Financial Regulation: Three Reforms Conservatives Should Support

How many of you have heard the term “repeal and replace”? This very vague term has become a favourite for conservatives ever since Barack Obama was elected. Whenever Obama implements any piece of legislation or a financial regulation, Republicans are quick to promise to “repeal and replace” said legislation or regulation. A big problem for Republicans has been to answer the question: Replace – with what? Usually this question is answered with vague clichés, like “We’ll work with the private sector to…”, “We will design free market solutions…”, “More government is not the solution…” etc.

This appeals to the Republican base and to low-information voters who can be convinced by anything, if it’s repeated enough. But no-one else. Many voters think that when Republicans say “repeal and replace”, we really mean “let’s go back to status quo”. No-one doubts that we want to repeal, many doubt that we will also replace.

Financial regulation is one of these areas where voters doubt Republicans will do anything more than repeal the Dodd-Frank act if elected. And sadly, most Republicans don’t know exactly what type of financial reform they want – they know the system under GWB wasn’t working perfectly, and they know that Obama made things worse, but what exactly should be done instead is a trickier question.

So, what should you tell your undecided friends when they ask you what type of financial reform conservatives would support? Here I list three reforms that require a minimum amount of government intervention, yet would go a long way in preventing another financial crisis from happening again:

1) Raise the reserve requirement. I have a confession to make: I’m not a Ron Paul fan, I’m not a fan of the gold standard. While great in theory, the gold standard doesn’t provide the kind of protection against currency manipulation that its supporters seem to think. However, the reserve requirement should be raised – meaning banks should have to keep a higher % as reserves for each dollar they lend out. Currently, the reserve requirement is 10 % – which, in the most simple terms, means that a bank can lend out ten times the money it actually has in its bank vaults. Many conservatives support 100 % reserve banking, which I consider to be unrealistic (no matter the benefits it may have in theory). However, a reserve requirement of 15-20 % should not be unreachable – of course, the increase would have to be incremental so as not to cause too much of a disturbance of the credit market. This will slow down the inevitable rise of inflation that will come as a result of too much stimulus and bailout cash, and also make the banking system more stable and less sensitive to panics and bank runs.

On a related note, banks should be forced to reveal their reserves in advertisements. If a bank is offering 4 % interest on your savings, but only keeps 1/10th of your money in their bank vaults at any given time, is this not information you as a consumer should have the right to know? While its hard to tell what effect this would have on consumers, it certainly isn’t unreasonable to think that some consumers might take a bank’s reserves into account (whether they have excess reserves or just the minimum) when choosing where to open a savings account.

2) Audit the Federal Reserve. This one is obvious and shouldn’t have to be explained: The Federal Reserve is the only authority that is not being audited, by anyone. It’s one of the most secret government institutions (that is technically private, I know), and despite being the catalyst of the financial crisis, the Dodd-Frank act didn’t affect the Fed one bit (it did, however, affect hundreds of small banks which had nothing to do with the crisis). The Federal Reserve is too powerful to be left on its own; we have a right to find out what they do, how they do it and why.

Critics of a transparent Federal Reserve will claim among other things that the mission of the Federal Reserve requires its operations to remain a secret. This however is just a smoke screen: At its core, what these critics fear is that once people understand what the Federal Reserve is doing, they might get angry about it. Who knows, the practices and malpractices of the Federal Reserve might even become an election issue – we wouldn’t want that, would we? Certainly not if “we” are central bankers, who feel that any attempt to audit the Fed is an attack on their personal privacy that is protected by the Bill of Rights (actually, that’s not nearly as farfetched as abortions being protected by the Bill of Rights). They fear that if voters can see what the Fed is up to, it will be kind of like stepping into a sausage factory: It will turn anyone into a vegetarian/Paulbot.

I personally don’t think the effect will be that great – most people are just too busy with their regular lives to care about what the central bank is up to. This, for me, is a matter of principle: Government should be transparent, and that should include the people who indirectly govern over the value of our money.

3) Introduce a license for practicing finance. Think about it: You need a license to practice medicine, to practice law, to be a broker – hey, even opticians need a license. No-one – conservative or otherwise – has any problem with that. However, if you’re a trader at a big investment bank or prop shop with no real education in any area even remotely related to finance; you’re good to go. No need to take any pesky exam or anything to prove that you know what you’re doing; just go out there and speculate the economy down the toilet.

You see, since (roughly) the 1990’s, there has been a disturbing trend in the financial sector. Instead of hiring people with economics, finance, accounting and business degrees (you know – degrees were you learn a thing or two about finance), Investment banks and other financial institutions have largely resorted to hiring those with degrees in completely unrelated fields like engineering, computer science, theoretical physics and so on.

The thinking goes something like this: Finance, especially trading, is mostly math these days. There are returns, expected returns, standard deviations, betas, alphas – just a bunch of math, really. Therefore, hiring people who are really really good at math makes sense. And sure an engineer will beat an economist in a mathlete competition any day of the week. Now of course, an engineer will not know a first thing about the economy and how the stock market really works (the real world behind the numbers, so to speak), but they can learn that along the way, can’t they? If we just hire them, sure they’ll pick that stuff up.

The problem? No-one picks anything up. If you’re an engineer making $200, 000/year trading stocks, it probably never strikes you that you should be spending your free time studying micro- and macroeconomics. You’ll probably never pick up the Wealth of Nations, or any other book that might help you understand the economy. As long as the money keeps flowing, you won’t really worry about learning anything new at all.

There are engineers working in finance who can’t tell you what the law of supply and demand means. There are engineers working in finance who can’t tell you when the Great Depression occurred. There are engineers working in finance who can’t tell you what causes a stock market crash – there are many possible answers of course, but many of them will have never even thought about it. If you ask the average engineer working in finance what Behavioral economics is, he’ll probably guess it’s some type of exotic food.

Here’s the problem: Engineers view the economy as an equation that should be solved. Everything is math for them – and in social science, this is a big problem; because, well, people don’t always obey the equations. As soon as something happens that isn’t supposed to happen according to the rigorous differential equations engineers use, they are absolutely helpless and end up running around the trading floor like headless chickens.

Economists in finance use equations too, for sure – but we know at the back of our heads that these equations are not precise, that they have failed before, that humans can be irrational and that stock market crashes occur regularly (about every 10th year). Basically, we have a humble approach to our work, we know the limitations of our models, and so we stay calm even when the world around us is collapsing. We know bad stuff happens every once in a while, we (more or less) know why, and we know that the economy will rebound in the end – it always does. We’ve studied growth theory so we know that the economy in the long run converges to its steady state – how many engineers have even heard of the term “steady state”?

Very few people know this, but engineers are the reason subprime mortgages came into existance. The idea seems stupid, right? Packing your portfolio full of high-risk loans, and then expecting the portfolio not to have any higher risk than a portfolio without said high-risk loans. Hey, even the NAME kind of gives it away: Subprime mortgage. Subprime. Not prime. Would anyone ever buy subprime cheese? Subprime cheetos? Subprime pizza? Well, I guess some people do buy subprime pizzas or else Domino’s would not stay in business, but Domino’s at least has the good sense not to call their pizza subprime. They know that customers wouldn’t be stupid enough to buy anything with a name that included the word “subprime”. The only people stupid enough to do that are engineers at investment banks. Basically how things went down was that some engineer came up with a differential equation showing that giving loans to people with no chance of paying them back was a great business idea. Sure, this went against all common sense – but no-one dared to argue with these supposedly supersmart guys and their fancy equations.

Speaking of subprime loans, to be fair, the real issue with the engineers who promoted them was that they missed the macro perspective: The idea was that one bank could issue bad, high-risk loans, bundle them up with good loans, get a triple-A stamp from a rating agency and sell the whole package to another financial institution. When the high-risk loan goes into default, that’s none of your problem as the loan isn’t part of your portfolio anymore. And, if only one institution does this, it just might work – but what if every bank starts doing this (and they all did)? What if the amount of toxic loans becomes so large that it threatens the stability of the economic system? What if you issue a bunch of toxic loans, and suddenly find you can’t sell them as the people who used to buy them have realized that you’ve been scamming them? Yes, all this happened. On a micro scale, subprime mortgages made a little bit of sense – on a macro scale, they were a disaster. An economist could have foreseen this, and many did. We know that just because every actor does what is rational from his point of view, this doesn’t necessarily result in an outcome that is good for any actor. But you need a basic understanding of game theory to understand that – and most engineers don’t have that.

Before anyone points it out: Of course subprime loans would not have been possible without the “help” of the Federal Reserve and several other central banks in other countries. Without these institutions, the very money that was lent out in the form of subprime loans would not have been available. However, this fact does not relieve the banks and their incompetent non-economist staff from responsibility.

Another issue with engineers is that they have nothing to lose. Take our $200,000 – a year engineer in the example above. Suppose he loses his job. Tough luck – but since he’s an engineer, he can now go work for any of the tens of thousands of companies who employ engineers. He can design a bridge, or a road, or a building – you know, the stuff engineers are supposed to be doing. Hence, worst case scenario, he’ll have to go back to being an engineer, which is what he was in the first place. Hence he won’t be as motivated to do well at his job, as he doesn’t care as much if he loses it. For a trader, this means taking more risks, gambling more, playing around with exotic financial instruments – worst case scenario, he’ll lose the money (someone else’s money) and he’ll have to go back to a comfy job designing bridges.

Now compare this to someone who majored in finance: If he loses his job as a trader, the future is a lot more uncertain. Sure he might get another job – not as a trader (you only get one shot in this industry) – but maybe somewhere else. There’s always corporate finance, where he will be making a fraction of what he made as a trader. My point is, the downside of losing a job in finance is a lot bigger when your degree is IN finance.

Note that I’m not in any way against engineers as such: They’re great, as long as they do what they are educated to do – that is, engineering. No-one would ever hire a lawyer to do the work a doctor should do, or a doctor to do the work of a lawyer. So why would anyone hire an engineer to do work that clearly should be reserved for real economists like yours truly? This is even worse when you consider that the US has a shortage of engineers, a shortage that becomes bigger as more engineers find jobs outside of actual engineering.

I’m not saying an engineer should never be allowed to work in finance; I’m saying they and everyone else should have to take an exam, proving that they are knowledgeable enough to work in the field. Kind of like the bar exam. Such an exam would include questions on everything from stock valuation to macro/microeconomics and behavioral finance. Things you need to know to succeed in finance in the long run. Want proof of this? Look at the hedge funds which failed turned the financial crises, and look at the ones that survived. Basically all hedge funds that relied on “technical analysis” (ie, engineers) failed, while the ones that relied on fundamental analysis (ie, economists) survived.

These are just three of the reforms that conservatives ought to support – I would have loved to write about a few others, but my experience is that once a post goes above 2000 words, the number of people who bother to read it declines rapidly – and this one’s already at 2400.

So, I’ll stop here and write more another time. Thank you for reading.

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