Sunday, April 3, 2011

Run and Find Out

"There are more things to find out about in this house," he said to himself, "than all my family could find out in all their lives. I shall certainly stay and find out."

— Rudyard Kipling, Rikki-Tikki-Tavi

Aline van Duyn posted an interesting column in the FT Weekend about financial regulation. In it, she cites Alan Greenspan, who issued what she calls a "scathing critique" of the Dodd-Frank financial reforms in an earlier FT editorial:

"The financial system on which Dodd-Frank is being imposed is far more complex than the lawmakers, and even most regulators, apparently contemplate," wrote Mr Greenspan.

"We will almost certainly end up with a number of regulatory inconsistencies whose consequences cannot be readily anticipated...  These 'tips of the iceberg' suggest a broader concern about the act: that it fails to capture the degree of global interconnectedness of recent decades which has not been substantially altered by the crisis of 2008."

These are valid and worrisome criticisms. Unintended consequences are sure to be rife from such poorly-thought-out and hastily written legislation. Beholden to justifiable public outrage and the resulting political imperative to "just do something," Congress has defaulted to its all-too-common practice of Ready, Fire, Aim.

And yet, Mr. Greenspan seems to intend much more than a simple cataloging of potential weaknesses with Dodd-Frank:

The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems. Today’s competitive markets, whether we seek to recognise it or not, are driven by an international version of Adam Smith’s "invisible hand" that is unredeemably [sic] opaque. With notably rare exceptions (2008, for example), the global "invisible hand" has created relatively stable exchange rates, interest rates, prices, and wage rates.

In the most regulated financial markets, the overwhelming set of interactions is never visible. This is the reason that interpretation of contemporaneous financial market behaviour is subject to so wide a variety of "explanations", especially in contrast to the physical sciences where cause and effect is much more soundly grounded.

The force of his remarks—and the implication of the phrase "unredeemably opaque"—is clear: we will never understand how markets work, and therefore we should give up trying and go back to the unregulated state of nature Mr. Greenspan and his fellow Randian and quasi-Randian travellers cultivated so carefully in preceding decades.1 But this is nonsense.

* * *

Few people of sense would suggest that we will ever understand the inner workings of the global financial markets with any level of completeness or rigor. Certainly not to the extent we could predict their behavior under all circumstances, like we can in certain of the physical sciences. (For one thing, the components, interrelationships, and forces in financial markets are always changing, a substantial additional impediment to accurate prediction which most complex physical systems do not suffer from.) But that concession is miles removed from the belief which Mr. Greenspan seems to advocate, which is that we shouldn't even bother to try.

Scientists do not flatter themselves that they will ever be able to comprehensively model fluid flows in a turbulent stream, yet hydrodynamics remains an active and vibrant field of ongoing study. More to the point, geologists, meteorologists, and ocean scientists do not pretend they will ever be able to predict the sources and evolution of earthquakes, hurricanes, or tsunamis to the level of Newtonian mechanics, but that does not prevent them from trying to understand these phenomena better. Putting aside the claims of human curiosity, we try to understand such phenomena because they can have hugely destructive effects on our societies and persons. The analogy with a global financial crisis is exact.

* * *

So it pleases me to learn from Ms van Duyn that some people are trying to remedy our ignorance:

John Liechty, a professor of marketing and statistics at Pennsylvania State University, helped create the Office of Financial Research, a new agency created by the Dodd-Frank Act that is charged with identifying systemic risk in the financial sector. He first got the idea when he met regulators at a workshop after the crisis.

"It really was surprising to me," he said. "Regulators had a complete lack of real information about how the markets work, the size of positions and exposures among institutions."

He believes there is a "national need" to gather the data and do the research to understand markets better, just as was done to better model hurricanes and their impact. It took decades – and was a serious project.

This is exactly what we need: a well-funded, serious, permanent agency devoted to understanding as much as we can about the elements, interconnections, and vulnerabilities of financial markets and their participants. In addition, I would suggest that the constant mutability of this system argues strenuously for the implementation of a plan like that suggested some time ago by Economics of Contempt. Stationing a sufficient number of experienced, knowledgeable ex-market participants in regulatory oversight positions at the largest and most systemically important financial institutions would not only provide necessary close supervision (and perhaps help nip developing crises in the bud), but would also support the development of true boots-on-the-ground insight into the day-to-day workings of financial entities and markets. This type of knowledge would be invaluable to helping regulators develop a robust, dynamic understanding of global financial networks and players.

* * *

So let us have no more willful ignorance, no more worship at the self-interested shrine of laissez-faire Know-Nothingism. The acknowledged difficulty of getting to grips with the global financial system is no argument against trying to do so. Rather, it is an argument for the urgency of beginning forthwith.

The Pecora Commission investigation into the sources of the 1929 stock market crash began two and one-half years after the event, lasted over two years, and helped shape the regulatory environment for decades. In contrast, the underfunded, marginalized Financial Crisis Inquiry Commission lasted one year, at a time when the size, complexity, and interconnectedness of the global financial system has grown exponentially from 1934. In terms of academic interest, regulatory concern, and social impact, understanding the sources of the recent financial crisis must rank as one of the most important socioeconomic research projects of our time. From my perspective, it's time to stop dicking around and start trying to understand it.

In early human history, the shaman or medicine man was tasked with intermediating the needs and objectives of his tribe with the mysterious forces of nature. He developed a primitive understanding of cause and effect and was effective to the extent his beliefs and actions corresponded to underlying reality. Eventually, he became a sort of scientist, albeit one intellectually hobbled by superstition. As general knowledge advanced, some shamans must have realized that their position and authority in the tribe depended less on their true understanding of reality than on their ability to keep the mysteries of life secret from their charges. This, I am sure I need not tell you, was not in the best interest of those tribes.

So let's bow and scrape obsequiously to Alan Greenspan as he swans away in his buffalo robe and bear claw necklace. After he's gone, we can turn back to our microscopes and chemistry sets and begin to try to understand things for a change.

Here's your headdress, Alan. What's your hurry?

* * *

UPDATE: Writing in the FT today, Congressman Barney Frank more or less agrees with me:

When technology can track billions of transactions in real time, a failure to pierce the opaqueness of the system is mostly a question of will, not capacity.

I suppose Barney has been disinvited from Alan Greenspan's Christmas pow-wow, too.

1 I will not sport with your intelligence in the body of my remarks by drawing attention to the groaner for which Mr. Greenspan has been widely and humorously pilloried—"notably rare exceptions"—other than to note the irredeemable [sic] cluelessness and tone-deafness of its author reminds me of the no-doubt apocryphal remarks of the Ford Theatre stage manager after the assassination of President Lincoln: "Other than that, Mrs. Lincoln, how did you enjoy the play?"

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