Hank Paulson's Cognitive Dissonance

by: Barry Ritholtz

"The Paulson plan belongs in a fictional world where financial institutions do a good job in regulating and monitoring themselves. Unfortunately, that’s not the world we live in."

-Why the Paulson Plan is DOA

So says Michael Mandel of Businessweek. In addition to the quote above, he goes further, calling the Treasury Secretary to task:

"In the middle of perhaps the greatest financial upheaval since the Great Depression, Treasury Secretary Hank Paulson is proposing a change in financial regulations which basically amounts to a big wink to Wall Street. His plan will go nowhere, both for political and practical reasons. In fact, it does not even meet the minimum standard of improving transparency, which would reduce the possibility of a similar crisis in the future...

The most striking thing about the current problems is just how much money the banks and the investment banks have lost. They apparently had no idea of how risky their own exposure was. The supposedly smart guys were simply stupid."

I concur with Mandel: In order to avoid these issues in the future, depository banks and investment banks need full and transparent reporting of their holdings. No more side pockets, off-the-book SIVs, or buried derivative exposures. In fact, they should also clearly report the potential losses they have on their books via exposure to leveraged and risky counter-parties as well.

How did this all come about? Over the past 25 years or so, we have migrated from a world that was excessively regulated to a new world that was excessively deregulated. The initial problems were too much complexity, high costs, and time consuming bureaucracy. That's been replaced with an equally problematic situation: No adult supervision in places where the children require adult supervision.

Less financial supervision? More self-regulation? What hallucinogenics were taken prior to making those recommendations?

Bankers are not the folks who should be garnering less transparency, and less onerous regulatory requirements. Only a clueless ideologue would even dare suggest as much. Unfortunately, we have a clueless ideologue running the Treasury department. When confronted with what can only be described as insurmountable evidence that self-regulation has failed miserably, our man at Treasury proposes more self-regulation.

Riddle me this, Batman: If these finance wizards were any good job at the job of self-regulation, would we even be having discussions as to how to resolve a global credit crisis?

If you are wondering how certain people can fail to understand this, the simple answer is cognitive dissonance. If Paulson were to confront reality -- lack of supervision is how banks got themselves in this mess in the first place -- his entire world view would crumble. Thus, the problem is not one of lack of supervision, it's an issue of efficiency! Hence, we get these absurd attempts to make the lack of regulatory supervision "more efficient."

The Paulson plan isn't about avoiding future meltdowns in the financial system -- it's about allowing Hank Paulson (and others) to cling to their now disproven deregulatory fantasies . . .

Why the Paulson Plan is DOA
Michael Mandel
Economics Unbound, March 30 2008