A Sustainable and Well-Managed Financial System

As the financial markets continue their roller coaster ride, the issue of government’s role in our society returns to the

As the financial markets continue their roller coaster ride, the issue of government’s role in our society returns to the front pages. While Congress considers a massive buyout of poorly thought out investments, many are arguing that if we are going to provide these subsidies we need to impose rules to prevent future crises. It’s time to re-examine the way we regulate our economy and hopefully develop a more sophisticated approach to regulation and a more sustainable basis for our economy.

Regulation is a set of rules or directives intended to cause specific behaviors in target populations. The goal of regulation is to influence individual or organizational behavior.  To provide a graphic example, consider the case of automobiles converging on a corner traffic light.  The behavior of the drivers is hopefully influenced by the color of the traffic light.  The signal is relatively clear, although when the light turns amber the driver is faced with the need to make a rapid decision (slow down or speed up?).  What factors affect the drivers’ decisions to slow down, speed up, or stop?  Certainly, the following factors come into play:

1. Is the signal working?
2. Does the driver see and understand the signal?
3. Is the driver willing to adhere to the signal?
4. Is the car mechanically capable of stopping and/or accelerating?

Are the regulated parties, in this case the drivers, capable of changing behavior in the desired direction, and are they willing to do so?  The goal of regulation is to influence the factors that enter into a regulated party’s calculus of the costs and benefits of compliance.

The goal of traffic regulation is to reinforce the incentives to comply so that they outweigh the potential motivation to pass the red light.  The goal of financial regulation is to influence the perceptions and behaviors of regulated parties – both firms and investors.  Therefore, each regulatory program must be based on a strategy that seeks to understand the motivations of regulated parties and to influence their behavior. With financial markets you are not only regulating the behavior of people and organizations, but you are also regulating economic transactions between people and organizations. The transactions are complicated; people are unpredictable and it is hard to figure out the best rules and the best ways to enforce them. While markets may be complicated, one thing is simple – without rules markets cannot work. Like a busy corner without a working traffic light, a crash is inevitable.

The choice between command and control regulation and the free market is a false one.  All regulation involves gradual, strategic calculation and bargaining. These are not edicts handed down from “on high.”  Command and control results in regulations that adjust the law to reality, all rules and regulations must be interpreted in the light of real-world constraints.  In other words, most rules and regulations are not the unthinking work of nameless, faceless government bureaucrats. They are the carefully crafted rules of the game that are needed to ensure predictable, honest commerce.  Obviously, the market can never be totally free or there would be chaos. All markets, and in fact, all human interaction requires rules, order and law. A system with few rules and the most freedom feasible is an attractive one, but the key word here is feasible, not freedom.

Our economic meltdown is the result of the ideology of free markets run amok. It is the logical conclusion of a generation of attacks on the role of government in our society and our economy.  It is also a result of a culture of greed and conflict of interest so profound that Halliburton, the company that current US Vice President Dick Cheney once ran, was able to grab billions of dollars of no-bid contracts in Iraq.  

According to this absurd ideology, corporations must be free to do whatever they want, or we will end up living in some grim communist gulag. Somehow, we still seem to be fighting an imaginary battle between socialism and capitalism. It’s time to share a little secret: the war is over and the winner is – both. We need capitalism to generate wealth and we need socialism to protect the losers in the capitalist competition from the winners. We have developed and need a mixed economy. It’s really time for our rhetoric to catch up with economic reality. No one is willing to abandon Social Security and Medicare – and these are not free market concepts.

In addition to government intervention in the economy, we need the rule of law, and a system of economic regulation to keep the capitalists from destroying each other and from destroying the market system itself. It’s well known that the capital market system can only work when people have confidence that the money they invest will not be stolen from them. People and institutions must feel confident in letting go of their cash, or they will simply hide it under their bed. The Great Depression resulted in a loss of confidence that was only restored by an innovative system of bank and market regulation.  Our recovery also benefited from that massive public works project known as World War II.

The work in Washington this week is about revitalizing the rule of economic law that we have eroded over the past three decades. Simply paying off Wall Street will not cut it. We need to take this opportunity to develop a system that encourages sound financial relations. This is an opportunity to re-imagine the definition of a solid, conservative investment. As we think about what type of enterprises are likely to provide a long-term return on an investor’s cash, it is worth considering the concept of sustainability. As economists sometimes say, “other things held equal,” an enterprise that uses water, energy and other resources efficiently will produce more profit than an organization that wastes those resources.

In all of these discussions in Washington, the emphasis is on building confidence in the economic system. The best way to do this is to have a system that is worthy of our confidence:

  • A nation that invests in the future, educates its people and rebuilds its infrastructure.
  • One that balances its books, eliminates its trade deficit and learns to live within its means.
  • A nation that protects its natural resources and uses them wisely.
  • A country that only goes to war when their truly is no alternative.

As a great baseball visionary once said: “If you build it, they will come……” Or, at least invest in it….

A Sustainable and Well-Managed Financial System