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As someone who works in finance during the week and plays on and near the ocean during the weekend, the Wall Street coup of 2008 and the 2010 BP Oil catastrophe have both been distressing. Even more distressing is the fact that so many people, including opinion shapers in the media, refuse to understand what is at the heart of these massive failures, regulatory capture and perverse incentives.
First, we need to know more about what George Stigler called "regulatory capture." When there are regulations that are meant to manage several aspects of how an industry operates, expertise is needed. The problem is that the best expertise usually comes from the industry. As a result, government gets most Federal regulators from the industries which they are supposed to regulate. Most of these "public servants" are doing the job so they can be given great consulting jobs in the same industry after a few years. As a result, industry regulation tends to be anemic and too many industries operate with the upsides of laissez-faire capitalism and all of the help and assurances of socialism. They get to take risks (while regulators look the other way), reap the huge short term rewards and then when the risks turn into major losses, the public is forced to incur some or all of the costs.
The only person who can make complex regulation of industries to work are those with great expertise (good public servants have to know what they are doing no matter how good their intentions), a completely disinterested nature (Hank Paulson of who left Goldman Sachs for Secretary of the Treasury let Bear Stearns and Lehman fail but did not let his friends at Goldman fail) and totally selflessness (if you had the talent to run a bank or oil company why not make the money instead of make a pittance as a federal bureaucrat or if you do not have talent you start as regulator and eventually get a wink and nod deal to go into the industry and be well paid after a few more years of "public service."). It is hard to find someone with two of those three qualities, let alone all three.
The problem with complex regulations is human nature itself. The way to make businesses behave in a manner that minimizes risk to the public, you have to look at the incentive structure. When we accept that people are greedy (if not greedy for mony then for power, prestige or other goods), that business tends to look to maximize profits and that government officials can be bribed (if not for cash right now then with very well paid consulting jobs in the future or campaign contributions perhaps and other totally legal means of making bribes) we can change the underlying incentive structure to make imperfect human beings to police themselves.
The people who have the most knowledge of banking in general and their own bank specifically are the management of that bank. If they did not have the safety net of bailouts and golden parachutes and instead had their compensation tied up in long term stock option (or better yet if the bank is a partnership) bankers would balance risk in as efficient a manner as is possible (because now you face the prospect of gains and losses and not just gains alone, with tax payers incurring any serious losses) and in the most efficient manner possible and more efficiently than any regulator could do (if the regulator knew better what the ideal balance of risk and prudence was, he probably wouldn't be a federal regulator).
In the case of BP, there bad behavior was nurtured by the knowledge that with the liability cap those Congress had created for oil spills, they would never be subject to court judgements that would be great as to make them insolvent. In normal civil cases, punitive damages come into play and punitive damages are a sum of money that the offender has to pay. Punitive damages are meant to go above and beyond the cost of compensating the victims and the punitive damages are supposed act as an effective deterant for future bad behavior of the type that causes the civil lawsuit.
Thankfully President Obama got the 20 billion dollar escrow fund established (even if his methods were troubling) and Eric Holder is using every statute that he can find tp punish BP financially but the sums will still prove to not be enough to act as deterant against future reckless behavior. If BP could be suited with no liability caps or other legal safeguards that create perverse incentives, we could see a judgement that would include punitive damages well in excess of 20 billion. If a firm like BP had a 100 billion dollar or greater judgement levied against it, they and other oil companies would never skimp on safety procedures, they would have better plan in place and they might avoid the more risky drills sites. Like almost every other business, BP, is run by accountants and the accountants weighed the cost of the a few million in safety devices and redundancy against the cost of the risk of incurring a judgment of a few billion dollars. The accountants will find a few million on safety is worthwhile when those cost are weighed against the risk of insolvency.
Cliff Notes:
-Federal Regulators are either inept, corrupt or both so complex regulations of industries are difficult to do.
-People are greedy including regulators that can be bribed.
-Because we are all greedy, the threat of having to take financial loss forces the industry to police itself better than the Government can.
-Sadly, big business rarely has to take financial losses in the manner than individuals and smaller firms have to so they do not have to police themselves.
-Incentives matter.
BTW, I think I am going to start doing this every month and write a column about Economics, Business, Public Policy and how they relate to each other and maybe sometime looking at the Economics of certain things in pop culture (Game Theory at Work in Halo, Seinfeld and "the Road") or something like that.
Also, I know that most of you will not read this because it is too long, I am not offended but please do not type "TL;DR" I know that some of you do not have the brainpower to read a few paragraphs and if you did not read it, that is okay, you do not need to tell me why. Also, I am aware that it is Friday and that it is the night time ( In the Americas) as the time of my posting this but you do not have to read it tonight.
I welcome comments and hope that we can get a discussion going over the next few days or weeks. Whether you agree or diagree with what I wrote, if yo uwant to talk about it, go ahead and send me an AIM, my name is "Roy Anglais."
First, we need to know more about what George Stigler called "regulatory capture." When there are regulations that are meant to manage several aspects of how an industry operates, expertise is needed. The problem is that the best expertise usually comes from the industry. As a result, government gets most Federal regulators from the industries which they are supposed to regulate. Most of these "public servants" are doing the job so they can be given great consulting jobs in the same industry after a few years. As a result, industry regulation tends to be anemic and too many industries operate with the upsides of laissez-faire capitalism and all of the help and assurances of socialism. They get to take risks (while regulators look the other way), reap the huge short term rewards and then when the risks turn into major losses, the public is forced to incur some or all of the costs.
The only person who can make complex regulation of industries to work are those with great expertise (good public servants have to know what they are doing no matter how good their intentions), a completely disinterested nature (Hank Paulson of who left Goldman Sachs for Secretary of the Treasury let Bear Stearns and Lehman fail but did not let his friends at Goldman fail) and totally selflessness (if you had the talent to run a bank or oil company why not make the money instead of make a pittance as a federal bureaucrat or if you do not have talent you start as regulator and eventually get a wink and nod deal to go into the industry and be well paid after a few more years of "public service."). It is hard to find someone with two of those three qualities, let alone all three.
The problem with complex regulations is human nature itself. The way to make businesses behave in a manner that minimizes risk to the public, you have to look at the incentive structure. When we accept that people are greedy (if not greedy for mony then for power, prestige or other goods), that business tends to look to maximize profits and that government officials can be bribed (if not for cash right now then with very well paid consulting jobs in the future or campaign contributions perhaps and other totally legal means of making bribes) we can change the underlying incentive structure to make imperfect human beings to police themselves.
The people who have the most knowledge of banking in general and their own bank specifically are the management of that bank. If they did not have the safety net of bailouts and golden parachutes and instead had their compensation tied up in long term stock option (or better yet if the bank is a partnership) bankers would balance risk in as efficient a manner as is possible (because now you face the prospect of gains and losses and not just gains alone, with tax payers incurring any serious losses) and in the most efficient manner possible and more efficiently than any regulator could do (if the regulator knew better what the ideal balance of risk and prudence was, he probably wouldn't be a federal regulator).
In the case of BP, there bad behavior was nurtured by the knowledge that with the liability cap those Congress had created for oil spills, they would never be subject to court judgements that would be great as to make them insolvent. In normal civil cases, punitive damages come into play and punitive damages are a sum of money that the offender has to pay. Punitive damages are meant to go above and beyond the cost of compensating the victims and the punitive damages are supposed act as an effective deterant for future bad behavior of the type that causes the civil lawsuit.
Thankfully President Obama got the 20 billion dollar escrow fund established (even if his methods were troubling) and Eric Holder is using every statute that he can find tp punish BP financially but the sums will still prove to not be enough to act as deterant against future reckless behavior. If BP could be suited with no liability caps or other legal safeguards that create perverse incentives, we could see a judgement that would include punitive damages well in excess of 20 billion. If a firm like BP had a 100 billion dollar or greater judgement levied against it, they and other oil companies would never skimp on safety procedures, they would have better plan in place and they might avoid the more risky drills sites. Like almost every other business, BP, is run by accountants and the accountants weighed the cost of the a few million in safety devices and redundancy against the cost of the risk of incurring a judgment of a few billion dollars. The accountants will find a few million on safety is worthwhile when those cost are weighed against the risk of insolvency.
Cliff Notes:
-Federal Regulators are either inept, corrupt or both so complex regulations of industries are difficult to do.
-People are greedy including regulators that can be bribed.
-Because we are all greedy, the threat of having to take financial loss forces the industry to police itself better than the Government can.
-Sadly, big business rarely has to take financial losses in the manner than individuals and smaller firms have to so they do not have to police themselves.
-Incentives matter.
BTW, I think I am going to start doing this every month and write a column about Economics, Business, Public Policy and how they relate to each other and maybe sometime looking at the Economics of certain things in pop culture (Game Theory at Work in Halo, Seinfeld and "the Road") or something like that.
Also, I know that most of you will not read this because it is too long, I am not offended but please do not type "TL;DR" I know that some of you do not have the brainpower to read a few paragraphs and if you did not read it, that is okay, you do not need to tell me why. Also, I am aware that it is Friday and that it is the night time ( In the Americas) as the time of my posting this but you do not have to read it tonight.
I welcome comments and hope that we can get a discussion going over the next few days or weeks. Whether you agree or diagree with what I wrote, if yo uwant to talk about it, go ahead and send me an AIM, my name is "Roy Anglais."
