Sensory Overload Produces Sloppy Policy
Washington policymaking is caught in its own version of sensory overload. All at once, there are too many problems that seem — and actually are — urgent, mind-bogglingly complex, and politically ultra-sensitive to handle well. The result now emerging could be waves of ill-considered decisions.
Exhibit A is climate change. Taking serious measures to protect the planet’s climate and ecosystems by driving down greenhouse gas emissions comes as close to an imperative as exists in science-based policy. But a small group has used this imperative to try to force a decision quickly, without preparing the public or most representatives for how their cap-and-trade scheme would affect everybody — for example, by increasing the volatility of energy prices, and setting off frenetic Wall Street speculation in the emission permits created by cap-and-trade. That’s just the start of the sloppiness: the process of corralling the support to pass the measure in the House of Representatives — the vote is expected this week — has become a frenzy of giveaways that have cost the program most of its teeth and all of its bite. The result is the worst of both worlds: a measure that most environmentalists agree (at least privately) would do little about climate change, while unnecessarily harming the economy. Thankfully, the Senate is unlikely to go along. Once it fails there, perhaps we can get on to more serious and public deliberations about what will be required from all of us to shift to a less carbon-based economy.
Financial regulation is Exhibit B. The minimum for sound policymaking here has to be a genuine recognition of how our capital markets came to melt down and what irreducible steps can prevent it from happening again. We now know, to start, that the most prominent institutions in our financial system have operated for years in ways that create unsupportable levels of risk. We also know that their risky behavior wasn’t an accident, but the result of thousands of calculated responses to real incentives. The toxic combination here is what insiders refer to as limited liability plus leverage: the executives, managers, traders and dealmakers at Bear Stearns, Lehman Brothers, Merrill Lynch, Citigroup, Bank of America, AIG, Goldman Sachs and others could borrow unlimited amounts of money (the leverage) to enter into almost unlimited numbers of risky deals. For the deals that worked out, they pocketed enormous profits and additional compensation; and for those that went south, only the shareholders suffered. If the bottom fell out on thousands of deals at once, they also all believed that they would be both too big to fail and not too big to save — and but for the incompetence of the Bush Treasury in the Bear Stearns and Lehman Brothers cases, they were right.
Today, after $3 – 4 trillion in federal bailouts and federal guarantees, these incentives for undertake risky deals are even greater than they were before. And if the latest OECD forecast is right, and we should expect at best a weak and fragile recovery next year, the incentives to go for a killing will be even greater still.
Yet, most current proposals for new regulation would do little to head this off. Part of the problem with the financial system comes from simple size — firms that are too big to fail — yet none of the proposals even approach this issue. For example, we could debate scaling up a firm’s capital requirements with its size: The bigger it is, the less pure risk it can take on. And with the collapse of so many large institutions, the survivors are now even bigger. So here’s another thought we haven’t heard from the administration or Congress: Shouldn’t the rules of antitrust apply to finance?
We also know that part of the problem is the nature of the risks taken by these huge institutions: complex derivatives being traded outside regulated markets, and so not subject to the normal capital and governance rules applied to those issuing them or to the normal disclosure and transparency requirements applied to all transactions in regulated markets. So, requiring that all derivative-like instruments henceforth be traded on regulated public markets seems like a no-brainer. Perhaps sensory overload can help explain why the leading reform proposal preserves the right of those undertaking “large private transactions†in these derivatives to operate outside the regulated markets. If this sloppy decision stands, another element for the next market meltdown will be in place.
We also know that part of the problem lies in compensation arrangements that reward executives, managers, deal makers and traders for the highly-leveraged risks that pan out, but exact no costs for those that don’t. The issue here is not how big the bonuses are — that’s their business — but rather a structure that actually drives decisions to take unreasonable risks because they carry no personal price. Yet, for all of this issue’s urgency, addressing it among the hundreds of others demanding attention has apparently been too complex and politically-sensitive. Why can’t we have a serious discussion of creating a new SEC rule that would require a shareholders’ vote approving any compensation over, say, $1 million? Better still, how about a genuine debate about compensation arrangements that would claw back previous bonuses to reflect large losses by the same people?
Maybe everybody needs a break to clear their heads — and remember their principles. Let’s hope it happens before the new regulatory reforms for climate change and finance become law.