Regulating the regulators

Imagine a school with a strict teacher in every class. In one such class, are a bunch of kids playing with fire. While the teacher watches, the kids set fire to the window curtains. The fire spreads, and engulfs the school and burns down most of the infrastructure. It then spreads to the neighbourhood and affects the nearby buildings. While trying to bring the fire under control, and examining the cause of the fire, the school principle suggests that one way to prevent another such occurrence would be to appoint the errant teacher as the fire warden for the neighbourhood.

Sounds like a fantasy out of Alice in Wonderland? Welcome to the real world – this is how the financial system of the world operates cica 2009. Gordon Brown, in preparation of the G20 summit on the financial crisis, exported to the world by the USA and UK, writes

“I have learned from this financial crisis that the disciplines we expect of markets cannot be guaranteed without strengthened supervision. “

Uh? Let’s see which part of the financial system that caused the breakdown was unsupervised. The most maligned are the hedge funds. Did these loathed vehicles need a bail-out – not really – for the most part, they just quietly wound down and exited. However, we have had multi-billion (totaling trillions of dollars) of bailout for supervised entities - banks, insurance companies, and investment banks. So don’t you see, the solution to the problem must be more supervision!

Having efficiently “supervised” an excellent problem situation, the regulators in the US have now suggested a Geithner plan to fix it. The plan involves a “put” to investors of banks and distressed asset funds, while transferring the entire risk to the tax payers. As Paul Krugman writes,

"Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard."

Mark Twain could have been speaking about regulators when he wrote

"All you need in this life is ignorance and confidence then success is sure"

especially if success is measured by negating the principles of free markets, and forcible propping up defunct organizations.