The Theory of the Idiot Class

Today, the White House unveiled its plans for changing the way banks and financial markets in the U.S. operate. While the proposed changes, outlined in an 89-page document, were very wide-ranging, they seemed to be based on one underlying idea:

The current financial crisis came about due to a lack of proper regulatory oversight.

While I agree that our regulatory approach could use some fine-tuning, I disagree with the simplicity of the administration's premise. Other factors, beyond regulatory oversight, were at play here. More on that soon.

To be sure, there are several elements of the plan with which I agree. Hedge funds should be required to register with the SEC, just as other investment vehicles do. Trading of all derivatives should take place on exchanges, and not on an over-the-counter basis. Our organized financial exchanges work quite well; as a group, they have the capacity to make markets in even the most exotic of securities.

Adjusting compensation practices to align the interests of corporate executives with
their shareholders? I'm all for it. Let's all just understand that this concept is synonymous with "stock option-based compensation." I recall how stock-based compensation was all the rage in the 1990s, until the stock market surged in the latter half of that decade, and we heard reports of corporate executives making tens of millions of dollars annually, when they exercised those options. The liberals howled, claiming that executives were simply manipulating their company's share prices. (I don't really need to even bother explaining how preposterous that claim actually is). In fact, some tweed-wearing, tenured buffoons went so far as to suggest that Chief Financial Officers not receive any stock options, and should only be paid in cash, to remove the temptation to "cook the books," in order to drive their company's stock price higher. Of course, once you pay executives only cash-based compensation, and their company's stock prices stagnate, or decline, those same people will decry the travesty of paying so much money to executives while their shareholders suffer, bringing us full circle to the "new" idea of paying a major proportion of executive pay in the form of stock. See how this works?

In any event, Wall Street and the banking system had to know that increased regulatory scrutiny was unavoidable, so I can't imagine that they're too upset about this plan, which is vague enough to not have much bite, and will be changed hundreds of times before it's actually passed by Congress.

As I mentioned above, my issue with the plan revolves around the idea that lack of proper regulation was the cause of our current problems, and that increased regulation will prove to be an adequate cure.

For one thing, that idea is very self-serving, which is what I've come to expect from this administration. They might as well have entitled this plan the "Government Employee Full-Employment Act of 2009." In its current form, the plan advocates for the creation of more regulatory agencies, as well as the expansion of existing ones. In just the first 150 days of the Obama administration, we have witnessed on several occasions that these guys believe that bigger, more intrusive government is the answer to everything from financial market volatility to the auto industry's woes. It's a troubling trend, to say the least.

My biggest issue with the plan is that it doesn't address, or even directly acknowledge, another major cause of the current economic crisis: People. Stupid ones, to be exact.

While you can argue that the housing market bubble was caused by aggressive lenders, and the off-loading of risk via the often-dubious securitization of mortgages, to at least some extent, foolish borrowing was to blame. Simply put, in many cases, people took loans that they could never realistically hope to repay. In other instances, people accepted sage advice from well-meaning relatives and friends, like "Don't worry, you'll just refinance. Housing prices never go down." We haven't heard much from these amateur Milton Friedmans since most of the country's major housing markets entered "Neverland" in mid 2006, but they're still out there. In fact, they're breeding.

I'd like to hear a plan for dealing with these people, as well as the self-proclaimed investing experts whose investment rationale essentially amounts to "It can't possibly land on red four times in a row, can it?"

Yale Economics professor Robert J. Shiller, in his book "The Subprime Solution," recommends a sort of national education program, aimed at teaching the masses the basics of mortgage borrowing, with an emphasis on risk.

I will admit to being somewhat partial to Professor Shiller's views. At the moment, he is probably my favorite contemporary economist. (I know, that's like making a list entitled "Top 10 prostate exams.") He coined the phrase "irrational exuberance," which was borrowed a couple of years later by Alan Greenspan, to describe the overheated U.S. stock market of the late 1990s. He co-founded the Case Shiller Index of U.S. housing prices, which essentially predicted the housing market bubble, and remains the most widely-used indicator of housing price trends. He does a good job of blending academics with a pragmatic approach, in recommending policy changes. However, I'm not so sure about the practicality of his "educate the masses" idea. Perhaps some form of standard risk disclosure could be used, which a mortgage applicant would have to declare that he/she has received and read, before any loan could be approved. Needless to say, that's hardly a fail-safe method.

For now, we'll just regulate everything to the hilt, and hope that it works.


Unless, of course, there's enough stimulus money left to perform a few million brain transplants.