Will Regulation Hobble Capitalism?

Will regulation hobble capitalism? I think the opposite is true. Properly done – and I think most of the financial regulation that is envisioned fits into this camp – government regulation of the financial industry will move the industry closer to the capitalist ideal. By capitalism, I mean where those who take the risks and put up the money get the fruits of their labor. And, importantly, where those who take the risks and put up the money actually do take the risks, bearing the full costs of failure as well as success.

Capitalism means bearing the costs
I sometimes miss the rugged beauty of Utah, where I spent some of my pre-Wall Street years. From my house on the foothills of the Wasatch mountains, I could see the cliffs of Mount Nebo to the south, nearly fifty miles away. Ten miles north, the western face of Mt. Timpanogas, capped with snow into early summer. To the west, the sun reflecting on Utah. Oh, and on the eastern shore of the lake, the black smoke billowing out the stacks of Geneva Steel.

Geneva Steel was built to produce steel during the war effort, and kept in operation until seven years ago. It teetered at the edge – and at least two times over the edge – of bankruptcy, closing for good in 2002. Left behind were assorted furnaces, presses and scrap metal sold to a Chinese steel producer, and a giant pond of toxic sludge.

Fortunately, we’ve learned a thing or two about toxic sludge in steel production. The steel producer, in this case the original parent of the Geneva plant, U.S. Steel (X), has to set aside a fund to pay for the clean-up. The sludge is part of the production process, and the clean-up is a cost of production, even though it is a cost that is not realized until many years down the road. As a result, steel costs are little higher and the shareholders fare a little worse than if this longer-term expense were not forced onto the producers. The regulation that requires setting aside funds for the clean up might be considered intrusive to the core values of capitalism. But it is the contrary. It is forcing the steel mills to recognize all of their costs rather than leave society to foot part of their bill.

Wall Street’s Toxic Sludge
Wall Street has its own forms of toxic sludge, longer-term costs and negative externalities from products and strategies: The increase in the risk of crisis that comes from the opacity of complex derivatives; the fat tail risk of positions that are short credit or liquidity; negative gamma trading strategies, strategies that in various guises are like naked call writing, making money most of the time, but on occasion failing spectacularly; the forced deleveraging and liquidity crises that come from high leverage.

These costs are easy for the Wall Street capitalist to ignore, because unlike the sludge pond behind the steel mill, they are not visible until they finally hit. Indeed, they are not even deterministic. They might hit or they might not – so what we have in financial markets is invisible and probabilistic toxic sludge. Which makes sludge-producing strategies all the more popular with banks and traders, because if you can do things where you don’t have to bear some of the costs, the odds are better you will turn an apparent profit.

The limited liability assault on capitalism
The banks and trading firms don’t have to bear these costs because of the widespread use of limited liability. Limited liability creates a ‘heads I win tails you lose’ relationship. The template for limited liability is the corporation, a template that has been copied to create the trader’s option and short-term compensation, paid out before the full costs of a product or strategy are manifest.

If I want to get the most value out of limited liability, I will gravitate toward fat tailed and complex businesses, where most of the time I pump money out with regularity, but face some prospect of a catastrophic loss. How catastrophic? The bigger, the better. It doesn’t matter to me how bad things get once they have passed my liability limit. And the larger that catastrophic case, the more costs I am passing on, and thus if a general risk-return relationship holds, the more return I will get as long as the catastrophe is kept at bay.

Put in other terms, I will look for businesses and strategies that produce the highest level of costs that I can slough off, that will be unrecognized by others. Is this the direction Wall Street has gravitated? Are the exposures of traders and banks biased toward taking credit risk, being short liquidity risk, and short gamma? Do they prefer the complex to the simple? Do they push leverage as far as regulation allows?

Regulation and capitalism
Regulation that exposes these costs and forces the trader or bank to absorb them makes the markets more true to capitalist ideals. Capitalist regulation forces the producers to recognize all of their costs. It undoes the harm to capitalism that comes from limited liability and its kissing cousins, the trader’s option and short term compensation deals. The flip side is that with capitalist regulation, no one can take on more risk than they are capable of absorbing. Which means requiring higher levels of capital on the one hand, restricting leverage on the other, which in turn means reduced capacity to generate high returns.

The aspiring capitalists among us will decry such regulation because it invariably makes our lives harder; we can’t make as much money. But if the reason is that the regulation is now forcing us to bear all of the costs of our enterprise, then we are feeling the pain of having the socialist trappings removed, and entering into a more robust capitalist regime.

Comments

[TxTim:]

Chap08 has got it nailed.


On Sep 16 09:54 AM chap08 wrote:

> Good article and absolutely right. In a well functioning market,
> no one should be able to escape the implications of their actions,
> be they costs, externalities or criminal charges. At the same time,
> penalizing risk taking is harmful to growth. Market solutions are
> not the best in all cases, regulation is needed too. Getting the
> balance right is difficult, but the balance has swung too far in
> recent years. A system of privatized gains and socialized losses
> is no way to promote a well functioning market.

Sep 16 04:06 PM

[ewing:]

The community I live in at one time had a flourishing automotive plant. WWII came along and the plant converted to producing airplanes for the war effort. No one was worried about regulation or the impact this production had on the environment. Over time public perceptions changed on the environment, local governments and employees became greedy. Now that plant has been idled (no employment) the buildings torn down (no tax benefit) and is now a superfund site (government seizure of personal property) with the likelihood of development near zero. It is certainly heartwarming to see how government involvement has improved my community.

Sep 16 04:20 PM

[Matt Blackman:]

Interesting article except for the fact that the government can't even come close to enforcing current regulations. Yes, there may be a need for some tweaks to present day regulations but could someone please explain just how is new reams of regulation and an even more bloated government sector is going to help markets?

Sep 16 04:30 PM

[rpgpa:]

Its not capitalism if the big corp in wallstreet pays off the government in the politically correct term... campaign contributions.. Its only capitalism when laws are made and enforced to protect the whole. Its not in the US so keep writing and keep wasting your time. Everyone needs to get rid of this magical dreamworld that were back in the 50s with a moral based country. Its not!!

Sep 16 06:22 PM

[driftwood2:]

Having been in various industries I can tell you that regulations have a very significant cost. However, regulation in the financial industry is entirely warranted in my opinion because history has shown the tremendous cost of not doing so. Also, it really seems to me that 80% of the "innovation" in the financial industry is actually new ways to swindle people or print money rather than anything that actually produces anything of real value. Preventing most of the "innovation" in the financial industry will only increase GDP.

Sep 16 09:08 PM

[Liz:]

This is one reason why our society is in the fix that it is in right now -- this attitude that lawful, proper, and legitimate regulations are obstacles that somehow must be "gotten around".

Instead of trying to dodge regulation, how about *complying* with it for once? (I'll bet you have a radar detector in your car too. :P )


On Sep 16 02:34 PM Troy Jensen wrote:

> it would be a dream to clean up regulation, strengthen where needed,
> eliminate the ridiculous overkill (and the billions of dollars associated
> with both government oversight costs, as well as corporate expense
> to navigate and find ways to get around those regulations)

Sep 16 09:17 PM

[Liz:]

This is one reason why our society is in the fix that it is in right now -- this attitude that lawful, proper, and legitimate regulations are obstacles that somehow must be "gotten around".

Instead of trying to dodge regulation, how about *complying* with it for once? (I'll bet you have a radar detector in your car too. :P )


On Sep 16 02:34 PM Troy Jensen wrote:

> it would be a dream to clean up regulation, strengthen where needed,
> eliminate the ridiculous overkill (and the billions of dollars associated
> with both government oversight costs, as well as corporate expense
> to navigate and find ways to get around those regulations)

Sep 16 09:17 PM

[Moon Kil Woong:]

Yes, it is the lack of any morality and proper regulation that is hobbling the economy than the reverse. Simply put, capitalism requires some level of honesty, trust, and certainly proper accounting. Without these tools we can just forget about making a rational market, or any market for that matter. Just let Goldman Sacs dictate random prices and let people bet on them. Just let banks siphon out endlerss streams of money off of the rest of the public. And just have all Americans turn into pennyless surfs.

Sep 16 10:11 PM

[THofler:]

I read Mr. Bookstaber's paper on VaR, fat tails, and financial crises, and loved it.

This article is fine as far as it goes, but the author expresses faith in the new gov. regulation near the top. Hmmm.

Exhibit A: The new credit card regulation has mostly fine and modest improvements -- except for the big one; the fixing of interest rates. Sure the borrower should have a 45 day warning of interest rate hikes, but even then the issuer can't boost rates unless they can demonstrate some index (libor, prime rate?) has shown a sizeable increase. What if the loan losses have quintupled because of a recession? Don't bother Congress with reality, they're too busy pandering to voters.

I suspect that the new CFPA will be like the credit card legislation only worse. Much worse because it can be tweaked endlessly to siphon more and more regulatory authority away from the Fed and into the hands of politicized regulators like Liz Warren.

Sep 16 10:52 PM

[carey_jim:]

Formal laws and regulations are simply practical ethics and without ethics, or rules of behavior that regulate all human interactions, human beings would be animals.

I love cats but I would hate to have my cat running the economy.

All criticisms of rules and the people who enforce them are similar and amount to telling the police to go to hell.

I had a friend who worked as the head of Security for Oracle and he said that it was not unusual to see Larry Ellison come to work in the morning, or whenever it pleased him, trailed by ten or more California Highway Patrol cars. He said that Ellison had instructed Security to pay the officers whatever they asked for, and to get rid of them as soon as possible. He said they always did and Ellison never mended his speeding ways.

Somehow that seemed to me to sum up government-business interactions.

On second thought, my cat might have a better solution to the regulation problem but, to paraphrase Wittgenstein, if cats could talk, human beings wouldn't be able to understand them.

Sep 17 04:46 AM

[User 417228:]

Richard, do you mean we are not required to privatize the gains and socialize the losses forever? but of course you do. how refreshing!


carey_jim, at least ellison bore MOST of the costs of his choices/actions - except the marginal ones avoided by his successful efforts to keep his actions out of the public/shareholder eye.

Sep 17 06:27 AM

[Mike Kane:]

regulation = capitalism's worst nightmare

Sep 17 10:46 AM

[Mike Kane:]

we need a true, unfettered free market...not one controlled by morons in Washington


On Sep 17 10:46 AM Mike Kane wrote:

> regulation = capitalism's worst nightmare

Sep 17 10:47 AM

[Jeff Nielson:]

This article makes many good points, however it suffers from using an incorrect label. It is not the "limited liability corporation" which is the bane of capitalism, it is monopolies/oligopolies.

Most "LLC's" have no ability to pass their losses onto society and thus be indemnified. If that was true, we wouldn't currently be seeing a wave of corporate bankruptcies in the U.S.

It is only when the "too big to fail" label is attached (the calling-card of oligopolies/monopolies) that such power to plunder the wealth of society exists.

For two hundred years, anyone who has actually STUDIED "capitalism" new what was coming. As ALL capitalist economies mature, there is the inevitable rise of oligopolies/monopolies UNLESS there is rigid regulation (and enforcement) to prevent companies from acquiring such power over an economy (and the government).

Once this is allowed to occur, "capitalism" becomes an inherently parasitic system - where those with the power PLUNDER an economy, causing irreparable damage and wealth destruction.

Many pundits incorrectly refer to the growth of the Wall Street crime syndicate as a "failure of capitalism". In fact, Wall Street represents the ultimate "triumph" of capitalism: the ability of a small group of oligarchs to blackmail the U.S. government for $10 trillion in loans, hand-outs and guarantees.

The FAILURE which took place was the failure of the U.S. government to rein-in the inherently self-destructive capitalist forces which arise in a maturing capitalist economy.

The issue is not whether regulation will "hobble" capitalism. The issue is whether there is the political will to CONTROL the forces of capitalism to a sufficient degree that they do not destroy the U.S. economy (and that of other maturing, capitalist societies).

Sep 17 01:16 PM

[TeresaE:]

Nice points Jeff, the only one I would add is the FACT that any of the people we have elected/hired to protect us from the demons are directly BENEFITTING from those same institutions.

We pay, and beg, the foxes to protect our henhouse from the wolves.

Funny, I find the result is the exact same whether my henhouse is overrun with either of them.


On Sep 17 01:16 PM Jeff Nielson wrote:

> This article makes many good points, however it suffers from using
> an incorrect label. It is not the "limited liability corporation"
> which is the bane of capitalism, it is monopolies/oligopolies...
>
> Most "LLC's" have no ability to pass their losses onto society and
> thus be indemnified. If that was true, we wouldn't currently be seeing
> a wave of corporate bankruptcies in the U.S.
>
> It is only when the "too big to fail" label is attached (the calling-card
> of oligopolies/monopolies) that such power to plunder the wealth
> of society exists....
> The issue is not whether regulation will "hobble" capitalism. The
> issue is whether there is the political will to CONTROL the forces
> of capitalism to a sufficient degree that they do not destroy the
> U.S. economy (and that of other maturing, capitalist societies)...

Sep 17 01:22 PM

[TeresaE:]

The true definition of capitalism is very Darwinist.

We have never been a truly capitalistic society. Our government, especially over the past 150 years, has stuck its nose into so many places it does not belong. Creating winners & losers based on nothing more than the economy of those that pay the politicians and media.

We as a nation are being crushed by regulation. Our rights, freedoms and opportunities for keeping what we earn, have been slowly taken away.

And so many choose to do so little that they just find it easier to cry to the government rather than take care of their own problems. The solution to big banking systems is to take your money where you trust is.

The way it is now the government fortifies the corrupt and weak, and the clueless public are led around blindly by the government's stamp of approval.

I will guarantee one thing that will come out of ANY increased regulation: fewer American jobs and fewer choices for our citizens.

The small banks and firms will not be able to afford the new regulations and will either close, or sell out to the big guys. End result will be fewer jobs (every "merger" or closure results in fewer jobs) and fewer choices.

Soon, we will all be forced to spend our money (gift it) to one of two or three banks.

Oh the joy, transperancy and protection that will follow having only one or two games in town.

Sep 17 01:34 PM

[Kimball Corson:]

No, regulation will not hobble capitalism for two good reasons, one is certain and the other a closer call. On the closer call, getting a set of good regulations passed is very problamatic. The finance and banking industry has tremendous lobbying muscle. Regulation may be gutted there. If it is not and something passes we can be sure it will be ineffective because as the Univ. of Chicago has documented for years, "regulators become the captives of the regulated" and regulation becomes ineffective, as loopholes and work-arounds are created, if not just a lack of enforcement.

Sep 17 02:01 PM

[TeresaE:]

We need to keep in mind, or become informed, of the FACT that the Zimbabwe Finance Minister and President are 100% in favor of what our government/treasury /federal reserve is doing and of our upcoming regulatory nightmares.

Why, with such a stellar endorsement from such a shining example of wealth and prosperity, really, why are we even having this discussion?


On Sep 16 02:28 PM Dirk McCoy wrote:

> Accurate information, rule of law, private property rights, and limited
> liability have been cornerstones of capitalism for hundreds of years.
> Regulation that replaces these with government partisan babble, special
> rules for special parties, government confiscation, and expanded
> liability beyond anyone's ability to bear it will only slow down
> capital investment in this country, leading to a hording of capital,
> deflation, and malaise.
>
> By focusing law enforcement on those who defraud (Madoffs) or are
> willfully negligent (rating agencies), we can create an environment
> where honest businesspeople who want to make money via creative interests-
> including properly guaging fat tail risk and mitigating it because
> it can cause them to lose their money and their reputations.
>
> But regulation that just creates more barrier to entry, higher operating
> costs, and fear that elected (or appointed) officials will be in
> position to "pick winners" will only serve to damage our economy.
> Take a look at Africa and their top down "regulation" of their economies
> to see just how damaging this can be.

Sep 17 02:01 PM

[doubleguns:]

I love that point!!!!!


On Sep 17 01:22 PM TeresaE wrote:

>
> We pay, and beg, the foxes to protect our henhouse from the wolves.
>
>
> Funny, I find the result is the exact same whether my henhouse is
> overrun with either of them.

Sep 17 02:36 PM

[Living4Divi...:]

" The limited liability assault on capitalism
The banks and trading firms don’t have to bear these costs because of the widespread use of limited liability. Limited liability creates a ‘heads I win tails you lose’ relationship."

Your article suggest that this a new phenomenon that is corrupting the structure of capitalism.

The fact is that the limited liability concept has been around a very long time. It is called a Corporation.

Sep 18 10:35 PM