A Regulatory System as a Competitive Advantage

One of the most central themes in how I think about the interaction between economics and politics is the importance of the rules governing capitalism, in order for capitalism to reach its full potential and serve society in the best way it can.


The case for a well regulated economy is quite simple when you look at the alternatives:


Socialism does not work because no one can ever know enough about human economic behavior in order to plan everything in advance, and an unregulated economy does not work because that leads to monopolies, oligarchies and crime, and makes a democratic process impossible.


The economic crisis has now reached a stage where the role of regulation is becoming apparent for the U.S. financial system. More specifically, I argue that U.S. financial companies are now doomed to failure in competition with foreign financial companies because they have not, and will not, be adequately regulated.


A recent article in the New York Times highlights this problem. The article explains that, as a result of the crisis, the influence of British, German, Swiss and Japanese banks is growing on Wall Street and in the U.S. in general. As Eugene A. Ludwig explains, this could have something to do with regulation:


“What worries me is the competitive edge that non-U.S. banks have vis à vis U.S. banks,” said Eugene A. Ludwig, the comptroller of the currency under President Bill Clinton, who now runs the Promontory Financial Group, a Washington bank consultant group. “Non-U.S. banks generally operate under more coherent regulatory structures than U.S. banks do, which creates imbalances that non-U.S. banks can exploit, especially at a time when their U.S. counterparts are operating under extraordinary constraints.”


In short, the U.S. economy has again reached a stage where it is a wild west-style economic system that is essentially unregulated. The little regulation that exists is highly fragmented, where different financial regulators oppose each other and where financial companies can choose their own regulator, invariably picking the one that enforces the least amount of regulation.


By contrast, financial institutions in the EU operate in a much more comprehensive economic framework in general. A lot of this has to do with the work that was done in anticipation of the introduction of the Euro as the common currency. More specifically, Germany refused to go along with the project unless the German brand of stable capitalism became central to the operation of the Euro zone.


Some of the best examples of this are:


- The European Central Bank has a single mandate: to fight inflation ONLY, and not concern itself with economic growth, and to be wholly independent from politicians. A very helpful international comparison of central banks can be accessed here: http://www.bis.org/publ/mktc01.pdf?noframes=1


- Antitrust laws and fierce enforcements of those laws are meant to ensure that the “too-big-to-fail” problem does not occur.


- Bank capital requirements are higher, and additional credit rating standards are imposed on complex financial products such as mortgage-backed securities.


In addition to these rules, several countries in the EU have other regulatory advantages over those that U.S. companies have, such as:


- A single financial regulator with clear, often internationally harmonized rules (such as Basel I and II, and multiple EU agreements)


- Unlimited liability instead of limited liability. In many countries in the EU, financial executives are personally liable for what happens in their companies. This obviously creates a different risk-taking climate.


- The right of the government to take over non-banking institutions such as mutual fund companies and hedge funds in order to protect investors, much like the FDIC takeover authority in the U.S..


What I have listed above under the heading of “regulatory advantages” may seem like a not so coherent list of issues, but what these things lead to in terms of the role of financial institutions in the economy is one central thing:


A focus on long-term profits instead of short-term profits


It would be very hard to argue that a focus on short-term profits is a good thing from a societal economic perspective, or indeed from any perspective other than that of the individual financiers.


A focus on short-term profits, I argue, leads to large-scale “looting”, which I explained in
this blog post on circular looting.


Needless to say, the focus that American financial institutions have on short-term profits, as a result of the inadequate regulatory framework, is the explanation as to why U.S. companies are being challenged by foreign ones now. U.S. companies are simply not equipped to compete in the long term. When the looting is done, the companies have nothing to show for.


What we are seeing right now is a failure of the central functions of capitalism. Because the system has been under-regulated, if not unregulated, the good dynamics of capitalism where efficiency, choice, competition and innovation are central components have been shoved aside, in favor of outright looting.


Presently, U.S. financial companies appear to be doing better, but make no mistake, this is only an illusion. The suspension of the mark-to-market rule has enabled them to grab numbers out of thin air and make it look like they’re profitable again. Also, because the federal government is lending money to them extremely cheaply, on a highly unsustainable level I might add, these companies are currently experiencing some short-term gains.


As soon as the government realizes that the enormous subsidies cannot go on anymore, U.S. financial companies will start to tumble once again. My guess is that that will happen within 1-2 years.


The New York Times article gives the example of the U.S. auto industry not being able to compete with the Japanese auto industry, which I think is an excellent example. Because the U.S. government failed to implement proper standards for automobiles there was seemingly no need to change anything, you just keep churning out new cars for quick profits.


One day, though, the confidence of the public was used up, and the U.S. auto industry as we knew it died. In a not so distant future, Bank of America will be the new GM, and Deutsche Bank will be the new Volkswagen.





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

The Shimon Peres Proposal

The New York Times reported yesterday that the President of Israel, Shimon Peres, had come up with a suggestion for dealing with fraud and other abuses on Wall Street. During a Sabbath dinner last week, Peres reportedly proposed that, instead of giving huge bonuses to executives of failed banks and Wall Street firms, large bonuses should be given to federal employees who sniff out the next Bernie Madoff or expose the next financial derivatives scheme à la Lehman Brothers.


The proposal is a very good one, and it goes deeper than what it seems like on the surface. It is not the most sophisticated of political tools, but it is one that most people can understand and embrace. It may not be fair to other federal employees, but desperate times call for desperate measures.


The core of the problem is bad governance. For decades, people who have worked as federal regulators have only done so long enough to make their next career move: to work on Wall Street with ten times the salary. This makes regulators unmotivated and decreases the skill of the regulatory institutions in general because of poor staff retention numbers.


Also, financial regulation is simply a game of cat and mouse, where regulators try to keep up with Wall Street’s innovations, but always lose. The reason: Wall Street employs ex-regulators who know how to structure everything relating to financial transactions so that they will be kept under the radar.


The situation for federal regulators is very similar to that of Mexican policemen who can’t feed their families on their salaries and turn to the drug trade to make much needed money. I don’t think the families of regulators are starving, but when prosperity is put into a relative context, as it always is, they might as well be. The incentive to move to Wall Street is simply far too great.


People who work for the United States government are actually not that poorly paid from a comparative perspective. They get a fair salary and pension, a good amount of vacation time, good work hours and are allowed time with their families. In most respects, working for the U.S. government closely resembles working in a middle-class job in the EU, where all jobs, whether private or government paid, come with such benefits.


So, theoretically, I disagree with the fact that financial regulators should be paid much more than other federal employees. However, this is a crisis if gigantic proportions, and because Wall Street is the biggest part of people’s financial well-being, problems with fraud and schemes can rock the foundations of society.


I hereby suggest a few more details to the Shimon Peres proposal:


- give regulators who expose fraud and schemes a share of the fines in the eventual court settlement


- increase incentives for the already enacted whistle-blower compensation with respect to Wall Street firms


- consolidate all financial regulatory agencies into one huge agency


- consolidate all financial regulation into clear, simple, federal legislation (this is definitely easier said than done)






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