Thursday, March 26, 2009

Financial Minority Reports

Since taking office, Timothy Geithner has been an absolutely appalling Treasury Secretary with only one strategy: to pamper and protect Wall Street as much as possible with taxpayer money while opposing legislation that would hold Wall Street accountable for having run the economy into the ground.

I was thus highly surprised when he on Thursday came out with a sweeping program to deal with the deadly mess in the financial markets, a program that was meant to deal with both long and short term problems.

The most important suggestion in the program presented by Geithner is the creation of a single regulator, “with responsibility for systemic stability over the major institutions and critical payment and settlement systems and activities”.

This may not sound like much on the surface, but it actually deals with some of the central problems in the American financial system, as well as problems in the academic world of economics.

It is a well-known fact that the American economy is a so-called “boom-and-bust” economy. It cannot seriously be denied that this is a result of the fact that the U.S. has an essentially unregulated economy. The lack of a social safety net is also a significant contributing factor.

Geithner’s new, single, regulator would actually, according to him, continuously research the dynamics of boom and bust, and try to prevent the harmful results.

More specifically, the new regulator would try to find out when an asset bubble is building, such as the tech bubble in the 90s, or the housing bubble of today, and then try to stop it in its tracks.

This is critically important, and it is a strategy that can prevent financial crises, similar to the murder prevention strategy in the movie “Minority Report” with Tom Cruise.

In that movie, some type of psychic people called “pre-cogs” can see into the future, and they can see who will commit murders in the future. The would-be perpetrators of murder are then arrested and jailed in advance, so that the murder never actually takes place.

There is no ”pre-cog” needed for the new regulator, nor will anyone have to go to jail for crimes not yet committed, but studying emerging asset bubbles in the economy and acting on the findings will produce a functionally similar result: preventing pain and suffering in the future.

The way this could be done is rather simple. The new regulator would study anomalies in the market. If the price of an asset, say real estate in Florida, starts rising unusually quickly and without a clear reason, that would be a strong indication of a bubble.

This would then be made widely known, the public would be strongly cautioned, and perhaps some temporary legislation could be put into place in that region (temporary changes in zoning laws to prevent over-building maybe). The regulator would immediately look for evidence of predatory lending and other fraud in Florida, and act on anything it would find.

On the other hand, let’s say there were an area in Florida where new and profitable industries were being built. Jobs were being added and the population was growing. At a time like that, it would make perfect sense for real estate values to go up, so an instance like that would be ignored by the regulator after an investigation was done.

Unfortunately, asset bubbles are poorly understood among academic economists in the U.S. today, or at least they are said to be poorly understood. In reality, asset bubbles are products of simple, basic human behavior. To understand asset bubbles, you need to know only 2 things:

1. When everyone else is doing something, people in general will automatically think that it’s a good thing to do. It’s a basic function of being a pack animal.

2. When it seems that there exists a real possibility of making money quickly and easily, even the smartest people get sucked in to, for instance, a speculative bubble. This human tendency is the reason why some of the most successful investors on Wall Street invested their own money with Bernie Madoff.

However, these facts are rarely recognized by American economists because they defy free-market orthodoxy.

Hence, Geithner’s new program of establishing a single regulator is a big step away from the free market orthodoxy that is prevalent among the vast majority of public and academic officials in the United States.

I believe that the program could become an extremely important tool in a sustained economic recovery in the United States.

Moreover, I advise that the winner-takes-all voting system should be destroyed.

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