Friday, March 6, 2009
Don't just "Change"; "Adapt"
The world economy has changed but our government's regulation of it has not adapted. The world has become so interwoven that what used to be a regional issue quickly becomes an international crisis. History says WWI started because some archduke and his wife got capped in the Balkans. I'm guessing that if the shooter missed, something else would have been the catalyst. The world had become a dangerous place. After that war there were half-assed efforts to organize the international community to avoid another world war. After that didn't work and the world got a glimpse of how World War III would be fought, there was finally consensus to form a body that could help to avoid repeating history again in another 20 years (I'd say the U.N. was a 3 quarters -assed effort). That's where we are financially. The old system doesn't work and the U.S. needs to lead the way to a new, safer system. The states regulate insurance. The Feds have at least a half dozen agencies that have some regulatory responsibility. The regulated determine who regulates them through loopholes (who knew AIG was actually a thrift?) and lobbying efforts. Some avoid regulation altogether. The regulating chain is only as strong as it's weakest link, and, as it turns out, that was every link. When one financial behemoth metaphorically gets capped, the whole world economy is threatened. This is a pre WWII system getting drubbed by 21st century innovations. The solution is to take advantage of this crisis, not by cloning the French economy, but by rebuilding the parts of our economy that are outdated. We need a regulatory system that works to prevent the next crisis. Risk management does not mean coming up with a model that calculates a likelihood of a position blowing up. Effective risk management models identify the risk of blowout and prescribe a hedge to avoid it. It is possible to know absolutely that a position will not sink the whole firm, let alone the whole economy. This means lowering leverage and, therefore, paper profits. But as we've found out, those profits were never real anyway. Deferred bonuses are also a good idea, disincentivizing burying long term risk for the sake of short term paper profits. Special interest groups will fight this regulation but the taxpayers, as the insurer of last resort, have earned the right to control risks that affect the whole world. As Warren Buffett said, "derivatives are financial weapons of mass destruction." Like military w.m.d.s, they cannot be uninvented. We need a system that guarantees they never go off again.