I was watching "Inside Man" and thinking about some of the big picture issues that it raises. While there is a lot of explicit and implicit suggestion that lack of regulation allowed this horrible event to happen, which is true, it also highlighted for me the structural effect of regulation.
Don't get me wrong, I don't think a completely deregulated market is a perfect market. The point I am trying to make is slightly more subtle.
A regulation is a rule. A rule encodes knowledge about whats permitted based on assumptions. Enforcing a rule allows whats permitted and relies on the assumptions. A rule cannot work the way it was envisaged if the assumptions no longer hold.
Now all this is fine, except for the fact that the assumptions are rarely stated. This is a problem for both dungeon masters and financial regulators. Mainly because they both forget this simple fact.
If we use the iceberg metaphor, the rule is the 10% and the assumptions are the 90% that is hidden. The thing to take away from this is that the assumptions change easily and constantly while the rule text stays static.
You could see it in a different way.
A set of rules define a market place. If the rules are fairly comprehensive and prescriptive, they make for a very structured and "known" game. There are still plenty of variables but most of the big ones are locked. Its a game most people could play.
The rules are the encoded wisdom of the market regulators about what is and is not allowed. They encoded knowledge about what has worked and what has not worked. In effect they try to freeze time. The market is frozen at a point that the regulators are happy with how its performing. This gives the ecconomy around the market a very stable base and everything adapts to the stability of the market.
Happy days..
But what happens if one of the commodities in the market in no longer available? Easy enough, just don't use any rules that apply to it. But what about the capital that used to invest in that commodity? It moves into other commodities and changes the prices and the values. More people trade in those commodities. Ok, its a subtle change but thats what markets are about.
Now take a more radical change in the assumptions. A whole new currency is in use and competing with the existing currency. Its electronic currency and everyone can print their own money. It has a wildly fluctutating exachange rate with the existing standard currency but people are still willing to exchange between them. (Don't asky why or how, think dutch tulip bubble if you want an example) Yes it may be a bubble but its still violationg the assumptions of the market place and has introduced changes that the existing rule set were not designed to handle. Much like any social rule set. Except in a market, the dependencies between the rules are much more immediate. Its a dynamic system. Closer to fluid dynamics than a newtonian clockwork.
You need to remember that a market does not have a fixed equation like an energy equation. It has fluffly edges that at any time may introduce more or less products onto the playing field, players on the field may put value on the table or take it out of circulation randomly. There may be idiot sistuations where structures allow emergent bubbles or drains to occur. The point is that a static rule set that is highly prescriptive will be much easier to break in a dynamic environment.
If you want a look at a fixed environment, have a look at the Japanese banking system. Its been stuck in the 1930's for the best part of a century. It has begun to change but its way past its used by date.
So whats the point. One of the interesting points that I took away from watching Inside Man was a throw away comment that someone made about allowing the market to take on more risk and to explore more risk.
The interesting point I think was that removing some of the regulations allowed the market to explore new ideas. This generated a whole new set of opportunities and threats. The biggest problem was that no-one did anything about the emerging threats. The regulatory systems were completely corrupted and all the watchdogs had their teeth systematically removed.
Now imagine the same situation with a strong hand at the tiller. As the economy started to explore all these new opportunities, and made some exploratory moved into toxic CDO's, a good regulator would have pointed out that these were a ticking time bomb, helped the market to unwind the situation gracefully and prevented more of them being generated. This would have been the encoding of new wisdom into the market regulation mechanism.
The consistent failure of the US administration is not that it has failed to shackle the market with lots of regulations, the failure is that it has failed to build a set of dynamic regulatory mechanisms that have teeth.
Regulations have a used by date. A good market needs to adapt to change and allow some exploration of both old and new ideas to see if they may be valuable in the moment.
Around the edges there will be theft, fraud, ethical failures, conflict of interests, lies, deceit etc, but these can be dealt with by a strong market regulator. They just need some flexible rules that allow them to rein players in, give them a clear talking to, impose a penalty and continue playing. Markets do not need bursting bubbles. Many lose while few win.
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