Peter Fox-Penner Replies

On October 24, we published a guest post, “Patchwork Fixes, Conflicting Motives, And Other Things To Avoid: Some Lessons From the Regulated Non-Financial Sectors,” by Peter Fox-Penner.  Below is his response to some of your more than 200 comments.

As a stuck-in-the-last-century guy, I’m remiss in not replying to the many comments to my guest post. As an I-O (industrial organization) economist, I learned a lot more than I contributed reading the many colloquies.  Here are just a few general observations stimulated by the discussion:

To start off, there seems to be agreement on the difficulty of measuring risk, either because there is no transparency and/or the instruments are so darn complex.  Incidentally, the best short piece I’ve ever read on the emerging science of systemic risk measurement is Andrew Lo’s Senate testimony; perhaps all of you have other good pieces.  The one thing I learned from Andrew’s piece is that we are a long way from knowing how to do it.

Many folks agreed that if you can’t measure – it you can’t regulate it.  Bond Girl and others worry that regulation will stifle innovation.  In my view, there is no question about it.  There is no free lunch.  Regulation reduces the variance in outcomes in a market – that’s its job.  Innovation increases them and even disrupts the distribution.  When disruptive events have large economic fallout, or violate our norms for justice, the cost of diminishing these risks via regulation outweighs the costs of reduced innovation.  

More practically, however, this is not a question of zero innovation versus zero regulation.  All regulation allows for innovation – it just reduces and controls it.  New drugs are introduced – lots of them.  New electric power pricing approaches are approved.  And thank you, James Kwak, for reminding commenters that I don’t say “ban derivatives”, I say “oversee them properly.”  Furthermore, it is not just the regulated products that evolve – it is also regulatory processes themselves.  There is a steady stream of regulatory decisions that find their way into the courts precisely because the regulator did something different this time around and one party challenges whether this (dare I say it) innovation is consistent with the regulatory agency’s  legal charter.

Every regulator allows innovation – some even encourage it.  But under prudent regulation, you don’t allow a product to be introduced in widespread ways that might undermine the whole goal of your regulatory scheme.  Financial regulators did – though it was partly because their authority was balkanized so that new products had no natural regulator.   In the end, that’s Joskow’s point and mine as well.  Mind the gap, as they say in the London tube.

Redleg asked a simple, fair question: “Doesn’t simplifying the regulatory system simplify how one might compromise it?”  In my own limited experience: “No.”  Simpler systems are harder to compromise because many more people understand them and can therefore police them, formally or informally.  Regulatory agencies don’t need as high a level of skill.  So let’s be clear: regulation should be as complex as is necessary to do a good job, but not more so, and regulators MUST have the resources (educational and otherwise) necessary for their job.   

Regulatory capture is unquestionably a huge and generally not solvable issue.  It is an unavoidable aspect of regulation that civil society must seek to minimize.  There is a century of experience with mechanisms that reduce capture: overlapping terms of regulators, requirements for political balance, revolving door rules, and so on.  This is the hugely important day to day work of regulatory practitioners and legislative overseers.

Finally, Uncle Billy makes a number of points about Commissions, including the Pecora Commission.  In the current ultra-polarized legislative climate, I think these commissions are extremely important and I have high hopes for what I will now call the Angelides Commission. 

As to my background and motivation, my vita is posted on the Brattle website at and more is at  No Brattle client (or anyone else) knew that I was doing this post, much less reviewed it, much less paid for it.  (However I do genuinely like Rowe and Joskow).  See the disclaimer at the start of the post.  And yes, we are proud to consider Simon a senior advisor to our firm.   I sought out Simon to contribute to the discussion and he consented, not the reverse. 

By Peter Fox-Penner

Peter is a leading expert on regulation at The Brattle Group.  The views expressed here are his alone.

39 thoughts on “Peter Fox-Penner Replies

  1. Dr. Fox-Penner —

    Thank you for contributing your thoughts and expertise to the discussion.

    I have a question for you. What is your opinion on the “too big to fail” problem? In particular, would limiting the size of regulated institutions make regulation easier, or is size a completely orthogonal issue in your view?

  2. “Many folks agreed that if you can’t measure – it you can’t regulate it.”

    There’s a difference between a political problem and a mathematical problem.

  3. Isn’t this just a cost benefit problem? Costs of too much regulation include reduced innovation, whereas costs of too little include more frequent and perhaps more violent economic disruptions. Find measures, do your math and lets compare the results.

  4. Of course people making money from trading derivatives (99% of which is for speculation), making money from usury rates on credit cards, making money from packaging garbage and selling it to municipalities, making money selling insurance (swaps) for which they have ZERO collateral, they don’t care if EITHER the political or mathematical problem is solved.

    Those people always find a reason why “carte blanche” is always the best policy. I hope the people with that attitude end up where they belong. They may find that place after their time here on Earth.

  5. I think the cost part of the problem is the easy part. What are the benefits, and who will see them? If it only benefits a tiny elite, and the cost is spread out to everybody, the analysis is flawed even if math is flawless.

  6. The offending questions:

    Angelides Trivia: “In a 2000 episode of The Simpsons entitled “Pygmoelian,” there is a character who takes Moe’s picture for the Duff calendar, introduced by Duffman as “Duff’s Vice President in charge of calendars and fake IDs, Phil Angelides.” When asked about the episode, the real-life Angelides acknowledged Simpsons creator Matt Groening as “a friend” and said “By the way, that made me very popular among my three daughters. It raised my hip status among all my daughters and their friends.”
    (Clearly written by a flack)

    He was a “Coro Foundation Fellow”:

    Is this true? Angelides was “hand picked” by Nancy Pelosi?

    And if this is true, It’s easy to see the ties to Big Energy, Union Money and Politics, pension thievery, etc:

    “Angelides earned his position as chairman of the Apollo Alliance by loyally steering literally billions of dollars of the pension funds he controlled as California State Treasurer to the pockets of the renewable energy, organized labor, and community organizing interests that make up Apollo. His biography on the Apollo web site boasts:
    “He directed $26 billion in state investments to promote smart growth. He put the weight of California’s $400 billion pension funds behind investment in clean energy and the fight against global warming.”

    Angelides brought his top staffer, Cathy Calfo, with him from the California State Treasurer’s office to become Apollo’s new executive director. Apollo boasts that, while in the Treasurer’s office, Calfo steered an incredible $1.5 billion in state funds to “renewable energy, cutting edge environmental technologies, and environmentally responsible companies.”

    (No, this does not mean I endorse Breitbart and whatever else he writes about)

    Commissions — gotta love ’em. They make us realities we can’t refuse.

  7. My concern is the scope of regulation that would be required. Specifically, what counts as a derivative? (If a shipping company signs a long term contract with contingent clauses, what is that? What if they sign a contract, but then buy insurance?)

    My concern is thus the level of heterogeneity in private contracting, and subjecting that to oversight – aside from questions of government control, I don’t even know _how_ that would be done. The sheer magnitude defies description.

    One possible solution would be defining a workable definition of what is allowed in law, declaring everything else unenforceable (after a certain date), and letting private contractors work out the details in the courts. Even the risk of unenforceability would cause private actors to avoid those contracts that _might_ be unenforceable. A few court cases would become precedents, and private sector would largely self-regulate after that.

  8. The above mentioned implementation issues, but these are almost secondary: the defenders of complex financial systems seem to have a fundamental disagreement with others. They believe that (except for a few bad apples) the financial system is contributing a lot of value to society. Many – I would hazard that most – Americans disagree.

    I’m sympathetic to the populist argument in this case: We can create huge problems for ourselves when the sheer magnitude of “bets” and “trades” swamps the underlying assets and economic activity.

    So much effort is spent by very smart people “outguessing” each other, “protecting” assets, etc… And the feedback from finances, which are supposed to reflect fundamentals, instead dominates the fundamentals.

    Even completely getting rid of deposit insurance and implicit TBTF guarantees (which create moral hazard) does not fix this. We still have 6% of our economy – and many of our brightest individuals – spending their lives trying to outguess each other, with HUGE rewards on the table. That’s a lot of rent-seeking effort. It’s exactly the same problem with insurance overhead in the medical sector – wasted effort that become structurally embedded in the economy, and which we measure as “GDP” as if they were producing something of real value. (When someone trips, and two parties go to court, GDP goes up because “value” was being created… But GDP doesn’t measure value, just activity.)

    It’s like competitive marketing – one company launches an ad campaign to build share, the other company replies. Both companies end up with the same market share, but lots of money was wasted subjecting consumers to commercials.

    So we can argue about details and implementation, but the really deep argument seems to be whether Finance (at its current levels) has become rent-seeking, or is primarily value-creating.

  9. Rather than treating the economy as a science or a religion, it might be beneficial to treat it like a dynamic system. Taking this approach, step one would be to develop and maintain a set of objectives for the system to deliver. Step 2, taking a systems approach, set up the monitoring required to determine to what extent the objectives are being met. Step 4, set up early warning monitors to issue alerts when the system is at risk of not meeting an objective. Step 5, build a plan to tune and trouble shoot the system. Step 6, define and build the tools necessary to tune the system (regulation would be one tool). Step 7, implement the plan, validating the effectiveness all the way along. Step 8, go to step 1.

    Taking this approach we would not be focusing on how to measure risk, but on how to tune the system so that we do not approach massive failure of our institutions.

    The financial industry has become so mesmerized by their own complexity that they fail to see the problem looming. All I had to do was look across the valley at the houses just like mine that were selling like hot cakes for over a million dollars that I couldn’t afford to buy without over leveraging, to know that there was a serious problem in the offing when variable mortgage rates started resetting. Sub-prime mortgages did not cause the problem, they merely caused the problem to happen sooner. Good systems trouble shooters would have identified the up and coming problem much earlier – leaving enough time to correct the problem without the massive disruption.

  10. Systemic risk is a consequence of permitting banks to gamble with insured deposits via OTC derivative contracts. There is no real world benefit to this innovation. There is merely a black hole in which nobody’s money is safe since no one has any idea what anyone else’s obligations are. This of course doesn’t matter to people who simply play with other people’s money and rake off a nice percentage so long as they can record profits through accounting gymnastics. When the #hit hits the fan people like Mr. Fox-Henhouse start writing about how ‘folks’ are confused. I am not confused in the slightest. The financial system is a fraud from end to end. Further, in my experience, anyone addressing his remarks to ‘folks’ is invariably a charlatan. Andrew Lo’s Senate Testimony is complete nonsense, equations and all.
    I hope this clears up any lingering doubts Mr. Fox Henhouse may have regarding my confusion. What does he think of a proposal to tax and require full disclosure of OTC derivative contracts, to account for them at current value?

  11. Not all innovation is good. Rampant innovation can be dangerous or even destructive. I would agree regulation can slow the pace of innovation. But what is wrong with slowing down the pace of innovation in the financial industry?

  12. There is no longer any innovation in finance. There hasn’t been for decades. There’s been only “innovation”. That is, lobbying, cons, manipulations, speculation, and complexity for its own sake, all to collect rents for parasites.

    And even if there were some vestigial innovation possible, no cost-benefit calculus would find it even remotely worth trying to achieve given the proven disaster tendencies of financialization and psychopathy of the cadre.

    So the only “regulation” that would be worthy of the name Reform would be a radical structural simplification. (Along with the restoration of rational marginal tax rates.)

  13. It shouldn’t be labeled “innovation” anyway. It’s an extremely flattering word which is used to describe financial products designed to dupe investors and eventually the American taxpayers.

  14. More innovation?

    How about innovation in — financial regulation —. Taxing OTC derivatives appears to be a promising innovation in this direction.

  15. “Regulatory capture is unquestionably a huge and generally not solvable issue. It is an unavoidable aspect of regulation that civil society must seek to minimize.”

    What bothers me about discussions of regulatory capture is the air of inevitability. The argument seems to be that because of regulatory capture, regulation is futile. We will never be rid of police corruption, either, but we do not, as a rule, shrug and accept it. In most times and places we fight against it. If we do not roll over for police corruption, we do not need to roll over for the lesser evil of regulatory capture.

  16. Yes, let us take a systems approach. Politicians are not unaware of how systems work. They are often quite good at revealing the systemic flaws in the simple minded proposals of their opponents. (And then they turn around and make their own simple minded proposals. ;))

  17. , step one would be to develop and maintain a set of objectives for the system to deliver

    Oh dear… we could take a while on that first one (though if the economy / society descends to the pits that I foresee, it might be easier than we think to reach a consensus on this. (With the help of our bloggers, of course)).

  18. It seems to me that the main problem with regulation is finding some way of establishing logical, realistic regulation outside of the political process. So long as the establishment of regulation is left to a coopted Congress, the degree of its efficacy will be severely, if not fatally flawed. It seems that what Congress could do, logically, is to establish a board with the same level of independence as the Fed, so that it could continuously monitor markets and products and devise regulation and regulatory authority sufficiently independent to do so on an ongoing basis.

    This would enable us to be protected by a group who is not answerable to those vested interests who are currently spending millions to promote flawed regulation and regulatory practices. For instance, it is true that Congress is presently working on regulatiing derivatives, and, in the political process, it appears that only a fractional portion of that market will even be subjected to regulation. It seems that this is completely flawed, especially since it is widely known that the various formulations will remain opaque in the specific area which is generally believed to have contributed the most to our completely unbalanced economy and the catastrophe of one year ago.

    Everything you say makes good sense, but is presently politically unfeasible.

  19. The solution to regulatory capture is obvious: throw out Congress and change campaign laws. If that isn’t done, the problem will persist until it is. Period.

  20. That’s been tried (in effect) in Europe in a number of countries. It works great, generally. There’s a certain amount of griping re: taxes (I’m in Belgium right now) but one certainly doesn’t hear many people pining for the American system.

  21. It’s not a question of inevitablity, so much as pervasiveness. You could argue, as Fox-Penner does, that “there is a century of experience with mechanisms that reduce capture: overlapping terms of regulators, requirements for political balance, revolving door rules, and so on. This is the hugely important day to day work of regulatory practitioners and legislative overseers.”

    But what happens when the decision-makers of every regulator are captured and actively trying to frustrate regulation? What happens when the legislative overseers are captured? What happens when both parties have been bought, so “political balance” loses its meaning? I would say capture, if not inevitable, is at least powerfully self-perpetuating in our current environment.

    It’s not like some cops have been bought off. In our situation, the process of capture has been thoroughly institutionalized. It’s intellectual and cultural, diffuse, not just transactional. This isn’t something we are going to change incrementally by adding more checks and balances here and there.

  22. I am so impressed by clear-thinking of Peter Fox-Penner that I could not believe he is an economist! Sure enough he is an electrical engineer by training. (OK, OK, there are some competent economists but there are as rare as ethical lawyers.)

  23. Has the financial innovation of the past 20 years delivered any new products? Aren’t at the consumer level the products still just loans? Were those products higher quality? Retrospectively, obviously not. Were these products lower cost? Only from the point of view of obfuscating costs and through cost shifting.

    What if Verizon came up with a cell phone plan that was normally $100/mo, but would give it to you for $50/mo for 2 years, but would have a balloon payment at the end, or the payment would go up to $200/mo for the last 2 years of the contract. Is that an innovation or a trick?

    The whole regulation aspect can be mooted if financial institutions explicitly stated they would not accept govt funds during times of crisis. Follow this logic – how would those ‘innovative’ firms cost of capital compare to the ‘less innovative’ but backstopped? Which would end up delivering better products?

    I don’t mind innovative unregulated financial firms existing, but they need to be on their own. Their actions also need to be segregated from the regulated firms. But this really wouldn’t work: say Lehman was unregulated, but their bonds still got AAA ratings, people would still buy them, even if they didn’t get Fannie wrappers.

  24. What if the regulation of home construction was as shoddy as the regulation of home financing? Doesn’t regulation of HC stifle potential innovation? Why? Massive risks.

  25. Johnny One-Note back again. I remain perplexed,
    indeed, transfixed by the question: what is the
    social utility of e.g. derivatives, cred def swaps,
    etc? I am talking _theory_ here; I know that
    the TBTF banks, insurance, etc have our Congress
    in a vice. But we need to figure out what we are
    _for_(or perhaps against :) ) instead of doing our
    standard bitchin and complainin.

    I am using the phrase “social utility” in as broad
    a sense as possible. E.g. I think gambling is
    foolish and hurtful. But lots of people don’t and
    thus Las Vegas and lotteries serve a social purpose,
    bringing enjoyment to millions. Ditto drinking
    and smoking.

    But how do cred def swaps and derivatives help
    our polity? Do they make it easier for me to get
    a mortgage, or buy a new car? or do they help
    a business, small or medium-sized, get a loan for
    expansion? My feeling is: the answer to those
    questions is No. But I could be wrong; it has
    happened before.

    I would like Messrs Johnson and Kwak to give
    Bond Girl, who by her moniker and the tone of her
    posts seems very qualified to answer my questions,
    a guest column.

    Finally, I consider these questions to be important
    because people trying to change things have got to
    be _for_ something, not just a mob uttering cries
    of complaint in various voices and various keys.

    Best wishes to all,

    Alan McConnell in Silver Spring, MD

  26. It would also create a broadly-based middle class :). A mentor once told me it is our civic duty to pay taxes. It is an interesting state of mind.

    While it seems drumming up anger against the gub’mint and taxation is a political instrument used to great effect by the American right-wing.

  27. Here’s a thought experiment.

    What kind of country (and global influence) would America create if there was a gap between high and low income earners of 1:5 or if this is too limiting of 1:10?

  28. Here’s a thought experiment.

    The G20 will be meeting in Huntsville Canada in 2010. The top item (?)on their agenda will be regulating the world financial system.

    What if they emerged with the following consensus: To reform the global financial system, compensation in investment banking will be limited to 5X national median income.

    The aim would be to encourage innovation and responsible risk-taking at the same time. Would 5X be too limiting? If so what should be the multiplier?

  29. Bond Girl – See Bayard’s comment, just above yours. With such political capital and positive momentum when he first was sworn in, it’s a terrific shame that the president didn’t move to enact strict campaign finance reform and anti-lobbying measures in Congress.

  30. Bond Girl: “But what happens when the decision-makers of every regulator are captured and actively trying to frustrate regulation? What happens when the legislative overseers are captured? What happens when both parties have been bought, so “political balance” loses its meaning? I would say capture, if not inevitable, is at least powerfully self-perpetuating in our current environment.”

    We have been here before. “The best legislature money can buy,” and so on. Incremental change is possible. The abuses of the 1870s took more than 20 years to abolish. As for our current situation, we did not get here overnight, and we probably will not reform it overnight. Brooksley Born was not captured, she was squelched. Would that happen today? I doubt it. The politics is different now. The Consumer Financial Protection Agency is a step in the right direction. Institutionally, it is antagonistic to the Fed, which is a good thing. As long as their jurisdictions overlap, it will be hard to capture both.

    The subculture of financiers, regulators, and legislators is contained in a larger culture that does not share its values. Witness the popular outrage about executive compensation. Change can come to that subculture quite rapidly, if its protective shell breaks. Just let people get mad as hell, so that they really won’t take it anymore. A prolonged period of high unemployment, foreclosures, and bankruptcies could lead to that. The Pecora hearings galvanized public opinion at the time of the Great Depression. Something similar could happen this time around, too.

  31. Would Brooksley Born be squelched today?

    I don’t know – what are her noble opponents doing these days again?

    This is so predictable and so sad.

  32. Great ideas here, but now you’re making me wonder if regulation might be a GOOD thing. It’s silly to think that innovation for innovation’s sake is the right step forward. As Vision Critical points out, when a company innovates it should add value to the customer.

    Now obviously, you’re not just talking about customers here, but something much bigger. But the principles still apply. Innovation shouldn’t be the aim; GOOD innovation should be the aim.

    Obviously, it is impossible for a nation-state to control an entire economy. It’s just not scalable. At the same time, though, there should be laws that protect the average citizen from companies that engage in unethical practices.

    Our current economic crisis is a result of BAD innovations. The subprime mortgage fiasco is one such example. Regulation should therefore act as a mechanism to encourage good innovation and discourage bad innovation. In fact, perhaps the government shouldn’t be afraid to say “No!” to more innovations.

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