How about this one: If you can’t beat them, join them.

If you see a catastrophe coming when it’s too late to prevent it, should you work hard to mitigate it or should you pile on?

If you work hard to mitigate it, all sorts of influential people will attack you for saying there’s a problem. If it’s your job to mitigate it, they will try to get you fired. You will have a miserable time and then the catastrophe will happen anyway.

If you join in, you can make a big pile of money in the short run, and if you play your cards right you can walk away with a big pile of money when the catastrophe comes. That pile of money might be very useful during and after a catastrophe. Or you can think about what you’ll need and buy it sooner. Buy land on a tropical paradise? Generators, fuel supply, MREs? A talented woman to share it all with? All stuff you wouldn’t have if you spent your time trying to block the other team’s advance when they’d be happy for you to join them.

Actually, I kind of like that. There used to be two different approaches to law enforcement. One way, everybody pitches in. The other way, professionals do it all. The former is inefficient, cheap, and high-morale. The latter is inefficient, expensive, and low morale for everybody but elite police.

So, you do something criminal in a bar and everybody says a crime has been committed and let’s all get it sorted out. Maybe they argue it out among themselves and decide you aren’t so bad, or yes you are. Maybe they take you in to the authorities. Maybe they disagree enough it turns into a free-for-all. People care about crimes when it’s up to them.

You get some famous criminals that hardly anybody’s ready to go up against. Some brave people get a big reputation by taking them on. Famous criminals. Every man has the idea he might need to stand up for himself and do the right thing, or else cravenly tiptoe away.

With professional police you get less bias. Somebody picks a fight with you in his favorite bar where everybody likes him and you’re a stranger—when the police get there they’ll be more impartial than the guy’s friends. On the other hand, if you have an in with the police then you have an in wherever they show up, not just your favorite bar.

With professionals you get more competence. Everybody waits for the professionals to arrive, and then they’re very competent. They look down on everybody else except the rich, who scare them.

With professionals you get more impartiality. Everybody worries when the police arrive. But the times they aren’t impartial and are on the other guy’s side, you’re completely screwed.

Police can control things for the government. So why would any government give up having as many professional policemen as the tax base can afford? They enforce the laws the government wants and not the common law that the citizens understand and agree on. Without arbitrary laws stringently enforced, would lawyers be so important? Would the writen law be so important? Get individual ad hoc vigilantes deciding whether there’s a crime worth prosecuting, and all of a sudden the nation’s capital is a very distant place. Local law gets real imminent, though it’s usually fairly easy to discourage vigilante hangings.

Without professional police there would be many more known criminals walking around. Both because it takes somebody real tough to arrest them, and because nobody has a professional interest in catching somebody—anybody unimportant—to charge with the crime to close the case. Without professional police there would be many more chances for righteous tough guys to make a name for themselves as good tough guys. Without professional police the legal system would be devoted to dealing with criminals that some individual human beings wanted to get caught, and not so much with people who inconvenienced the central government.

I think it might be an improvement. But I see no possible way to convince any government of that.

I’m not sure what to make of your comment on my comment. Analogously, you could argue there’s no point in having police because, even though we have cops, we still have crime. Even unsolved crime. And corrupt cops. And even some unsolved crimes because of corrupt cops. So—cops: forget ‘em. What’s the point?

Now, there is a fair question in all this, and Brad Delong, among others, has asked it more than once: How could so many different things have gone wrong? Is there an underlying cause for most or all of these failures of vigilance?

I don’t know what that single cause would be. My best theory isn’t very good, and isn’t complete, but has the virtue of being pretty simple, at least, and rooted in causes everybody can intuitively understand.

(1) Memory, Babe: People trying to repeat something good when it’s actually unrepeatable. By the late 90s, things were a lot better than anyone had any right to expect. Trying to get back there (so soon, anyway) was an attempt to return to the unsustainable. In the process of getting back up there, very few questioned whether it was a realistic place to be, and most who did were treated as alarmist Chicken Littles.

(2) School of Hard Knocks, R.I.P.: People not believing in the possible repeat of something bad, because they haven’t seen it. Living memory of trying to feed a family after losing one’s job in the Great Depression was evaporating fast in the first half of this decade. Seeing is believing; not-seeing is not-quite-believing. If you were, say, 16 years old in 1930, contemplating early entry into the labor market, you’d have been 92 in 2006. I think Paul Samuelson is 93, now. It’s interesting to read what he has to say about all this. Brace yourself first, though.

(3) Busted Boomers: Baby boomers not benefiting by habits of thrift that one might ordinarily develop in periodic hard times, and later trying to catch up faster in retirement planning than all of them can catch up, at least in the same decade. For many boomers, the main extended experience of a bad economy—the stagflationary 1970s—saw inflation not only eroding existing savings but making it harder to save appreciably. There’s been a lot of get-rich-sooner-than-is-probable investment in the last decade and a half. Such malinvestment has a strong incentive: comfortable retirement for the boomers will require catching up fast to where they should have been by now, financially—and where they feel entitled to be, both because of the example of older generations now in retirement and because of late-1990s prosperity expectations.

Now, I’d argue that all three of these factors led to a pervasive psychological environment where almost everybody in a position to wake up, get alarmed, and throttle their part of the scary feedback loop relaxed a little too much. Those in the “Watchdog Class” felt they could safely assume any possible problem area was somebody else’s job, a job that was getting done. Or they felt it was a job that didn’t need doing anyway, because no really bad history was going to repeat, but good history might—actually, uh, it kind of had to repeat, or else forget the idea of annual Club Med jaunts in retirement, and a couple or five skiing weekends every winter, etc. Those things were coming because they had to be coming. Because we have them coming. (Um, don’t we?)

Well, that’s my sketch of it, anyway. Try your hand at yours. The blind philosophers all need to stand back and ask themselves, What does the elephant smell like? They’ll probably answer, “Why, it smells like . . . air freshener! Which means—we’re in a room! What the hell is an elephant doing in a room?!?” Then they’ll be halfway to the answer, because they’ll be asking about the environment, not so much about the beast and its curious behavior and features.

Yes. We can expect the govt to regulate every trillion dollar ponzi scheme.

Like this!

Or did I include the wrong keywords?

What’s wrong with caveat emptor? Tell people not to buy financial instruments they don’t understand.

Well, what's wrong with that is that when it's very profitable to invest in financial instruments you (probably) don't understand using other people's money, then people who trusted you with their money can lose it all.

They should have known better than to trust you. Caveat emptor.

Well, but people didn't know they were trusting you. They thought they were trusting their bank or pension fund. It's wrong for lots of innocent people to lose their money.

They shouldn’t have trusted their banks or pension funds. When you have the money yourself, you can invest it in local businesses that you can watch. Of course then you lose when your local economy tanks, but if you invest globally you’re gambling that way too. At least local investment helps improve your own community. When your employer says he’s putting money into a pension fund for you, but you don’t actually get the money until a lot later, you might as well write it off in these times. Or if you think times like these might come back before you get the money.

Well, but it's so simple to just buy a CD. You pay the bank and the bank pays you back with interest. Your money is guaranteed unless the bank goes broke, and if the bank goes broke then things are pretty bad, right?

Right. Things are pretty bad. Trusting that the banks won’t fail worked for a long time. No longer.

And for as long as I can remember the smart financial advice was to buy no-load mutual funds. Small investors can't pick stocks, so invest in everything and the winners will outweigh the losers. It worked adequately.

But it quit working.

We need to regulate so innocent people won't lose their money.

I’m going to put aside the hypocrisy. This crisis is the ending of a giant ponzi scheme. People are being polite and not calling it that, as if it happened by accident, but that’s what it is. Can we expect the government to regulate every ponzi scheme, when the whole point of them is to find something people will strike at without seeing the hook?

We already saw this stuff in miniature with Enron, run by Bush’s friend Ken Lay. They squeezed lots of money out of the public, and then when they couldn’t serve up an even bigger encore they faked the accounting. How do you catch it early when they lie? You’d have to actually check the facts on the ground, which in general no one has the legal right to do.

When poor people have a chaln letter going, and they’re mailing $100 bills to people they’ve never heard of on a list, the government announces it’s a scam and shuts it down. What would you think if the government announced that the chaln letter was perhaps overheating a little and they were going to revise policies to give it a soft landing?

What would you think if the government refused to act because if the chaln letter failed there would be a panic?

What’s wrong with caveat emptor? Tell people not to buy financial instruments they don’t understand.

Well, what's wrong with that is that when it's very profitable to invest in financial instruments you (probably) don't understand using other people's money, then people who trusted you with their money can lose it all.

They should have known better than to trust you. Caveat emptor.

Well, but people didn't know they were trusting you. They thought they were trusting their bank or pension fund. It's wrong for lots of innocent people to lose their money.

They shouldn’t have trusted their banks or pension funds. When you have the money yourself, you can invest it in local businesses that you can watch. Of course then you lose when your local economy tanks, but if you invest globally you’re gambling that way too. At least local investment helps improve your own community. When your employer says he’s putting money into a pension fund for you, but you don’t actually get the money until a lot later, you might as well write it off in these times. Or if you think times like these might come back before you get the money.

Well, but it's so simple to just buy a CD. You pay the bank and the bank pays you back with interest. Your money is guaranteed unless the bank goes broke, and if the bank goes broke then things are pretty bad, right?

Right. Things are pretty bad. Trusting that the banks won’t fail worked for a long time. No longer.

And for as long as I can remember the smart financial advice was to buy no-load mutual funds. Small investors can't pick stocks, so invest in everything and the winners will outweigh the losers. It worked adequately.

But it quit working.

We need to regulate so innocent people won't lose their money.

I’m going to put aside the hypocrisy. This crisis is the ending of a giant ponzi scheme. People are being polite and not calling it that, as if it happened by accident, but that’s what it is. Can we expect the government to regulate every ponzi scheme, when the whole point of them is to find something people will strike at without seeing the hook?

We already saw this stuff in miniature with Enron, run by Bush’s friend Ken Lay. They squeezed lots of money out of the public, and then when they couldn’t serve up an even bigger encore they faked the accounting. How do you catch it early when they lie? You’d have to actually check the facts on the ground, which in general no one has the legal right to do.

When poor people have a chain letter going, and they’re mailing $100 bills to people they’ve never heard of on a list, the government announces it’s a scam and shuts it down. What would you think if the government announced that the chain letter was perhaps overheating a little and they were going to revise policies to give it a soft landing?

What would you think if the government refused to act because if the chain letter failed there would be a panic?

A general sense of the word “regulate” might include self-regulation. Self-regulation could take the form of markets behaving more rationally (without central direction) when there’s more transparency. Or it could be a case of industry choosing to self-regulate (supply its own central direction) in the interests of the industry’s general reputation. What I mean by the above is “government regulation”. However, where the government mandates transparency, or always threatens to step in if industry self-regulation doesn’t work, I suppose even those scenarios should count as “government regulation”, however indirect.

Hyman Minsky (apparently very prescient about what we’re now going through) pointed out a generation ago that globalization and securitization were both very much enabled by computerization. Another way of saying that: financial information management costs were trending towards negligible, making possible whole new classes of transactions that might heve been forbiddingly expensive before. The marginal cost of handling more information crashed, courtesy of Moore’s Law. It can make for astonishing volatility in a crisis. However, the same technology also potentially enables much more regulatory oversight than could have been practical before, because government can participate in those same cost savings. Maybe it’s about time. Have reporting requirements caught up with Wall Street technology?

My limited understanding suggests that the financial products themselves were not the direct problem. Rather, the fundamental source of the problem was a lack of information about them, which made risk assessment difficult. Registration might make things more transparent, but does not necessarily imply any explicit restriction (which is what I think “regulation” means).

The arguments for regulation above seem to be, mainly, arguments for registration. And the arguments against regulation do not seem to be against registration.

I’d take a middle position: monitor the market for the appearance of new instruments, perhaps requiring at most some sort of registration process, at most, but keep a close watch thereafter, designing and amending regulation as you go.

Would this mean more regulators? Would it mean you’re constantly chasing innovation to see if it’s good or bad on balance? I suppose so. The question isn’t one of good or evil, but whether the achievable benefits are worth the costs, including the social costs. Settling that sort of question might be virtually impossible before the fact. A certain amount of damage might be inevitable, but as long as you catch up to it not long after, you’re not flirting with disaster.

I think Greenspan’s position was simply, “more regulators, bad.” At one point, it was proposed that the Fed play a greatly expanded role in overseeing mortgage lending. Greenspan’s objection was that it would mean vastly expanding the number of bank examiners. (I think his objection before that one was along the lines of “That’s not what we’re here for,” but it turned out there really was no legal reason why the Fed couldn’t have been doing that job.) I can’t really understand his objection, unless it was of some virtually religious adherence to small government and reducted regulation.

The current proposal has the burden of proof reversed. Some bright spark comes up with an innovation that gets around existing regulations and regulators can either acquiesce or scramble to design new regulations.

The answer to this question depends upon whether you want to have market makers. I don’t mean that in a sarcastic way; I could be convinced that we can live without them.

It’s possible that the Treasury market is different, and my views are overly concerned with the fact that I made markets in stock options. As the newbie, I got stuck with all sorts of crappy illiquid stocks. When something went REGSHO, trying to make the markets was a disaster. Your ability to price was entirely dependent upon whether you were long or short the underlying. If you wanted to be able to hedge the delta, you couldn’t let yourself buy calls or sell puts. I put all sorts of crazy fake dividends into the system to keep it from happening.

As for the specialists, sure they can manipulate the market. They don’t need naked short selling to do that. Specialists fuck you. That’s their job description.

And how did we get to a point where any amount of leverage (up to 33-to-1) was possible? That’s a clear failure to regulate. Hard to pin blame for that kind of thing, sometimes. Especially when the specific problematic loosening (or failure to tighten) was in some huge package of legislation like the 11,000-page Commodity Futures Modernization Act of 2000.

But with innovation, precisely because inventors tend to be proud of their inventions, you can almost always pinpoint the actual innovators. There’s nothing nebulously “systemic” about origins. So, y’know, let’s pick on those people. For example, that woman credited with inventing the CDS, who was reportedly so obsessive-compulsive about her beloved “financial weapons of mass destruction” that she kept monitoring them through her cellphone even as she was going into labor in the hospital. Except, oops, they got that story wrong.

It turns out, there was an explicit decision to not regulate the CDS market (thank you Phil Gramm, et al.), in the above-mentioned bill, one that Alan Greenspan endorsed warmly. Later on, he seemed to blame CDS’s. But when I look at how CDS’s actually work, it seems to me that a transparent, well-regulated market for them, starting from not long after their invention, could have saved us all a lot of trouble. Such a market could have provided a pretty objective indicator that a huge housing bubble was forming. Instead of Alan Greenspan poo-pooing the housing bubble threat earlier, then later shifting the blame onto the CDS market, we might have had Greenspan warning of a housing bubble, as reflected in the CDS market. Or we might have had someone persuasively testifying that Greenspan was full of it when he continued to ignore the signs, pointing to the CDS market as evidence.

Isn’t it funny how stuff that’s frighteningly toxic and radioactive can be so useful and lifesaving when it’s installed in X-ray machines, properly contained and monitored? Oh, but no, let’s just say it’s poison, brewed up by witches who give birth to babies with “666” birthmarks on their scalps. While they thumbtype on their cellphones to continuously monitor the bubbling in their cauldrons.

Nice one. It is pretty sad that I didn’t catch it. I am new to the comments, so maybe now I will be more aware of your personal style.

It is a sad that for decades the mantra has been we can’t afford to bailout the consumer, but once a crisis hits the banks, we write $7T worth of checks in a few months. That this hasn’t solved the problem isn’t being talked about in a serious manner by our press. That this huge amount is a direct transfer of wealth from taxpayers to financial institution shareholders is glossed over. We still have people decrying ‘class warfare’ on raising taxes very little on the richest among us. It is a tragedy that these people are being taken seriously.

We have had rich people for millenia. They have always had good food, drinks, and were able to travel, had servants and the like. Our progress happened when we decided to begin to enrich the lower classes. Cell phones are impossible without many people using it, and same with the internet.

Michael Turner,

There are no problems with the CDS and CDO as theoretical instruments for trading and investing respectively. There is problems with these structures when plugged into a financial marketplace where almost any amount of leverage is possible. Worldcom on its own was fradulent, but the problem being talked about here isn’t their criminiality, but rather the demostrated difficulty for markets to allocate resources with effectively.

It is important to avoid this systemic risk. Right now, questioning the validity of the products themselves is compeltely logical. Clearly there is a problem in something about these markets. Telling the people who warned everyone that these instruments are problematic when plugged into the system that the problem isn’t the CDS specifically doesn’t change the fact that there is a massive problem that now must be rectified.

Looking at the innovation surrounding the Internet, it’s surprising how little it owes to the financial sector.

I can’t see where I said it did.

The Internet itself and the Web are both public sector innovations that beat out private competition.

Can you point to where, in my post, there’s anything to suggest I believe otherwise?

And during the dotcom boom, the financial sector threw hundreds of billions at the likes of Pets.com while missing just about everything that makes up Web 2.0 (blogs and wikis being the most obvious examples).

You mean, they threw money at ideas that looked like they might actually make money, and ignored stuff that pretty obviously couldn’t? (Blogs and Wikis, both of which appeared years before anyone uttered the silliness that is “Web 2.0”, are somehow Web 2.0? At this rate, they’ll be calling the QWERTY keyboard Web 2.0.)

Also, if we’re talking about innovation, tell me what’s innovative about Pets.com? Selling stuff over the web? It had already been done. That wasn’t innovation. There was no technology risk. It was pure marketing risk. You might as well call a gold rush “innovation”. It was speculative mania as well. The Tulip Bulb bubble wasn’t based on innovation. It was based on a plant, and the belief in a Greater Fool willing to pay more for that plant.

And while the optical fibre that was rolled out by Worldcom and its competitors came in useful in the end, the process was the opposite of the kind of rational investment allocation financial markets are supposed to deliver, and much more reminiscent of the kind of thing that makes a Five-Year Plan then tries to deliver it in four.

Uh, as I understand it, Worldcom engaged in fraudulent accounting practices under the cover of ordering and installing much more IP switch capacity and lines than it needed, and the rest of the telecom industry, seeing how much Worldcom seemed to be spending on fixed capital, decided that Worldcom’s (implicit) estimate that the Internet was growing by a factor of 8 or so every year must be right. Because, after all, if it wasn’t right, Worldcom must be engaged in, well, massive fraud. Or it was completely out of its mind. And how likely was that? So those other telecom providers also overinvested to try to keep pace. They just didn’t know they were overinvesting, because Worldcom had already gobbled up so much of telecom, everybody else was small compared to Worldcom. Seems like we could have avoided a lot of confusion with better antitrust enforcement.

I think I’ve made it very clear that I believe transparency, regulation and accountability are very important in ensuring the benefits of innovation. Let me go WA-A-AY out on a limb, here: much of what we regard as social dividends from private investment in innovation can also be attributed to public investment in the form of taxes that pay for regulation to make sure that those innovations are acceptably safe, or at least to make sure that buyers are informed of the risks.

The biggest innovations to which the financial sector has contributed are its own, and look how that has turned out.

Sigh. Did you actually read what I wrote? Someone, please, can you tell me why a CDS or a CDO is bad in itself? Subprime lending, done right, can be both a boon to lower-income would-be homeowners and make decent money for the lenders. We know this because, prior to the housing bubble, subprime had been performing pretty well on both counts, where it was practiced. Tell me why all this wasn’t more a failure of regulation and oversight, as well as an expression of speculative mania? Tell me why it’s somehow innovation itself that’s the culprit?