a real, free and fair market system.

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