Nobel Prize Winning Economist Joseph Stiglitz Tells Us Who Caused This Mess

[Independent]

To take your analogy a little further:

That's why to do work on your commercial building downtown you have to be a licensed electrician & your work subject to inspection by the government building inspector to make sure it's up to code - while just anybody is allowed to wire their own barn out in the country without oversight.

Exactly. It doesn't make sense to regulate everything that moves. But it does make sense for those things that can do a lot of damage to bystanders.

So - who was licensing the "electricians" and writing the the "code", & who/where were the "inspectors"?

And when the buildings burned down - was it the fault of the electricians, the code, or the inspectors?

Because you put words in quotes, I'm assuming that you are looking for the financial system analogy. The way it's supposed to work is that "banking examiners" and "insurance examiners" look at companies' books to make sure that their capital is adequate for the risks they are assuming.

"Who's at fault when something goes wrong?". Any or all, depending on the facts. The system is supposed to be somewhat redundant. The electrician who did the work is supposed to do good work, and the inspector is supposed to catch the rare case when he doesn't. So if the reason the building burned down is poor electrical work, then both the worker and the inspector failed.

(I'm not sure if you are looking at "the code" as a separate issue. If so, then regulation can fail because the code the inspector is supposed to be following is bad, or because the inspector didn't follow it, or both. Stiglitz referred to this example The New York Times > Log In
It seems like the people enforcing the rules had the power to write the rules, so it's kind of hard to distinguish between "inspectors" and "code" in this case.)

Note: The link above has an odd name. When I click on it, I get a 10-2-08 NYT story with a headline "Agency’s ’04 Rule Let Banks Pile Up New Debt".

 

[ERD50]

Great analogy, and great way to look at the issue.

I'll add that with the building code analogy, there are a few more things at work:

The system is supposed to be somewhat redundant. The electrician who did the work is supposed to do good work, and the inspector is supposed to catch the rare case when he doesn't.

1) Also, the materials used are standardized, and have 'evolved' to be more mistake proof in all steps of the process.

2) There is at least some transparency to the owner (who may not be too concerned about his neighbors, but does not want his own building to burn down) - I look over the work that is done in my home to make sure it was done properly. Even if you are not an expert, you get a sense of things, even if just the general 'did they act professional'.

3) Your insurance company wants to know the work was done right. They have a direct or indirect hand in this (I'm pretty sure the ins co had input on building codes, and are pretty much the reason URL was formed).

4) Feedback. There are millions of buildings, and many fires each year. When a fire breaks out, there is a postmortem. Ins cos collect data, and will ask for changes if something stands out.

5) Time. Buildings and ins have been around a long time. Things move slow enough, that bad practices can be corrected. Maybe aluminum wire was eliminated just due to cost, but IIRC there were safety issues (it contracts/expands more than Cu, I think - causes more mechanical stress on connections).

So look at that, and see how many things are missing in the financial side. New products, things hidden from view, failures far-and-few between so not much corrective feedback, who holds the risk, etc....

So yes, regulation is needed, but it needs to focus on transparency, or who the heck knows what is really going on until it is too late?

-ERD50

 

[Independent]

Great analogy, and great way to look at the issue.

I'll add that with the building code analogy, there are a few more things at work:

1) Also, the materials used are standardized, and have 'evolved' to be more mistake proof in all steps of the process.

2) There is at least some transparency to the owner (who may not be too concerned about his neighbors, but does not want his own building to burn down) - I look over the work that is done in my home to make sure it was done properly. Even if you are not an expert, you get a sense of things, even if just the general 'did they act professional'.

3) Your insurance company wants to know the work was done right. They have a direct or indirect hand in this (I'm pretty sure the ins co had input on building codes, and are pretty much the reason URL was formed).

4) Feedback. There are millions of buildings, and many fires each year. When a fire breaks out, there is a postmortem. Ins cos collect data, and will ask for changes if something stands out.

5) Time. Buildings and ins have been around a long time. Things move slow enough, that bad practices can be corrected. Maybe aluminum wire was eliminated just due to cost, but IIRC there were safety issues (it contracts/expands more than Cu, I think - causes more mechanical stress on connections).

So look at that, and see how many things are missing in the financial side. New products, things hidden from view, failures far-and-few between so not much corrective feedback, who holds the risk, etc....

So yes, regulation is needed, but it needs to focus on transparency, or who the heck knows what is really going on until it is too late?

-ERD50

Okay, I'll try to push the analogy a little further (maybe too far). I'll emphasize your 1 and 5.

In the electrical world, suppose a manufacturer comes out with a new, lower-risistence alloy that allows for thinner wire and lower costs. There is some concern that this alloy reacts with traditional insulation materials and degrades them. The manufacturer says to not worry -- their engineers have a computer model that says this can't happen. But, the model is proprietary and so complex that nobody from the gov't could possibly understand it. My guess is that the code doesn't get updated. Nobody thinks that the potential benefits of switching to the new wire outweigh the potential costs. Building codes are conservative.

But, in the last __ years, the word in the financial sector has been that we can't do anything to slow down innovation. Only the latest and greatest ideas will support our economy. The regulators can't keep up so they should get out of the way. I think that's the attitude that needs to change.

Fortunately, financial regulators have an intermediate option. Instead of banning a product, they can require a higher level of capital to support it. We'll lose some potential efficiencies, but that seems better than periodic meltdowns.

There may be better ways to provide information to owners (your #2) and creditors than we have today. Your #4 gets to the "too big to fail" issue. simply limiting the total dollars that any one firm can put in an unusual product could result in smaller failures where we learn instead of getting buried. Some people have suggested limiting the size of financial companies. That seems like a huge change from current practice, but it certainly seems to deal directly with the TBTF concern.

Except for the last option (putting a cap on total firm size), all of these possibilities are things that I thought regulators were routinely doing years ago. I don't think we need a whole new structure, we simply need to dust off the old ideas and use them.