Less than nostalgic
By Daniel M. Ryan
The regulatory revamp of the financial-services industry has finally been unveiled. One of the striking aspects of it has been the widespread disappointment liberals have expressed. They hoped for a big overhaul, a reprise of the 1930s, and an end to so-called 'deregulation'. The fact is, financial services as a whole were never deregulated. The only hook for the label, one used by libertarians as well as anti-libertarians, was the unregulated character of the hedge-fund industry and of exotic derivatives that weren't even around in the 1980s. Saying that the Bush and Clinton administrations "deregulated finance" is like saying Lyndon Johnson was a "deregulation" President, because he didn't insist on regulation of the then-new Eurodollar markets. Hedge funds were also unregulated in the 1960s, with the full blessing of the Securities and Exchange Commission. Its officials had decided that sophisticated investors, defined as those with $100,000 to deploy, were sufficiently capable of seeing through bamboozles on their own or with expert help.
The fact is, the Obama/Geithner plan makes adjustments at the margin; hence the liberals' disappointment. The marginal character of its reforms is solely due to already-existing financial-service regulations. A case could be made that some of its measures are there to correct previous excesses of regulation, particularly in the SEC's métier full disclosure. As Benjamin Graham suggested in the second (and sixth) edition of Security Analysis, much of the regulatory and legislative crackdown was to get rid of practices that were just not done previous to the 1920s. In other words, one of the two main thrusts was restorative: the securities industry as a whole was basically fine, until the crooks came in and started doing what was anathema to legitimate professionals in the good old days. "The bucket-shop crooks got in and were turfed out by law" sums it up.
Of course, the then-new system did more than single out the shady characters of the 1920s. Some old-line practices, considered tolerable before then, went out too. Insider trading was no longer considered a perk of the job, but an egregious violation of fairness. Many practices used by pool operators, formerly viewed to be picturesque or harsh teachers of fools, were deemed manipulation and banned. It could be argued that these practices were included partly to show that the white-shoe boys were clamped down upon too, although it could also be claimed that the establishmentarians went along with it because the 'chump' ethos kept Wall Street too small-scale. There was no way to reconcile a carney-barker's attitude with "The People's Capitalism," long-term.
Regardless of what motives were behind what, the reason why the U.S. government could effect such a wholesale change was because there were little to no previous measures at the time except for general fraud laws and NYSE rules. The Roosevelt Administration was like a builder on near-vacant land, with no previous buildings (or building codes) to obstruct. On the other hand, there were quite a few unwritten rules – customs – that could be formalized through regulations or laws. The builders had some building guidelines from industry vets to help them along. The only truly new principle in the SEC's mandate was its emphasis on full disclosure…the same measure that the current proposal is fiddling with. "Understandable disclosure" all-but-implies that full disclosure has led to information overload, suggesting that financial institutions have been too eager to comply in the past. The already-existing edifices of the SEC, the CTFC, the FDIC, the post-'30s Federal Reserve, can't be wished away in the fond hope that the 1930s will return again. They have to be built around; nostalgia for Roosevelt's vacant lot doesn't change the present un-vacant structure a whit.
Another reason why a Roosevelt dealie will not be in the cards is because there are few to no independent customs in Wall Street anymore. The number of investment pros who worked in a pre-regulated Wall Street, if only as quote boys, can be counted on one hand. Everyone else – I do mean everyone – has spent their career in a regulated environment. The same was almost as true as of the Crash of '87 and subsequent crises before the most recent. All of those developed in a regulated environment, making for long odds that the current reform package will prevent the next one. Even in cases where the products are not regulated, the firms are. (Hedge funds have to meet specific guidelines in order to be left alone.) If this were not the case, Used Car Joe could have set up a CDO chop shop.
Current customs, naturally, have grown around these regulations. In the olden days, when the bad-boy type was seen as having a rakish charm, there were shadow customs that skirted the regulations; not any more. To give an example of how things have changed, in the olden days Enron would have been shrugged off as tragedy or object lesson. Nowadays, most everyone sees those shenanigans as serious de facto crimes that demand legislative action. I can think of no better example of how law- and regulation-centric the securities industry has become. Hence, there are little or no regulation-independent customs that the Obama Administration could tap into. And, as indicated earlier, some of the "special interests" complicating the process are the already-existing regulatory bodies. Full disclosure might as well be the SEC's claim to fame; why wouldn't its administrators resist any attempt to fiddle around with it?
We now have two reasons why wishing for Roosevelt is completely impracticable. There's also a third, having to do with the Three Laws of Deregulation. Since "ideologues" are weeded out early in the political career track, except for isolated favorite sons, the First Law of Deregulation says that the U.S. government only deregulates when it has to. In some cases, this necessity is due to mercantilistic considerations, but mostly it's because the regulated industry is suffocating under the then-current system. That was the case for the S&Ls. Regulation Q had to be suspended in 1980 because all U.S. interest rates were going above its ceiling, and the Reagan-era deregulations were enacted because the S&Ls had been whipsawed by interest rates falling a couple of years afterwards. How else to make a profit after borrowing 13% money when rates had fallen from 15+% to well below 10?
The Second Law of Deregulation, which says that governments don't regulate when they can't, is intuitively obvious. Why would any practical-minded person try to regulate the impossible-to-regulate? What government official wishes to make Uncle Sam a mere blowhard or pipsqueak by pushing 'aspirational' regulations? This law explains why the Johnson Administration didn't try to regulate the Eurodollar market. It also explains why some of the recent fast-growing and exotic derivatives weren't, either.
The Third Law of Deregulation is less cut and dried than the two, but it's grounded more in common sense. Simply put, government officials are more likely to deregulate or un-regulate people that they know and trust. The CDO, CDS and other toxic-asset hawkers were neither flamboyant nor aggressive, and they were far from scofflaws. If anything, they resembled would-be professors. All of those products were justified as safe by sophisticated statistical models that might as well have been Ph. D. theses. Rather than resembling the stereotypical plaid-suited crook that scoffs at academia, they might well have been in academia. To put it succinctly, they hailed from a social group that Washington financial-service regulators considered disinterested and trustworthy. The fact that at least two financial crises in the last eleven years can be traced to 'pinheads' doesn't change that character judgment at all; LCTM had already been dismissed as an "isolated incident." Had the derivative experts acted like overgrown frat boys, it's almost a certainty that their products would have been scrutinized much more carefully than was the case.
We now have three solid reasons why we're seeing the Mulligan stew that's been unveiled, and why a return to the 1930s (which some liberal evidently see as the good old days) is impossible. Wishing for a wholesale Rooseveltesque burst of harsher law and tighter regulations might as well be the same as wishing for the good old vacuum-tube radio to come back, or…well, you know the patter.
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