Ponzi Schemes Of The Caribbean (A Weekend Comment Competition)

The IMF has just released a new working paper, with more detail than you likely ever wanted to know about how Ponzi schemes work – particularly in and around the Caribbean.

Ponzi schemes are everywhere and, at least in some environments, new versions arrive frequently.  But why are they so hard to prevent and shut down once they appear?  The paper contains some strong hints, albeit couched in very diplomatic language.

The comment competition is: what, if anything, does the failure of governments to shut down blatant Ponzi schemes imply about the prospects for a potential “macro-prudential” system/market-stability regulator implementing cycle-proof rules in the United States?  Is there a better way to prevent the kind of behavior that led to our current financial crisis?

91 thoughts on “Ponzi Schemes Of The Caribbean (A Weekend Comment Competition)

  1. Why and how could any government shut down ponzi schemes when the cynical side of me increasing senses that our Government(fed and treasury) are running the biggest ponzi scheme in the history of the world and everyone is gladly participating. Constantly rolling over old debt with new debt is the same as getting new investors to put up money to keep the game going. It’s also similar to everything from our recent home price debacle and stock market values decline. Ponzi finance is alive and well- it’s called the Fire economy and it owns our government.

  2. Greed trumps regulation every time. The current round of ponzi schemes seem obvious only because the regulatory system was compromised. If it appeared that someone was actually paying attention then tricks to hide and alter the scheme to avoid red flags would have been put in place. (No reason why a ponzi scheme always has to make money… just often enough to keep the suckers coming in) So strong regulation can protect us from previously discovered schemes, but financial criminals seem to have infinite creative ability…

  3. One more thing, Simon and James have been very critical with the Obama administration’s handling of banks. Tim Geithner made a fair point to the congressional oversight panel. His point is when you judges his approach, what do you compare it against?

    As an intellectual exercise, I am sincerely interested in learning about better approaches from you Simon and Jame Kwak.

    I’ve detail the constraints the administration has to deal with here:


    Intellectually, I love to hear a meaningfully better approach. I haven’t seen any good alternatives from any of the critics of the administration (baseline scenario, krugman, and etc.). None of the critics suggestions pass muster if you look below the surface.

    To be frank, if you cannot come up with something better, then what you are doing is pontification and undermining the support and effort of others working hard on the problem. Please don’t lose sight of the unemployment is rate 8.5% and grows 0.1% every week and the real human suffering.

  4. What sort of connection is there between off-shore tax havens and these Ponzi schemes? Do fraudsters prey on people who’re eager to escape taxes?

  5. By the way, I have offered my solution that does pass all the constraints. My solution is provable that most likely it will save tax payers money and reduce total cost to society. At worst, my solution will not cost *socieity as a whole* any more than what the crisis has already cost. It is all upside.

    I’ve detailed why right now we should relax banking regulation and we’ll address bank regulation and enforcement later in the following posting.


    Lastly, Simon, since my posting is a couple days earlier than yours, does my posting win the commenting contest automatically?! Never mind, I jest! Hahaha!

  6. I said the following on one of James’ posts on March 12th:

    “Have you ever heard of a Ponzi Scheme being stopped as soon as it began? I doubt it. That’s because it mirrors a particularly lucrative investment for quite a long time. How many people are going to let you close down there investor because you suspect that his returns are too high? They’re more likely to respond that you’re high.

    There’s no stopping a Ponzi Scheme until it runs its course. It’s a perfect crime for a fairly long time. Also, notice, Madoff admitted his guilt. Stanford isn’t so stupid it seems. He doesn’t believe that the government can even figure out how a Ponzi Scheme works, let alone convict him of running one. He might turn out to be right.”

    Now I can refine my view, based on that superb paper. First, this post for reference, from The Trader’s Narrative:

    “The Madoff Red Flags, Let’s Count Them”


    From the essay:

    “Red flags. Experience shows that there are certain hallmarks that point towards the
    existence of investment fraud. Thus, the development of such red flags creates a basic
    tool for the identification and investigation of fraudulent schemes. The Caribbean UIS
    had a number of features considered to be red flags by the Securities and Exchange
    Commission (SEC) and the Commodity Futures Trading Commission (CFTC).”

    I don’t think it’s an ignorance of Red Flags that’s the problem. The problem occurs here:

    “validation, when
    large and easy rewards earned by initial members generate strong word of mouth publicity”

    If you look at the recommendations, they depend upon giving the power to a regulator to confront people who are making big money. Depending upon who these people are and their resources, that is a herculean task. In other words, depending upon who is being defrauded, the regulator might not be able to stop the scheme until the major investors in the scheme begin to get hurt. I’m simply dubious that Red Flags are enough to stop a Ponzi Scheme, nor are Regulators enough.

    What regulators could do is develop a case and attempt to get the actual investors in the scheme to call for an accounting. Again, if you simply go to investors and say, “We’d like to shut down your investment because your returns are too high”, they will probably respond,”Are you high?”.

  7. The Answer is Simple: We Need a Teaching Moment
    First of all, was there not some unintended irony in that the IMF paper was dated April 1?

    Since we know that the “macro-prudential” system/market-stability regulator already exists in the US, in theory at least, then the issue isn’t how to set up new regulatory agencies or mechanisms but rather to understand why the existing ones failed.

    One particularly fascinating detail laid out in the IMF report is how the public often does not believe what the govt agencies say when they finally go to move against powerful and even popular ponzi or pyramid schemes.

    Now, given that the case can be made that what occurred in this country on a vast scale shares many of the red flags of the smaller scale ponzi schemes described in the report what stands out the most is:

    -politicians and regulators are often too close to the perpetrators to do anything. The fox guarding the henhouse.
    -thus they lose credibility in the long term. Faith in the objectivity of the gov’t regulators is lost.
    When they try to rein in the schemers no one believes them.
    -leaving the way open for future schemes

    And also, because of how they coopt the politicians and regulators and even the public, the bigger schemes, the ones that have the potential to inflict real macro damage to the economy- by definition are more likely to succeed than the smaller ones.

    What could have been different
    The one huge relatively painless inoculation against future abuse that might have been offered by the govt in our case is this:

    We had the potential of an enormous teaching moment. Had the gov’t clearly laid out the misbehavior of the banks, had they done nothing but at the very least forced the change in top management (and vigorously pursued any clearly illegal activity) they could have effectively used their bully pulpit to inform the public on what really happened. In doing so they could have gained enormous credibility. They could have continued to argue the banks are ‘too big to fail’ point, but at least they would have separated that from the question of individual responsibility–why are individual bankers also too big to fail (because they are the ‘best and the brightest?).

    This teaching moment could have helped provide the govt and regulators with the leverage of credibility–which could also be called political capital–to enable them to act more effectively when the next round of financial schemes begins to inflate. But as it is, that teaching moment has passed us by. The banks seem to have won. And everything is in place for a repeat of the same debacle.

    Maybe there is still a glimmer of hope. Perhaps Elizabeth Warren can provide us with this teaching moment. She seems to be trying. In any case, this would be the one major significant act that could help save us from ourselves next time around.

  8. Canonical research findings show that competition from disruptive start-ups is the likeliest source of regulation that is effective and sustained.

    In their 2006 textbook on International Economics (7th ed.), Paul Krugman and Maurice Obstfeld define “the problem of collective action”:

    “While it is in the interests of the group as a whole to press for favorable policies, it is not in any individual’s interest to do so.”

    Krugman and Obstfeld continue:

    “In a now famous book [The Logic of Collective Action], economist Mancur Olson pointed out that…the problem of collective action can best be overcome when a group is small (so that each individual reaps a significant share of the benefits of favorable policies) and/or well-organized.”

    From a 2009 book co-authored by Clayton Christensen, a Harvard Business School professor who originated the canonical Model of Disruptive Innovation:

    “Regulations ultimately change in reaction to [disruptive] innovators’ success in those markets.”

    Krugman and Obstfeld provide evidence that Christensen’s innovators equate to Olson’s small group. Specifically, the co-authors summarize research which makes it plain that, in their words:

    “Politicians are, indeed, for sale”

    Of course, successful entrepreneurs in a given industry are the small group that has the motive and the means to buy changes to regulation that disadvantage the industry’s old guard.

    — End of canonical research findings re: disruptive innovators as regulators —

    Bonus content:

    From elsewhere in the book co-authored by Christensen:

    “Those disruptors that successfully dismantled the regulations that stood in their way succeeded by circumventing the regulation — by innovating in a disruptive market that was beyond the regulators’ reach or was peripheral to their vision.”

    For a banking entrepreneur, an ideal peripheral market to disrupt is one wherein:

    1. customers become (more) creditworthy
    2. a lot of money can be made directly (i.e., independent of banking)

    In 2008, Christensen co-authored a book titled Disrupting Class: How Disruptive Innovation Will Change the Way the World Learns. From Disrupting Class:

    “In the last three decades, increasing numbers of cognitive psychologists and neuroscientists…have produced a multitude of schemes to explain…that people learn differently from one another…

    Students need customized pathways and paces to learn…

    We state above that in the first phase of the disruption of the instructional system the software will likely be complicated and expensive to build. The reasons for this can be traced to the use of the existing commercial system when marketing the system, as noted previously, as well as to the relative immaturity of Web 2.0 software. Within a few more years, however, two factors that were absent in stage 1 that are critical to the emergence of stage 2 will have fallen into place. The first will be platforms that facilitate the creation of user-generated content. The second will be the emergence of a user network, whose analogues in other industries would be eBay [i.e., an online market is a type of user network]…

    The data suggest that by 2019, about 50 percent of high school courses will be delivered online…

    80 percent of courses taken in 2024 will have been taught online.”

    A provider of said market is likely to be put out of business by competitors if it does not:

    1. introduce online markets that provide new and improved ways to showcase and earn money from expertise (details upon request)
    2. introduce a loan program for consumers of customized education ASAP
    3. make the popularity of the company’s markets and loan program mutually reinforcing, so a borrower who performs well in the markets — thereby demonstrating her ability to earn a high and/or fast-rising return on her expertise — is rewarded with a lower interest rate
    4. take advantage of new government regulations to become a bank, as a means of increasing the amount of money the company can lend
    5. introduce other loan programs and financial services that complement the markets

    Together, these new banks can be expected to facilitate a lot of economic growth.

    Paul Romer is a Stanford economist who originated New Growth Theory, which updates growth economics for the information age. Romer:

    “Perhaps the most important ideas of all are…ideas about how to support the production and transmission of other ideas…North Americans invented the modern research university…As national markets for talent and education merge into unified global markets, opportunities for important policy innovation will surely emerge…There are…safe predictions. First, the country that takes the lead in the twenty-first century will be the one that implements an innovation that more effectively supports the production of new ideas in the private sector.”

    Once the pockets of these new banks are deep enough, then, the regulation of banks can be expected to change in ways that best promote economic growth.

    By definition, these changes will end the reign of the kleptobankers.

  9. During the dot com boom; there were many cement companies in India who renamed themselves to sound like an IT Company. After that they went in for IPOs and a lot of people bought into them thinking that they were all IT Companies. This is the kind of stuff that prior regulation can’t really be expected to stop, but, when it’s happening, its pretty easy to spot and stop it. Little more common sense and better enforcement of existing rules rather than coming up with all kind of new rules is much better.

  10. And if I may add, to Simon: Clever of you to disguise your own teaching moment as a ‘competition’.

  11. There are two major barriers to counter-cyclical regulation.

    First, both human nature and politics rebel at the prospect. Nobody wants to be the kill-joy when things seem to be going well, and at such times few believe there is in fact any need to apply any such brake.

    Conversely, in the doldrum is when the psychological will and political space better exist to crack down, even if then is when it’s less necessary, and would perhaps be counterproductive. (Though I personally think the right time for increased regulation of casino capitalism is NOW, no matter when “now” is or what is going on.)

    Second, since the very basis of the modern economy and civilization itself is one giant exponential debt ponzi scheme composed of a multitude of smaller ponzi schemes, it would be counter to the overriding goal to have micro-policies seeking to limit ponzism even as everything seeks to maximize it at the macro level.

    It would be counter-policy, counter-ideology, and counter to the fundamental mindset of the existing cadre. Even if an administration arising from the current system were to, more or less by accident, decide this was a good idea, it would hardly be likely to do a good job of conceiving such a policy, nor to be very rigorous in enacting it.

    So for these reasons real reform like this seems unlikely.

  12. Hear hear. I like this distinction between “banks” and their management. I happen to disagree with letting institutions get this large as well, but it is nice to see you pointing out that there are people who without doubt made huge mistakes and are now hiding behind the size of the institutions they run. We continue to reward these individuals, above and beyond the institutions, for their monumental errors. This has to stop.

  13. 1) Criminalize mortgage fraud – if, as a broker you approve X number of egregiously bad mortgages on the books, you are subject to criminal charges, penalties, perhaps even a jail term. By this I mean mortgages that are approved without any regard for income at all – not mortgages that go bad at a later date due to a change in income status. Not hard to prove.

    2) Make it so that mortgage brokers have to disclose the commission they could make for each mortgage option offered to a client (i.e. – let consumers know if a broker is pushing a particular mortgage because it’s a good idea for the consumer – or because it has an enormous payout to the broker.)

    3) Establish regulations that ensure that financial firms with the kind of debt that brings down a nation’s economy must put future profits toward diminishing the toxic assets on their books prior to the payment of any bonuses to anyone.

    (I do not understand how “profits” can be declared by firms that are drowning in toxic assets. How does that work?)

    4) CEOs who have no clue what’s on their books and allow their companies to wrack up towering mountains of debt will be fired without a parachute and penalized for gross negligence.

    5) Establish fines, penalties and perhaps even jail terms for those responsible for fiscal catastrophes that result from the securitization of bad debt.

    6) Establish true campaign finance reform (a long shot in a field of long shots, yes.)

    7) Vote out pretty much everyone in Congress right now – or at least Frank and Dodd and all the others involved in the operations of Freddie, Fannie and the banking committees.

    In other words, criminalize the behavior that led to this situation. It is a joke to think that just flawed but understandable business decisions got us to this point of catastrophe. To bring the economy to the point of collapse must be considered a crime – but unfortunately, no one in our culture is being held accountable.

    Except the taxpayers, of course.

  14. Frank, you are repeating yourself. :-) Nonetheless, a good post which made me think of Arthur Koestler’s Act of Creation, 1964. You have the kind of rangey mind that might appreciate this. Disruptive Innovation [or should I say, disruptive innovation, in its broadest from] has application far beyond business, education and economics.

  15. The government’s failure to protect the common good is simply a failure of government, and when government fails, it needs to be replaced.

    Sadly, this is easier said than done.

    All crime is ‘cash and carry’. The operative word here is cash. Eliminate cash (tangible/transferable) currency and crime is eliminated by eliminating the victims ability to participate as well as the perpetrators ability to benefit from their act.

    As we have witnessed, the stock markets don’t exist to spread risk, they exist to harvest profits.

    Burn the stock market to the ground? Yeah, but they’ve done that already.

    No investments, no Ponzi.

    Sometimes the ‘straight-forward’ approach is the best approach.

  16. Bill, re: my being repetitive, thanks for noticing :-) Hopefully, Simon Johnson and others will follow suit, so I can abandon my avocational copying and pasting. :-) Re: Koestler’s book, I am familiar with it; good stuff (e.g., the part on humor). Best,

  17. TRANSPARENCY—the one word solution to Ponzi schemes and most financial fraud. Rather than trying to outwit the schemers, simply require transparency.
    You can’t protect people from stupid decisions that cost them money (nor should you protect banks from their stupid decisions) but you can require that the information necessary to make good investment decisions is available and clear and trustworthy.
    This is easier than figuring out how to catch the schemers because transparency, if it is properly implemented, becomes self-enforcing—anyone not meeting whatever standards of transparency are required, automatically becomes suspect.

  18. Prof. Johnson —

    You should be careful making a post like this, because it will almost certainly bring the banking industry shills out of the woodwork.

    As a public service to those who accidentally read the shills’ tripe, here is a brief shill-to-English translation dictionary.

    “Right now we need to focus on turning around the economy” = Give your money to the banks, right now.

    “counter cyclical policy” = Give your money to the banks, right now, and do not attempt to control how they spend it in any way. (After all, we are in the DOWN leg of the cycle, right? So right now, counter cyclical policy must mean lots of taxpayer largesse and relaxed regulation. Ironically, this is exactly the opposite of what Prof. Johnson and Prof. Rajan mean, but shills are masters of doublespeak.)

    “Let the banks earn their way out” = Subsidize the banks.

    “I haven’t seen any good alternatives” = The alternatives would reduce the power and wealth of the largest banks, which is unacceptable.

    “After we get out of the recession, …” = (Meaningless.) You can stop reading right there. Shills know that they can propose to do anything tomorrow because tomorrow never comes. By then, they will long since have slithered back under their rocks, because their services will no longer be needed. It is only during a crisis that any change is politically feasible, and since the banking industry’s only goal is to avoid that change, now is the only time you will hear from the shills.

  19. I’m not sure about that, but it seems to me people hiding money don’t have all the options and protections that honest people have. You have to find people to hold and invest your money who will cover your trail, and so you’re basically counting on honor among thieves. They are target rich environments for the fraudsters. Yet suckers have fewer legal protections and are at risk of being exposed as criminals in their home countries.

  20. When Ponzi schemes fail or are uncovered, the “mastermind” should be put in a windowless room for 3 hours with investors/participants who have all been granted immunity from prosecution for anything that occurs in that room.

    I think that would solve the problem quickly.

  21. A “macro-prudential” system/market-stability regulator?? Sounds too good to be true…so it’ll never happen…or happen effecitively. Before we even get to Ponzi schemes, I’d ask why isn’t there some sort of counter-cyclical intervention in the midst of normal bubbles. If Greenspan had the guts to call out “Irrational Exuberance” back in ’96, why didn’t he do anything about it? Or better yet, why didn’t he keep sounding the horn? Probably because someone very powerful told him to shut up. So back to Madoff…if it takes one guy 5 minutes to figure out Madoff is a fraud, why can’t an agency with hundreds of people figure it out…or why did this same agency see fit to ignore this man’s allegations? Wasn’t the SEC the slightest bit curious how Madoff made such wonderful results? Who knows, maybe they were and someone very powerful told them to shut up too.


  22. I’m going to boil this down to a concise statement: The people who run Ponzi schemes and other financial scams do it because there’s a big payoff for them. With this payoff they but political influence. It takes teo to tango. If a government really wants to regulate the financial sector, it bloody well can. If it doesn’t, it won’t.

  23. Oops…forgot to sign in. Point remains…you can’t “accidentally” fall asleep at the wheel 5 times in a row.

  24. Statement of the Problem (you can skip this part if it’s boring):

    Perhaps I can shed a little special light on securities fraud, having myself been the victim of one such fraud in the past. (Fortunately, losing a modest amount of money, but enough to feel like an utter idiot.)

    POINT 1: As the IMF paper notes, a fraudulent investment vehicle is very difficult to distinguish from a legitimate investment vehicle. This is inherent in a free market society. Many investment deals – far more than one would expect – are sealed with personal acquaintance and social networks. Personal networks provide the grease (e.g. trust) that allows deals to be inked when exhaustive due diligence is expensive. In my case, I conducted (what I thought was) due diligence – talked to existing investors, checked local press reports, spoke with local contacts, and did a low-cost background check. The fraudulent investment vehicle had physical assets to back up their claims. Everything checked out. In retrospect, there were small signs I could have discerned, but being young and green I missed them.

    But the general point is that fraud can be difficult to discern because fraudulent vehicles use the same tools that legitimate vehicles use – legal contracts, privacy, and social networks. A good perpetrator of fraud (and those that survive past a year are generally pretty decent) will invest considerable equity in creating legitimacy – creating showcase physical assets, donating to local charities to win local goodwill, etc.

    One could argue that being suckered in a fraud is the fault of the investor, and indeed that is partly true. Shrewd thinking is the best protection, but such shrewdness is not easily learned until you’ve experienced the outcome. Anyone who is defrauded at a young age and loses a modest amount of money is lucky.

    But in defense of small investors who do “dumb” things, it is very difficult to conduct the level of due diligence that would be required to completely ensure against fraud. The cost of that level of due diligence could equal the investment itself, or some large portion of it. This is why Donald Trump quipped that trust is the blood of capitalism. (I despise Trump, but he has a point.)

    Ben Stein (another fellow I rather dislike) made this telling point:

    Capitalism is “built on man’s notion that he can trust his neighbor with his money, and that if the neighbor misbehaves, the law will chase him and catch him, and that the ladder of law has no top and no bottom, that even the nobles get properly handled once they have been caught.”

    In other words, the promise of criminal/civil recourse can serve as an alternative “social cement” when it is very costly to conduct due diligence. So while proponents of liassez faire capitalism (who despise all regulation) may cry that individuals should be responsible for their own decisions, we must recognize that if everyone in the world adopts CAVEAT EMPTOR in all transactions, then modern commerce as we know it will grind to a halt.

    Trust – including the kind of trust provided by confidence that laws will be enforced and perpetrators will be brought to justice – is a massive factor in keeping transaction costs low enough for a complex modern economy to operate.

    POINT 2: Unfortunately, we face a steep tradeoff between too much and too little government. Fraud (including Ponzi schemes) persists because fraudulent actors simulate legitimate actors. In doing so, they avail themselves of the same legal tools that are available to legitimate actors. That is, laws designed to limit the power of the state and a court system that is frustratingly slow compared to the speed at which fraudulent actors can inflict damage and flee justice.

    In my case, the fraudulent entity was in a US state, not the “lawless Caribbean”. The fraudulent endeavor did not last very long due to aggressive private action, but the perpetrator was not swiftly brought to justice in spite of several state regulators pressing charges because the entity was able to create roadblocks using legitimate legal protests. The intent was not to secure a judgment of innocence, but to delay and create costs for prosecutors until the entity could declare bankruptcy, hide assets, and burn papers.

    Thus, the court system – which sanctity-of-contract folks like to idolize as the proper alternative to regulation – is a weak and crippled protector of citizen rights when it comes to fraud. It is simply way too slow, and the costs of pursuing legal action too large, to catch perpetrators of fraud. The IMF cases all showcase this aspect of Ponzi schemes, but it is true of other forms of fraud.

    Yet speeding up the justice process is challenging – justice in the US is designed to be slow and ponderous (innocent till proven guilty). Courts are designed to limit the power of government to intervene in private business. Fraudulent actors (like cancerous cells masking as normal cells) take advantage of the laws designed to protect innocent companies and people from abuse of state power.

    Slow court-enforcement, combined with massive information asymmetries (as discussed in point 1) and steep costs to pursuing collective action (either gaining information or seeking justice) mean that private enforcement is nearly worthless at containing this type of fraud. (…even if the defrauded people are
    rational investors, not elderly people who were bilked out of their savings.)

    Point 3: In the absence of a swift and effective court system that delivers harsh justice, the best options is active, speedy, well-funded, and independent regulators with appropriate legal powers – just as the IMF paper notes.

    The IMF paper, in their recommendations, cites speed as critical – and they are quite right. They particularly cite emergency asset freezes (but these are often blocked by anti-regulation judges or officials in response to legal challenges against regulators).


    Point 4: Regulators failed the public, but the public also failed the regulators

    We can blame the SEC for failing to identify Madoff earlier, but regulatory agencies become paralyzed when the public visibly expresses disgust for them at every turn and their budgets are constantly threatened. Wall Street disdains regulators – they are the butt of jokes. They paint regulators as incompetent buffoons, and regulators meekly wear the tag. They are terrified of taking on the very objects they are supposed to be watching, because WE the people have made a past-time of ridiculing them (led by anti-regulation economists and Wall Street kingpins).

    Just try Googling “SEC decline enforcement actions”

    Remember how fast the financial services industry grew from 2003 to 2006? Here is the data on total SEC enforcement actions for the same time period:

    2003: 679
    2004: 639
    2005: 630
    2006: 574

    Nor can we entirely blame oligarchic banks… While they contributed (both to the problem and to political lackeys in Congress), the primary cause was political hostility toward financial regulators. Yes, the financial institutions had their lobbyists, but more importantly, they had public ideology (from Congress right on up to the President) on their side. (Notably, 2003 was the beginning of single-party dominance of both houses of Congress and the Presidency and the Supreme Court.)

    Or in other words, you get what you vote for.

  25. Specific recommendations:

    Since SJ asked for comments and recommendations that reflect our learning from Ponzi schemes, here goes…

    First, Rajan proposes various “cycle-proof” regulatory contracts. While interesting, and perhaps beneficial, it does not fix the problem in the long run, and creates short term costs just like the current system.

    Consider bonds that forcibly convert to equity when bank capitalization is low (one of Rajan’s chief suggestions). Bondholders, seeing this risk, may demand higher interest (thus raising cost of capital, just like many other regulatory proposals). In addition, those bonds will have a higher risk rating (more like stocks), limiting the types of institutional investors that may participate (like state retirement funds), which could further increase interest rates. Also, bank managers – recognizing that bondholders now carry the downside risk – now get to enjoy the benefits of a new type of moral hazard (Rajan mentions dilution risk as a countervailing incentive, but why should we believe managers care about dilution when they don’t seem to care about bankruptcy?). Meanwhile, if we do allow large institutional investors to buy bank bonds (where else do they put that much money?), then if big banks go under we may find ourselves simply rescuing the big pension funds (who end up bailing out the banks through forcible bond conversion).

    Systemic risk is systemic risk – you can shift it, but it doesn’t go away unless you kill it.

    Second, Rajan’s sharpest point is about the boom/bust dynamic. We already know about euphoria relaxing credit costs… but he reminds us that the boom/bust cycle affects our political views as well:

    “Ironically, faith in draconian regulation is strongest at the bottom of the cycle, when there is little need… By contrast, the misconception that markets will take care of themselves is most widespread at the top of the cycle…”

    (Flashbacks of Alan Greenspan, anyone?)

    So the question becomes not just how do we create strong and independent regulators, but how do we protect them from political challenges over time when we know that we’ll forget in the future?

    Here are my recommendations for “tamper-proofing” regulation and regulators, and making regulation more effective:

    1) Create self-funded agencies. These agencies don’t have to be dependent on Congress for funding. The FDIC and FED proved stronger than other agencies precisely because they derive funding from specific sources outside of Congressional purview. The SEC, for example, should be funded by a tax on all investment activities they regulate. This will also help guarantee that the need for regulation grows, the funding for such regulation grows commensurately. But here’s a word of warning: We’d better think long and hard about exactly what powers we want to give these monsters, because they’re hard to kill once we grant them life.

    2) Radically increase criminal penalties – mandatory criminal penalties – for large scale white collar crime. We have ridiculously costly mandatory jail time for simple drug possession (that have turned our prisons into a vast welfare system), but pathetically weak punishment for fraudulent predators who inflict vastly more social damage (how many people died due to indirect causes resulting from Lehman’s failure?).

    3) In addition to institutional memory, let’s enhance cultural memory. I suggest that we raise a massive monument to this crisis right in the middle of Wall Street. Maybe next to the big metal bull. On it should be inscribed the faces and names of all the people responsible for this crisis, and their role in it. We should have a motto, like “In undermining good laws written by better men, these fools nearly crushed this great nation into debt and slavery.” Every accredited business school in the country should be required to have their graduates memorize the names and roles of these criminals as a condition for graduation.

    4) Create financial courts. There has been much talk of “science courts”, wherein judges are required to have some basic scientific training. It’s time to have financial courts, wherein the appointees are required to pass stringent bar exams that have a financial component. This will help stop low-quality political appointees. Give these courts powers to oversee regulatory actions, and to act speedily. Support them entirely with additional funding from a tax on transactions (see point 1), so that the courts have an incentive to keep those regulatory agencies in business too.

    5) Make real commitments. There are lots of ways to do this. A Constitutional Amendment (for example, detailing the powers of the Federal Reserve and related agencies) is extreme, but perhaps not uncalled for. Monetary regulation is central to preservation of democracy. But there are lesser forms of commitment. International treaties, for example, are binding (though often reinterpreted or evaded). But we can fashion more creative mechanisms – for example “Integrity Bonds”. This would be a class of government bonds issued by the Fed that pays a higher interest rate subject to certain conditions (e.g. low bank default rates/FDIC losses between a period that was 3-10 years after issuance of the bond). The goal would be to create a group of private moneyed actors who have a strong incentive to preserve the integrity of the regulatory environment over the long term.

    6) Create countervailing financial interests –and, yes, cut down large institutions and limit their lobbying power. Separate various financial activities, and create incentives for each of these financial interests to defend their turf. (Glass-Steagal did this, but one of the contributing factors to its demise involved changes in the competitive environment which caused one of the interests to lose dominance over its own turf, thus forcing it to seek expansion into other turf).

    For example, extend specific advantages to banks of a smaller size that enhance their competitiveness against larger banks. This induces smaller banks to defend those advantages aggressively. Perhaps community banks (who engage in narrower banking) can obtain significantly cheaper funds and/or pay lower deposit insurance and/or receive less expensive mortgage insurance. These are not merely “giveaways”, but reflect the reduced social costs of conservative smaller banks (due to lower risk resulting from lack of too-big-to-fail syndrome) vis-à-vis larger banks.

    In other words, if you want legislation that can defend itself, make sure to give it defenders.

  26. Stats Guy:

    1) What is the evidence that FDIC and FED were stronger? This plan sounds as sound as letting ratings agencies get paid by the companies they rate.

    2) Radically increase criminal penalties: A non starter. If these people don’t make it to trial, it doesn’t matter what penalties would await them. When enough money is involved, i.e., the more heinous the crime, the more chance that they will walk free.

    3) Memorials. Absolutely. Let’s make sure that they’re nothing like the Milken memorial, shall we? A conference that glorifies everything we need to get rid of.

    4) Financial courts. Sure, but why wouldn’t you be able to buy a financial judge as easily as a regular judge?

    5) Integrity Bonds: You, sir, win the kewpie doll. This is a brilliant idea.

    6) Counterveiling financial interests: Yes, separate the activities, buoy the community banks at the expense of large banks, or better yet, just get rid of large banks altogether. Major size restriction, and major capital requirements. And why just separate the activities? I have yet to hear an argument that convinces me we have a need for hedge funds, or derivatives, or securitization, or any of the other garbage. Get rid of the garbage and we get rid of the need to regulate the garbage. Drive a stake through the heart of Wall Streets all over the globe and kill them dead. (This of course will require throwing all the current bums out and growing a first generation of administrators that will manage our affairs properly).

  27. Does this particularly virulent swine-troll think he is Batman or something?… Never mind, I jest! Hahaha!

    I thought you had a spam filter that had an efficent discerning new rat trap feature. Was it silly of me to thing that.

  28. The problem with ratings agencies was that buyers of a rating were sellers of the security, and the buyer has an incentive to get a better rating. The buyer can therefore “shop around” since ratings agencies compete with each other for business.

    Self-funded agencies don’t have that degree of perversion built into their incentives. Among othr things:

    They benefit by expanding the scope of their jurisdiction, and so they have every incentive to extend regulation over new and innovative products.

    There is a potential problem with the agency encouraging more transactions; this can be compensated by writing into the law a 20% reduction in staff salary if banking losses exceed a threshhold. (or use a phased incentive schedule)

  29. Nemo – very nice job of predicting the arguments by the next poster. Didn’t seem to phase him much, though.

  30. In order to consider the prospects for a market stability regulator, one must first understand the reasons that existing regulators failed to shut down these blatant Ponzi schemes.

    The causes can be gleaned from the IMF’s recommendations on preconditions, without which, an effective regulatory response is quite unlikely. The most important of these preconditions is the independence of regulatory agencies. If this precondition cannot be met, then the prospects for effective cycle-proof regulation is quite bleak.

    StatsGuy’s first recommendation attempts to directly address this issue by creating “self-funded” regulators. However, his illustrative examples paint an incomplete picture of the efficacy of this solution. I agree that the Fed and the FDIC may be characterized as “self-funded,” however regulators such as the OCC and OTS would also have to be characterized as “self-funded.” Yet, it is quite difficult to argue that OCC and OTS were strong agencies in terms of promoting the safety and soundness of regulated institutions. Therefore, they do not meet the independence precondition.

    Perhaps the reason the Fed and FDIC have been “stronger than other agencies” is because they have skin in the game – FDIC wants prompt resolution of failing banks because they pay for the failed banks’ losses. On the other hand, OCC, which regulates national banks, goes to great lengths to prevent their banks from being resolved by the FDIC. This involves OCC’s manipulation of their analyses on the health of the banks they regulate and other forms of forebearance. OCC is funded by fees paid by the national banks they regulate, but have failed to be as strong as the FDIC simply because they bear only the reputational cost of being the regulator of a failed bank, while the FDIC will bear the financial costs of OCC’s forbearance.

    Indeed, being funded by the institutions that an agency regulates may even incentivize forbearance and lax regulation, especially in a balkanized regulatory system where financial institutions shop around for regulators. This creates competition among various regulators and results in a race to the bottom.

    The question then becomes, is it even possible to create an independent regulatory agency, which is necessary for the effective enforcement and implementation of cycle-proof regulation? The simple answer is that nobody knows, but that does not mean we should not try.

    However, in light of the preceding discussion, I believe it is necessary for an agency to have skin in the game. Indeed, the reputational risk of the agency could qualify as skin in the game, but it is clear that this has not been sufficient for OCC. Perhaps a market risk regulator may act differently since the reputational harm may be more severe, especially in the current political climate. Having this type of regulator gives politicians a central agency to point at when a problem occurs, which isn’t the case today with the US’ incomplete patchwork of regulation. Generally speaking, forcing any agency to bear some of the financial costs of their forbearance will lead to more effective regulation.

    Even if the US created an independent market risk regulator, it would not be immune from agency and cultural capture. However, the influence of regulated industries on the regulators seems like an unavoidable cost of democracy. Indeed, we must struggle to limit those who have disproportionate influence, but it will never go away.

  31. The problems highlighted in my preceding post are exacerbated in the context of extraterritorial and international regulation. Here, the only possible solution is the coordination of various national regulators. If the US managed to create an effective independent market risk regulator, it would have more moral authority to encourage more effective regulation around the world.

    But if one doubts the US’ ability to create such an institution, then the prospects are even more doubtful in the case of a small Caribbean nation, which is even less immune to the insidious influences of regulated industries on regulators,

    As a result, effective international cooperation in regulation appears to be, at best, a sisyphean task. The G20 meeting, however does give me some hope, because it appears as though these countries understand that cooperation is the only way to save themselves because, in the end, they are all in the same sinking ship.

  32. This conflict really only seems to exist with incredibly complex transactions, where the ratings are essentially negotiated. The rating agency says, give us a plausible cash flow scenario that meets these criteria, and you will have the rating you want. So the “ratings buyer” structures the product to the rating criteria on paper.

    I think the problem with ratings is the status they are given in general, as gatekeepers to certain investors and substitutes for due diligence.

  33. WINNER!

    I hope you can take note of Anne’s ponzi antidote here. Not the Pirates of the Carribean – but who cares about them. Close to home and right on point. If Obama would institute these reforms – tommorrow – it would be game – set and match for the good guys. Wake up Barack. You are asleep at the switch and the light you see is another train headed your way….. fast!

  34. Very basic point comes to mind. A democracy/free society means having a level of freedom that allows good people to prosper and be happy. I think, by definition, that this is going to mean that there’s always room for Ponzi schemes.

    I hate what corporate greed has done to us but over-regulation and even bigger government is far worse.

    Albeit very painfully, millions have learnt that if it looks too good to be true, it probably is. That lesson will be the best ‘regulation’ for a long time.

  35. A Ponzi scheme is a deliberate fraud whereas much of the banking failure represents excessive animal spirits. If Ponzi schemes are difficult to control, then animal spirits will be more difficult because they will infect regulators as well as players. Regulators did approve of ruinously low reserves for securitized mortgages.

    Idealy, something like the working paper’s list of red flags could be prepared for the financial sector, but it is necessary to report this information to the public to help counter insider manipulation. Ideally, countries should coordinate efforts with an international agency publishing assessments of red flag stats by company, investment vehicle, and regulating agency. Financial firms should be required to report red flag data to investors.

    A recent article by Gillian Tett, “Genesis of the Debt Disaster”, Financial Times, May 1, 2009, points out that J.P. Morgan’s management called a halt to further investment in bundled securities because of dismay at the huge sums involved and the minuscule reserves in spite of a good understanding of securitization. Therefore a key red flag will have to include the reserve ratio for aggregate kinds of investments, coupled with an opinion on the twin risks of correlation and component performance. (see Tett)

    Another set of reforms should center on some hazardous practices which have grown up lately:

    1. Traditional mortgage lenders have been partially replaced by mortgage agencies with no intention of managing a mortgage. If mortgage lenders were required to sell only the income stream and still be responsible for managing the mortgage, they would seek sounder clients and bundlers would be better able to judge performance.
    2. Some parts of the credit card industry have become predatory or silly, depending on ones point of view. Standard contracts and maximum interest rates should be established so that the only way to maximize profit would be to ensure sound clients.
    3. Rating agencies, insurers, auditors and similar facilitators should be assessed some responsibility for their mistakes and be required to maintain reserves for this responsibility.
    4. Firms too big to fail can sidestep most consequences. Control might be achieved by a tax on disproportionate size – if size matters, the tax would help offset the cost of mistakes, and if it does not, the tax would discourage size.

    Going up in generality, countries must ensure that government regulators have a culture that is different to their “regulatees”. There might be a cost due to a lack of insider knowledge, but knowledge does not help if regulators are too “understanding”.

    Lastly, US big banking has won several concessions lately in spite of their low public esteem. Perhaps the US definition of a viable democracy should include strict limits on publicly-funded-only election expenses. Will any meaningful reform happen before this one is implemented?

  36. Side comment RE: “proponents of liassez faire capitalism (who despise all regulation)”

    I’m not sure when “laissez-faire” and Capitalism became a taken-for-granted combo. I don’t recall Adam Smith ever mentioning laissez-faire. If he did, I’d appreciate it if someone would point out where.

    Laissez-faire and Capitalism actually don’t and can’t mix successfully. At a minimum, Capitalism demands oversight regulation to retain a competitive marketplace (to balance the individual & business drive to maximize profit by moving towards monopoly, the elimination of competition).

    You can either have: (1) A laissez-faire free-for-all (what we pretty much have had in the financial markets since the repeal of Glass-Steagall) – OR – (2) Capitalism with some reigns on the consolidation of economic and political power.

  37. Yes, that’s quite right. In the same way you can’t have constructive freedom without rules and limits, only aimless, formless chaos, so you can’t have “property” or “capitalism” or any economy beyond hunting/gathering and low-level local barter without effective government.

    I’ve often challenged the so-called “libertarians” on this and have never received a remotely coherent answer, because there is none.

  38. A further caution: beware the policy-entrepreneurship variant of “chinese math.”

    From http://www.businesspundit.com/please-stop-with-your-chinese-math/:

    “I’ve written about this before, but it is so damn pervasive among entrepreneurs maybe I need to be more thorough. Let’s start by explaining the term (which comes in several forms, but ‘chinese math’ is most common around here). Investors love companies that can a)stand on their own two feet early so that they don’t require much more investment and b)have huge market potential. So entrepreneurs try to convince investors that the market is huge, and in doing so they somehow convince themselves (and in turn try to convince investors) that it will be easy to reach cash flow breakeven because of the market size. After all, they only need a small percentage of the market. The name stems from the idea that there are a billion people in China, so if you sell a $1 widget to just 1% of them that is $10 million in revenue. The assumption that is incorrectly applied here is that 1% is easy to get because it is a small number.”

    Re: policy entrepreneurship, chinese math is being employed whenever the would-be entrepreneur’s proposal does not identify the source(s) of the money that is needed to buy a sufficient number of politicians to enact the proposal.

    Re: the need for this money, see my below comment.


  39. I think the IMF paper highlights the arguments James made in the post on Bourdieu (which I rather enjoyed, controversial as they were). Regulators already have all of the tools and powers they need to take the action necessary to avert a banking crisis, but they choose not to act.

    Why do they choose not to act? For the same reasons that investors in Ponzi schemes choose to participate. They want to believe in the promise of abnormal returns and they like being clubbable.

    You are asking for a means to eliminate the human factor, which would be great if laws were static. But they aren’t, as the Economist piece points out. People have incredibly short memories during good times, and any resources that are devoted to counter-cyclical measures, etc. during good times would just be perceived as a limit on how good things can get (and they would be repealed).

    The Federal Reserve could have stopped the financial crisis, but chose to debate whether its function was to pop asset bubbles. I doubt this will be much of a source of debate going forward.

    I think the main reason that we have had a banking crisis during each of the previous decades is not that we were better at governing our system in the prior decades or that our system was simple, but that the experience of an economic collapse was still relatively fresh in everyone’s mind then and now it has aged and given way to manic materialism. We’ve “managed” the past banking crises, and all it has done so far is set us up for even worse events.

  40. After reading the IMF paper (which was very tedious reading) here are my thoughts and/or solutions.
    1. Public Service announcements making people aware of what reasonable rates of return are. Anything equal to or above 10% should be held extremely suspect, no matter what the investment instrument (foreign exchange, real estate, options contracts etc) People should know if the returns are above 10% most likely it’s a BIG FAT LIE.
    2. Severe Punishment (Criminal or otherwise). Should we be surprised that these crimes happen again and again and again while men like Michael Milken are put in country club prisons and shortly after walk around free and are treated as heroes??? Madoff sitting in his penthouse for weeks drinking spritzer and premium kosher food asking his wife where the TV controls are. I don’t need to read a 40 page IMF paper to know that’s a pile of shit.
    3. A stronger Securities and Exchange Commission. For the last 8 years under Bush (maybe more) the SEC has done nothing but add legitimacy to guys like Madoff and Stanford. I don’t care to read about the failures in Jamaica, or that Afghanistan sanctions pyramid schemes. This is a waste of paper. What I want to read is why the SEC says Stanford was involved in 15 years of fraud, and they waited 15 years to stop him. Why the SEC says $50 billion in fraud occurred under Madoff, the SEC was warned several times with several “red flags” and did nothing??? That’s what I want to read. I don’t give a s___ what Columbia is doing to protect depositors.
    4. More active, responsible, and investigatory JOURNALISM (media). When some famous Italian female journalist at CNBC is more well-known for her rumored blow-jobs than her questioning of investment bankers and bank CEOS, something is seriously wrong. We need less pretty faces, less botox, and more REAL JOURNALISM where people know how to read the numbers and ask HARD QUESTIONS.
    5. MORE REGULATION AND TOUGHER REGULATIONS. Investment banks and commercial banks(depository institutions) should be kept separate. Putting investment banks and commercial banks under the same roof causes way to much temptations to play (speculate) with the savings of the average Joe. If regulatory agencies need more funding and resources fine, but I suspect just a change in attitude would help. For far too many years Congressman bribed by banks have said banks can be “self-regulating”. The idea that you can give ANY person or company gigantic sums of money and say “Ok go over there and regulate yourself” is laughable.

    There, done. Heigh!!! Is there a prize for this!?!?!?! A year’s supply of free IMF papers???? Simon’s favorite brand of American brew???

  41. I should have said that the conclusion of my reading of Ponzi’s Schemes is that Counter-Cyclical policies, if this means restraining investment during an upturn, are not likely to work well. The idea of the Fed, for example, slowing the entire economy in order to stop a possible bubble in one area of investment, just seems unrealistic, especially when it could add to unemployment. Maybe I’m wrong. My thought experiment is to consider how hard value investing is to do well. It’s hard to invest in a downturn and to cut back in an upturn.

    My reason for going to Narrow/Limited Banking is that it would place our free market system on sounder footing. There are certainly trade-offs, but allowing ourselves to be dealing with Debt-Deflation is really awful.

    To the extent that we’ve dodged a Debt-Deflationary Spiral, we ought to thank God. For those of us who are terribly afraid of this possibility, we cannot allow ourselves to let this happen again. Many other people don’t seem to fear this beast. I am certainly critical of Geithner, Paulson, and Bernanke, but, to the extent that their actions have been directed at stopping Debt-deflation, I’m glad that they understood the problem, and have attacked it, if not as effectively as I would have liked.

  42. The Fed not slowing growth because it would contribute to unemployment versus allowing an asset bubble to develop that could have crippled the entire economy is just the Fed applying the same thinking as the banking executives – valuing near-term gains over long-term losses (to understate the effect).

  43. I should qualify this opinion by saying that I work in public finance. The argument that the rating agencies just sell their ratings has always held some sort of irony for me because the rating agencies, for decades, have not rated municipal credits on the same scale as corporates with similar historical default characteristics, even though municipal borrowers likewise pay for their ratings.

  44. Stats Guy: “Systemic risk is systemic risk – you can shift it, but it doesn’t go away unless you kill it.”

    I am surprised to hear you say that. Quite a number of systems, both natural and human, are robust. Perturbations are dampened by negative feedback. (To be sure, runaway positive feedback happens, as well.) Perhaps I misunderstand you, but you seem to be saying that only drastic action can significantly reduce the risk of economic catastrophe.

    But is that so? The regulations that came out of the New Deal seemed to reduce the severity of the business cycle until the advent of Reaganomics. How drastic were they? Summers seems to think that great financial crises occur twice a century or so. But if those regulations had remained in effect, would we be in this pickle now? Is the Kondratieff wave destiny?

    Too big to fail seems to me to be something of a misnomer. In systemic terms, isn’t it more like too relatively connected to fail? That is, the failure of a few can bring down many, because of their connections to those many. Entities with fewer connections pose less of a risk. (Sure, there can be a domino effect, but the probability of triggering catastrophic failure is lessened.) In a globalized economy, restricting connections may well be impractical. However, there may be safety in numbers. That is, if the majority of economic entities are well connected, rather than just relatively few, then the large number of connections may mean that, if one entity that you are connected with fails, others will support you. Such a well connected web offers natural negative feedback and stability. To foster general connectedness, we might outlaw exclusivity contracts, for one thing.

    There are a number of positive feedback mechanisms in economics, and a number of negative ones, as well. Is it necessary to rely upon a few underpaid government regulators to apply the breaks when things threaten to get out of hand? Have we no ways to weaken positive feedback and strengthen negative feedback other than government intervention? (I am not talking about things like enforcing contracts.)

    I have a few thoughts, but leave this as a question. Can we not find ways to have a robust, largely self-regulating economic system?

  45. Of the many excellent commentaries here, anne, and particularly bigchubasco cut to the heart of the PONZI scheme problem. Where ever the potential of great wealth exists, – drugtrade, sextrade, slavetrade, weaponstrade, PONZI and Pyramid scheme’s, etc, – there will always exist certain (criminal) individuals compelled to exploit that potential with support of other unsavory indivudals, and the ignorance of still other individuals all of whom are equally compelled to acquire great wealth by any means possible. Criminal aquisition of great wealth is often quicker and easier, – and potentially more destructive to the greater society, as the IMF White Paper dutifully notes.

    De-incentivizing the unfortunate human proclivity toward criminal conduct in the finance sectors rabid pursuit of imponderable wealth demands implementing new laws to force broad expansive transparency in financial institutions and products, fierce regulation of those instititions, operators, and products, and harsh punishments in the form of destructive fines, and mandatory lengthy prison sentences.

    Regulatory agencies can benefit from the unique expertize of the intracies and culture of the finance sector by employing former operators from the finance sector. But the regulatory agencies serve the peoples best interests, not the finance sector, and any breach of this code or standard is a grotesque betrayal of the regulatory agencies mandate, – and should be subjected to the same fierce punishments (harsh fines, long prison sentences) as any finance sector criminal.

    It is impossible for me to imagine any circumstance (and recent history proves this point) wherein Mr. Bernake, Mr. Summers, or Mr Geithner put the American people’s best interests above the best interests of the finance sector, and the finance sector oligachs particularly. These individuals obvious and blatant conflict of interest undercuts any hope of achieving a work remedy that serves the people best interest, and constrains or holds accountable the finance sector in general, and select finance sector oligarchs in particular.

    No meaningful change in the finance sectors and finance oligarchs criminal and/or unethical and/or incompetent conduct is possible unless these three individuals, and several others are replaced. The are creature of the predatorclass, working for the predatorclass, on behalf of the predatorclass, advancing the predatorclass best interests exclusively.

  46. In my very humble opinion, the idea of “a robust, largely self-regulating economic system” in America is a dream that is now very much deferred, thanks to the startling evidence that self-regulation does not work on Wall Street – or at least that’s the narrative they’re spinning these days over in that neck of the woods….

  47. Please permit me to clarify what I meant by that comment – which perhaps was overstated.

    The point of Rajan’s proposal was not so much to prevent bad bank activities (aka, risky investments), but rather to build in a contractual mechanism for sharing the losses among bondholders to avoid pro-cyclical dynamics.

    He secondarily notes that such bonds create incentives for banks to seek greater capitalization when they have private information that their books are in jeopardy, but then quickly backtracks by saying “learning from the recent experience of foreign investors who put in money just before American banks declared more losses, new equity investors will need to be convinced that banks have disclosed fully all potential losses they know about”.

    Rajan’s insurance proposal is similar – it does not get rid of systemic risk, it merely insures it. The one advantage here is that fully collateralized insurers have an incentive to take aggressive measures to prevent risky behavior, but can they really hold that line? We must hope the insurers will be more aggressive (and competent!) than AIG at watching out for their investments… Especially when insurers themselves are Too-Big-To-Fail.

    My point is that countercyclical contracts does not inherently prevent the losses – just spreads them around, with the resultant costs still remaining an economic burden on the real economy (along with the risk of triggering systemic collapse).

    And this – to SJ’s initial point – presumes that the laws requiring such contracts can stand up to repeated tests by moneyed special interests. (Fully collateralized insurance contracts… Dang that’s expensive. Doesn’t that create a massive competitive disadvantage for domestic banks? How long will the banks stand for that?)

    The real goal needs to be preventing actions that incur excessive risk (unless, as you note, we want to radically deintegrate our economy).

    And one of the key difficulties (other than sustaining social memory, as others have also noted) is designing institutions that are resistant to political change. In the long term, one method involves creating concentrated interest groups that have a stake in keeping those laws from being rewritten.

  48. Dear Anne,

    I did not mean self-regulation, as in, “go regulate yourselves”, but self-regulation as in, for instance, requiring unions for businesses of a certain size, and relying upon the competition between adversaries to provide negative feedback.

  49. Stats Guy,

    Thanks for the clarification. :)

    As for Rajan’s proposals not really reducing the risk, but putting it on the backs of bondholders and insurers, they have at least one big thing going for them, IMO. They privatize losses. Yes, there is still the risk that losses may be socialized through the back door, but that step is a positive one. What Garrett Hardin called the CC-PP game, commonizing costs and privatizing profits, is a recipe for disaster, yet has been embraced for at least a generation by our government under the “too big to fail” doctrine.

  50. “strict limits on publicly-funded-only election expenses” is hard to enforce – anything that is strong enough to actually work is likely to run up against 1rst ammendment freedom of speech challenges. Anything which doesn’t risk violating the first ammendment is somewhat easily end-run (for example, by 509s).

    Here is Cato taking the issue to task:


    On this issues: “countries must ensure that government regulators have a culture that is different to their “regulatees”. There might be a cost due to a lack of insider knowledge, but knowledge does not help if regulators are too “understanding”.”

    Yes, it’s a tradeoff. We can partially offset this by regulating the contacts (no gifts, transparency/disclosure rules, formal settings/hearings, etc.). But informal contact is critical too. Also, a regulator must not be given incentives to over-enforce, otherwise we end up with passionate hatred between regulator and regulatee, which in the end will kill the institution. (examples of overenforcement are the grist for “studies” that show why an agency should be killed). Regulatees need a voice in the process, but that voice must be balanced by other voices. Imagine, for instance, a governing board (~12 people) that included a balanced representation of industry executives, small banks, pension funds, government regulators, academics, and public interest groups.

  51. You think that could work? Maybe – but Wall Street seems to function like the high school lunchroom – people see what others are wearing and then go crazy to get some of that for themselves – they whisper about the slutty/cool things other people are doing, condemning or admiring the object of gossip, depending on the rumors going around the room, someone starts a stupid, reckless trend that everyone must do because everyone is doing it and one must not hold back and be safe when everyone else is being reckless.

    Whole fortunes are made or lost based on rumors (according to some of the Wall Street people – it was rumors that killed Wall Street, not bad business decisions that ran up astronomical sums of debt – see the Frontline documentary on the meltdown for this.)

    The whole Wall Street hierarchy of who eats with whom (who feasts on what/who kills what to eat) seems horribly dependent on things that have no remote connection to “business” that I don’t have confidence that competition and negative feedback would change things.

    But I’m a tad gloomy these days – and not an economist either, so ignore my “half-empty” outlook….

  52. Anne: “You think that could work?”

    I don’t know. Which is why I did not suggest it in my original note.

    But I do think that one problem with capitalism is that success in competition can lead to reduced competition, as the winners wield economic and political power. That is positive feedback, which can be destabilizing. That is why I thought that, if you are successful enough to reach a certain size, you will automatically spawn an adversary (the union), and that would provide negative feedback, which is stabilizing. It is also a mechanism that would require little regulatory oversight. :)

  53. Are any of you prepared to march, armed, into Washington, and demand the truth…or is all this “blogging” nonsense exactly that: nonsense?

    Tell me, do you really think this blogging nonsense does anything…at all? Are YOU prepared to act?


  54. So, I’ll take a whack at the pinata:

    As I understand the exercise, the goal is to prevent the rise of a self-serving oligarchy, without placing significant restrictions on the aggregation of wealth. How’s that working out for you? When Wayne Gretzky was asked the key to his success he said, “A lot of players skate to where the puck is. I skate to where the puck is going to be.” I cannot easily imagine what subtle mechanism the lords of finance might invent to evade future regulations, but it’s a safe bet that the goal will not be different than it is today. Does this suggest a solution to anyone besides me? In the context of all of the challenges faced by a society, is this so utterly unthinkable?

    In 2007 Ben Bernanke gave a speech where he raised the issue of income distribution. He said, “Without the possibility of unequal outcomes tied to differences in effort and skill, the economic incentive for productive behavior would be eliminated, and our market-based economy – which encourages productive activity primarily through the promise of financial reward – would function far less effectively.” Does anybody even remotely believe that the dynamic that Bernanke describes here has any similarity to the real world? Does the system of incentives that is currently in place really have anything to do with effectively encouraging productive activity? Really?

    I am not suggesting that we reign in the wealthy to underwrite other projects for the benefit of “the people”. This is not about redistribution. We have a right as a society to counter any system of incentives which would undermine our common interests. I am suggesting that counter-incentives to the concentration of wealth have merit in their own right. A lack of such restrictions distorts our education, our commerce, our law, and our coherence as a nation.

  55. Many are prepared to act, adios amigos, but not in the way you propose which would be suicidal.

    Asymetric actions are the only options available for the poor and middleclass in the 21st century to deliver the necessary and just message to the predator class, and their spaniels in the government that grotesque ABUSE, ruthless plunder, wanton profiteering, predatorclass cronyism, and outright criminality will be not be tolerated peacefully, no matter how imponderably rich select criminal individual or oligarchs may be, and regardless of the socalled governments false framing of select criminal individuals and oligarchs as immune from accountability, above and beyond the law, and/or toobigtofail. The predatorclass criminals, – like the “unwashed masses” they mercilessly spurn and seek to dominate and control, can and will know real pain. The more abusive, obdurate, heartless, and detached the predatorclass acts, – the more certain and just will be the necessary retaliation. A reckoning is fast approaching. In a worlds where there are no laws, – there are no laws for anyone predators.

  56. The failure of governments, our own and others, to shut down blatant Ponzi schemes implies a great need for a “macro-prudential” regulator in the US. Cycle-proof rules that are flexible in setting self-adjusting sideboards are exactly appropriate. Mr. Rajan’s concept of “shelf bankruptcies” is elegant and debt that becomes automatically convertible as insolvency thresholds are passed is similarly brilliant. [Perhaps convertibility could work both ways and common stock could be converted back to ranking debt once a pre-determined level of solvency had been achieved and at the shareholder’s option. This would require two classes of common stock, the B distinguished from the A only by this reconvertibility feature.]

    Though a “macro-prudential” regulator with cycle-proof rules would be immeasurably helpful, it is hard to assess the prospects of developing such an authority soon. They are better now that it is generally accepted that markets cannot operate free of regulation without posing a threat to our economy. They will improve in time as the understanding dawns that the health of our economy and a return to prosperity depends on creating such an authority.

    As the IMF paper points out effective regulation involves: independence from any influence by the regulated, sufficient authority to intervene directly without referring to criminal authorities, sufficient power to enforce, i.e., the capacity to impose penalties or sanctions swiftly, the severity of which will act as a deterrent. Accordingly, in the US, the “macro-prudential” regulator should reside with the Fed and independent of Congress.

    The SEC might argue that it is the proper home for a “macro-prudential” regulator; however, neither the Fed nor the SEC is above criticism based on performance over the years. Keeping them separate guards against the possibility of both being wrong at the same time. The SEC should therefore retain its independent status and remain responsible for the quality of securities traded in US markets and “micro-prudential” regulation of those markets.

  57. Given a complex dynamic system, it is often fundamentally impossible to eliminate systemic risks. You simply cannot predict what can go wrong or how the dynamic can change due to unknown internal and external factors. Complex dynamic systems often have deeply hidden systemic problems.

    Because of our limited intellectual ability to identify hidden systemic problems, boom and bust cycles are inherently valuable to the system’s health. These cycles are an important way to expose the hidden problems and allow us to fix them.

    We cannot eliminate systemic problems. We should strive to minimize systemic risk and mitigate it’s consequence. We should also balance this aim against the goal of encouraging the dynamism of the system. After all, if a system is static and stale, than that too is a systemic problem. We can take solace of our imperfect effort in “whatever doesn’t kill us will make us stronger.”

  58. silly things: “Because of our limited intellectual ability to identify hidden systemic problems, boom and bust cycles are inherently valuable to the system’s health. These cycles are an important way to expose the hidden problems and allow us to fix them.

    “We cannot eliminate systemic problems. We should strive to minimize systemic risk and mitigate it’s consequence. We should also balance this aim against the goal of encouraging the dynamism of the system.”

    I think that we are in basic agreement here. Although I would not say that boom and bust are healthy. A moderate business cycle is, I think, like we had for a fairly long while within the memory of middle-aged people.

    What I am suggesting is that reliance upon centralized regulation is brittle. In a capitalist system, competition may be the best stabilizer.

  59. Yup, definitely agree that we should not rely only on regulation. I think regulation and competition should be considered on *equal footing*.

    One good way to think about this is to look at nature. There are all sorts of organisms competing and providing counter balancing forces. However, nature also operates on a set of natural laws. These laws defines the “stage” by which every organism act out their part.

  60. I read over some of silly things’ postings. They actually made a number of insightful points that we should seriously consider.

    It is unfortunate that his delivery is weakening his messages.

  61. I don’t actually know why your original comment went to the spam filter. I suspect it had too many links – that’s a red flag for spam filters. I could rescue it, but now that you have found a workaround I’ll just leave it there.

  62. Where it all began… (or, if we don’t learn from history, we are doomed…..) New Ponzi information at the NYTimes.

  63. Two points in reply to Stats Guy:

    1 – As a Canadian, I am always amazed at how many people change jobs with a new administration. In Canada few people, even the most senior, change. This means the civil service has its own culture and reward system so they can be independent of businesses they work with. When the US Administration looks for the new gang, the best CV’s come from people in related industries. People who will go back in four to eight years. Our people may not know everyone by name, but they generally understand the public interest.
    2-I agree about first amendment rights in the US, but the best excuse for a senator to listen to lobbies is the outrageous cost of election. If a candidate’s direct costs were all public (and modest), the rest would be easier to catch under “honesty” rules.
    3- Why is the US one of the few countries which allows politicians to set and enforce electoral law? Wouldn’t an independent commission do better?

    Regulations are like a dam, the dammed are always trying to work around them. Sometime if you move back and reshape the institutional structure things become easier.

  64. As I have heard, one reason that so many people change jobs when U. S. administrations change has to do with the radically different philosophies of governance. The Republicans are strong opponents of government, the Democrats are strong proponents. So if we had a very stable civil service, it would be filled with Democrats. The Republicans do not like the idea that the bureaucrats are their opponents, and clear out a lot of them when they take power. When the Democrats take power, they clear out the Republicans put in place by the previous administration — those that are left, anyway. (The Republicans really don’t want to be part of the government.)

  65. Stats Guy,

    I am interested in the idea of over-enforcement. Taiwan under Chiang Kai-Shek comes to mind. Can you point to some good examples in the good old U. S. of A.? Many thanks. :)

  66. The classic case is the FDA, which is alternately accused of regulating too much and too little. The time delay in bringing some drugs to market has been cited as costing many lives and/or discouraging development of niche drugs (e.g. orphan drugs). Early on, the uniformity of the FDAs review process probably did cause some harm. The FDA has responded with various special programs – fast-track approval, orphan drug programs, etc. But there is still heavy criticism, including by people who are generally pro-consumer.

    Try googling “fda time delay approval lost lives”…

    The FDA has held the line against drastic reductions in its authority, largely because it has prevented some real catastrophes (thalidomide!).

    Most of the examples of overregulation that seem plausible are situations in which the regulations were either badly designed, or situations in which regulation is emblematic of agency capture by special interests who seek to establish barriers to entry (i.e. George Stigler’s original Economic Theory of Regulation argument).

    Then on the Right, we have the “regulation is strangling business” crowd. And they do have some points – Sarbanes-Oxley is no joy for small business. Some aspects of OSHA rules are costly, and in some instances silly. Some moderate toxicity chemicals are less dangerous than a lot of stuff in your cleaning cabinet. Cost of compliance can be odious for small business.

    But many in this crowd despise all regulation, and there is a real risk that by over-shooting with a rule, we’ll create a scenario that can be used as an example for trying to kill the entire regulation rather than just reform it. And when you have regulators that are overly isolated from the real world, that risk increases. This simply means that some effort needs to be taken to involve regulatees in the process (without giving them too much influence).

  67. Thanks, StatsGuy! :)

    The FDA is a good example. As for regulatory legislation, a lot of regs are picayune, heavy handed, and overly complex. OTOH, simple regs that rely upon good will would probably be toothless.

  68. We have a really big Pozi scheme here in the UK- we call it the Basic State Pension.

  69. I think Ponzi schemes originated in America. If you compare Madoiff, Enron and the Savings and LKoans olus AIG i believe you will find Ponzis are far greater on shore verses off shore.

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