Tuesday, April 20, 2010

Regulation, Listening to Aristotle

We live in an age of regulation. But surprisingly, there are very few principles of regulation. As Karl Polyanyi said, “Laissez-faire was planned; planning was not.” Planning always seems to be something that arises ad hoc, to address a particular situation, but hangs on and acquires a life (and a bureaucracy) of its own, even after the situation changes. The result is that we are simultaneously over-regulated and under-regulated; we have thousands of pages of regulations that deal with situations that don’t require any, and no regulation in areas that need to be closely watched. The regs raise formidable barriers to competition, as the small businessman often finds that the cost and trouble of dealing with them is an insurmountable barrier to entering a given business. This leaves only the large players, for whom such regulation is a mere nuisance, a cost of doing business that brings a benefit of reduced competition. And since there are fewer competitors, they tend to be more politically powerful, and proceed to capture the very regulatory bodies that are intended to curb them. The government becomes, in effect, the protector of the oligarchs rather than their regulator.
Now, on to Aristotle:

Aristotle, and the Scholastics who adopted his approach to economics, were surprisingly sophisticated on these topics, while so many Prominent Economists are surprisingly naive. Indeed, Aristotle left us a principle of commerce that serves very well as a principle of regulation. This principle is the distinction he makes between natural and unnatural exchange. Modern commentators, who make no distinctions, have viewed this as a mere primitive hostility to business; actually, it was a shrewd appreciation of commerce. For Aristotle, natural exchange was that which was necessary for the provisioning of the family (the true meaning of economics.) Unnatural exchange that which had only money as it object.

The former is “natural” because it limits itself; that later unnatural because is has no natural limits. For example, a man wishing to buy bread for his family will buy only as much as he needs; this is a natural exchange. But a man wishing only to make money in the bread biz may wish to buy up all the bread and corner the market so as to raise prices and make a fortune on others’ necessities; this is an unnatural exchange. When applied to finance, a transaction is natural when it is when it is firmly and directly tied to the production of some actual product; it is unnatural the more abstract and derivative it becomes, and when its only object is to make money rather than profit from production. Thus, we may say that banks directly financing home purchases or construction are natural transactions, and less natural when they become “securitized,” bundled together and sold in packages to remote investors who will have no contact with the actual homes, banks, or borrowers. The situation becomes even more abstract when you speak of securitizing the securities (“CDO-Squared” or even “CDO-Cubed”) or with CDSs, which become pure speculative bets on the market. The more abstract the instrument, the more closely it should be scrutinized.

And yet, what we have is the exact opposite. Our regulatory system demands stay at home mothers must test their home-made baby bibs and hair bows for lead before sale, but leaves the massive and complex financial institutions that can imperil our economy and country to their own devices, allowing them to issue countless “Liar Loans” and NINJA loans (“No-income, no job or assets”), and limiting them only by their ability to "innovate" new abstract investments and speculative bets.

Somewhat related, somewhat unrelated - Simon Johnson of Baseline Scenario states in a separate post that "there are simply no social benefits to having banks with over $100 billion in total assets. Think clearly about this – and if you dispute this point, read 13 Bankers; it was written for you." I have not read the book, maybe because I am inclined to agree, but still thought it a challenging statement.

9 comments:

John said...

The excerpts quoted from John Medaille offer nothing new to the discussion of regulation. He forces an inapt juxtaposition and somehow ends up with a conclusion that, although I agree is a concern, is a little too conspiratorial in its underpinnings.

I have long supported regulation to bring information to the market, provided that the regulations did not impose excessive costs. Some here, including our host, seem to disfavor corporations a bit more and desire more stringent regulations of them. But, is additional regulation really necessary to regulate Goldman Sachs? The government apparently believes that it can use the existing laws to pursue Goldman's activities.

By the way, I've reviewed the case against Goldman Sachs, and as a personal matter, I question whether Goldman did anything wrong. Just as I object to the "too big to fail" policy, I oppose attempts to use the judicial system as insurance against loss.

Justus Hommes said...

I don't see conspiracy at work as much as human nature. Those with the power to influence regulation would be almost foolish not to ensure they benefited in some way, but that doesn't make it right.

I have read in detail about the case against Goldman as well, and would encourage you to read the two most recent posts at interfluidity.com (this
and this). Even if the action by Goldman was not illegal, it was certainly unethical.

I don't see this as an attempt to use the judicial system as insurance against loss. After all, this case deals with an almost insignificant financial amount as far as Goldman is concerned. I see it as an attempt to use the judicial system to deter and reform behavior.

John said...

I fail to see what was unethical in the conduct of Goldman Sachs. These are sophisticated buyers knew what they were getting into and the risks; they simply discounted them. My link is shorter. :)

http://online.wsj.com/article/SB10001424052702303491304575188352960427106.html

Justus Hommes said...

I've read your link, and still prefer mine. However, I am SHOCKED that the Wall Street Journal would defend Wall Street. Who would have thought? ;-)

Look, I don't really care about the Goldman Sachs case. It really is a water pistol instead of a smoking gun, BUT, I agree with Aristotle's distinction between natural and unnatural exchange, and with Medaille's assertion that the latter deserves more regulatory scrutiny.

Refusing to see the differences, and failing to handle accordingly would be very dangerous, much like failing to see the difference between an economy built on production/farming/manufacturing and an economy built on debt/financial services/outsourcing.

John said...

Glad you could read it because I just now discovered that it's in the password-only part of the site. Oops.

As long as you're not accusing Goldman of crookedly introducing unnatural things into the economy, I'm OK with your position regarding Aristotle, though I don't presonally internalize that lens.

I disagree with your suggestion that an economy should be founded on production/farming/manufacturing and not debt/financial services/outsourcing. In essence, your example pits manufacturered products against offered services and suggests that only the former offers value. We heard similar arguments in the early 1900s with populist leaders who harangued on the gold standard and the implicit argument that only certain types of labor contributed to the economy. An economy can be founded on anything; the sole question is what it can provide in return for compensation. A national economy based solely on its citizens' making widgets will survive if it can sell those widgets in a manner that allows its people to live at a desirable level; similarly, an economy founded on enabling the owners of that factory to obtain the financial resources to start and operate that factory can also flourish. Quite simply, there is nothing unnatural in offering your services for compensation.

Justus Hommes said...

I am not necessarily advocating for for a more agrarian or industrial economy. I rather like being part of a diverse and advanced economy. I am only saying that they are distinctly different types of economies with their own advantages/disadvantages. Obvious, I know, but it is frustrating that so many approach their views with respect to "the economy" as something that should operate as a whole under a universal and constant set of principles and laws.

Anonymous? said...

John, maybe you didn't intend to make a point of this, but I would say that debt is a very bad thing to be the foundation of the economy. Debt is a poor choice to be the foundation of anything. It will eventually lead to problems because if we have learned anything from ourselves it is that we use debt to trick us into thinking we can afford things we can't. Profits based on that create a false market that will fall.

John said...

Not to put words in our host's mouth, but I understood us to be referencing service sectors, particularly the financial sector, in the context of "debt/financial services/outsourcing," and then juxtaposing that against more traditional industrial/agricultural industry. So, yes, I did not intend a contrary interpretation.

As a practical matter, I think we'd all agree that living beyond our means is bad. Still, I believe that debt for a limited duration is a useful tool, such as in buying a house, taking out student loans, or expanding a business, provided that the borrower can reasonably expect to pay back the debt.

Anonymous? said...

Understood, and I think we agree.

I do have a bit of a concern that many companies primary source of revenue is debt and not the products they sell (see Sears), but I don't think that is what you were arguing.