Feedback mechanisms

The optimist says the glass is half full.  The pessimist says the glass is half empty.


The engineer says the glass is twice as big as it needs to be.


The issues of failed regulation, and failed political systems more generally is not one of left or right philosophy in particular, but rather mis-aligned feedback mechanisms.


When my house gets cold, my (properly engineered) thermostat simply turns on the furnace.


But when Congress designs the process, and the house gets cold, the Congressional thermostat turns on the lights, opens the curtains, plays loud music and starts mixing drinks, on the theory that neighbors, believing there is a party, come over, and their body heat warms the house.


Doubt that?  It is in fact not a joke.  Consider how Congress tries to monitor financial markets....




It’s almost a toss-away line: “Politicians want to overrule the boards and shareholders who normally determine CEO salary and bonuses.”


But if boards and shareholders had in fact determined CEO salaries, if they had set up rational feedback mechanisms and enforced sound risk management, then CEOs would not have gone so far off the rails.


The real issue in capital markets is the Rube Goldberg apparatus that passes for regulation. Whatever else history records, the current financial contretemps did not result from lack of regulation. Rather, it arose from human weakness on both sides–government AND industry. The amorality of industry is widely discussed. What is too often ignored is the human weakness in government.


Consider the specifics:

·         Congress delegates to SEC, which delegates to PCAOB/FASB to set rules for accountants, who then compel GAAP and SarbOx reporting to shareholders, in the vain hope that they will in turn force directors to rein in managements. (.)

o    Perverse outcome 1 – Auditors deny blame for fraud, and get rewarded with more work under SarbOx.

o    Perverse outcome 2 – Rating agencies in epic fail, and get rewarded with more work under TARP.


·         Coming along after the fact, shareholder suits are too blunt a corrective. They create uncertainty, and raise D&O premiums, but have no effect on management and emphatically do not discipline boards.

·         Meanwhile SEC also allows SROs and exchanges to set their own  rules.  As does CFTC.

·         Then Labor, by way of ERISA, tries to define prudent investing, which means delegating authority (but not responsibility!) to rating agencies, who are paid to say “yes.”

·         Beyond this general corporate regulation, there is special banking oversight, including the Fed, OCC, FDIC, and OTS. On top of that come the state banking regulators.

All of that ignores the fact that the sole proper role of the Fed is to make sure the Treasury does NOT cheapen the dollar and thereby rob investors by inflationary default.  (cf. Bagehot vs. Hankey.)


With so many moving parts involved, no specific party can ever be called to account. No one gets blamed for failure.  Being mortal, bureaucrats love power just as much as private enterprise loves money.


Even worse, it is far more profitable to game the rules than to enforce them. So the best minds are squandered on games. Witness the over-reaction of SarbOx, the waste of money on useless reporting, and the ease with which companies avoided real change.


Such a scheme is far worse than nothing at all, for it deludes us into thinking that Someone, Somewhere, is Responsible.


Free markets are great, but that’s not quite what we have now.


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