Why We Need More Financial Regulation

Did deregulation cause the Wall Street meltdown? Yves Smith discusses the dangers of deregulation and the unethical (if not illegal) behavior at Goldman Sachs.

Why We Need More Financial Regulation Jill Schlesinger: With Financial reformed finally on the front burner in Congress we’re pleased to have Yves Smith in the Money Watch Studio. She’s the powerful voice behind the economic’s blog Naked Capitalism and author of the new book “Econned”. Yves thanks so much for being here. Yves Smith: Thanks it’s a pleasure. Jill Schlesinger: So you don’t like economist? Yves Smith: I actually don’t dislike all economists. It’s this flavor of economics. It is now called mainstream economics. It’s rooted in the classical economics. There’s also with its evil sister financial economics and at this were textbook teaching tools that would be fine. It’s the fact that these very abstract models are taken away beyond their limits both in policy and in practice. That’s where the problem is. Jill Schlesinger: And how have those sorts of the new breed of economics? How have those folks who spell that? How have they gained ground and how they changed the system? Yves Smith: Well the big way is the with the deregulation way that we saw on the 19th and which we actually saw in the 70’s that Reagan was given credit for but it started to before then. In theory, there’s nothing wrong with finding the back right balance between regulated markets and deregulated markets. This is political that moves over time but with the endorsement of these different schools of economics deregulation was pushed very hard particularly in financial services where markets have a propensity to be unstable and therefore it’s possible for as we’ve seen in the crisis for self interested parties to basically get themselves in a lot of trouble and brought customers into behaviors that in the long term they are in their best interest. Jill Schlesinger: So let’s look at that crisis for a second. So we have the economist who come in and they say, “Oh, don’t worry based on our models and based on everything we say markets are going to take care of themselves so we don’t we need as much regulation.” Now comes the crisis and what do we learn from that crisis? Do we get to kind of throw the economist out and start over or what are we to take? Is there anything good from what those economist have spouse? Yves Smith: There is. It’s just different schools. In fact, there’s one-school information asymmetry but it’s not really well integrated into policy or theory yet. But it basically says that if you’ve got parties that know more than other parties you know that the guy who knows less can be taken advantage. It was kind of common sense. He knows a very famous people called the market for Lehman to talk about the used car market. As the prototypical example and the old regulations that we have that the securities lost in 1933 and 1934 were very concerned about disclosure. You know the old rules actually without having this grand theory to wrap it in understood that there were issues if you’ve got people who don’t have a level playing field in the terms of information. Jill Schlesinger: And do you think that that’s the core of the crisis even when we just look at the mortgage crisis that people were getting products they just didn’t understand. Do you sort of count in and then say look if we had had more disclosure people really understood the stuff they were buying we wouldn’t have gotten into this mess. Yves Smith: That’s a very big part of it. I mean the part unfortunately is we’ve got very bad incentives and this is another part of economics that the model, that in financial economics the models all have the effect of encouraging people to take more risk. So you sort of look at each of the ways, the models have problems and yet you’ve got investors particularly institutional investors who are measured on one-year time frames so if one of their competitors is taking a lot of risks and their performance is lagging even if they think it’s a bad idea they’re going to lose out. The short terms and the other guy will look better. They looked like an idiot. And you know you’ve got these huge bandwagon pressures that even if somebody really in his heart of hearts knows that he shouldn’t be going along with that, he’s got a lot of institutional pressure to follow the herd. Jill Schlesinger: So let’s talk a little bit about that in light of this Goldman Sachs and this Securities and Exchange Commission so we have this poor slab named Fabrice Tourre, the fabulous fab who did seem to acknowledge that things were beyond his capability of really understanding who was getting beyond him. He puts this deal together and at the heart of this matter it sounds a little bit like asymmetrical information that Goldman had certain information that they make. Maybe they should have told their clients or not. But I want to ask a different question here, what about that conflict of interests that exist right there in that moment. The Goldman created a product that it’s sold one of its clients that it basically knew was going to fail. Nothing illegal about that but what are the ethics behind that? What are regular Americans supposed to take from that? Yves Smith: No it’s usually problematic and this gets very far away from the idea of what market is supposed to do. I mean it would haven’t occurred to somebody 20 or 30 years ago, the idea that a product would be designed that was so much served one interest and what’s the short interest. Normally people think of for example capital racing. You bring a company public. People may differ over the price and if the price is wrong it’s going to be a bad deal but fundamentally you bring company’s public that presumably are good companies. If you bring a company public that’s a sham that’s usually huge calls for scandal. Conceptually this is no different. Here you bring something in this case it’s a complicated security public but again it’s like bringing a dodgy company public that maybe you should have known better. The underwriters should not have brought public at all because it was such a dog. Jill Schlesinger: But nothing illegal about it. Yves Smith: Nothing illegal but that is also a function of the deregulation. In fact there was an interesting proposal by the FDIC in terms of how to change regulation of all these structure products which are much more complex and traditional products and one of the things they said was all of the parties. Now these has been approved one but one of the things they really want to have happen is it all the parties very clearly disclosed their intention. Right now you read these documents and they contemplate so many different scenarios and parties like Goldman is in the deal and so many different sides that they could almost do anything and so they really want the people like John Paulson the short seller and Goldman itself to be very clear about what their intentions are. If you're going to be short on the deal you're going to let your investor know that was the philosophy. Jill Schlesinger: Tell me what’s the good news in all of these, I mean you’re not a huge fun of all the pieces of regulatory refund but what’s the good news out of this crisis and in regulatory refund with someone’s who’s watching can say well at least they’re doing that. What’s the good news here? Yves Smith: Well one thing is I think we see a switch in that added to about regulation. I mean now there is a recognition that regulation isn’t an evil, that regulation is actually valuable and necessary so now we’re back to debating what degree of regulation is important and I think that’s a big positive. Jill Schlesinger: All right I like that. I want one positive out of this whole thing. She’s the diva of derivative. Yves Smith, thank you so much Yves Smith: Thank you. Jill Schlesinger: And thanks for watching.