Crisis and Leviathon

Crises tend to expand the role of government, which then never subsides. The theme of Robert Higgs' Crisis and Leviathon was that wars and great depressions create a ratchet-like movement toward ever bigger government. The process involves government taking on new functions more than expanding traditional ones. In the end a distant set of bureaucrats regulates everything, but nothing well. Most functional units have specialized argot, data, processes, and contacts, and new employees takes months to know enough to be productive. A regulator has a few weeks at best, probably a few days, to review an organization. How is he to find problems, let alone fix them?

In practice, regulators ask for a select set of reports, usually highlighting statistics that would have been useful in the last crisis, and make bland statements about the desirability of 'clear lines of authority' or a 'prioritization of risk management' (see the Fed's new Senior Supervisors Group Issues Report on Risk Management Practices).

I've talked to many risk managers at large financial firms lately, and there appears an increased focus on regulators: what do they want? This is in contrast to asking, what do we need? The latter question draws on the parochial expertise of people who have to create products and services worth more than they cost to produce, the former draws on the results of endless committee meetings by people who are far removed from the front line.

The subprime crisis has discredited internal financial risk management, so now, instead of thinking about how to manage risk better, large firms have taken the understandable course of action in our Brave New World, of deferring such judgments to the regulators. Appeasing regulators determines whether one can, say, hire immigrants under H1B visa program, or pay a dividend, or worst of all, be labeled 'undercapitalized', creating a self-fullfilling death spiral necessitating an acquisition.

Firms, and the individuals therein, are in the best position to better their practices. With this recent crisis, they have strong top-down directives to placate the government, and cease all innovation because that was the kind of thinking that led to CDOs! Talk about a bad take-away. I expect banks to respond to their lack of productivity by increasing lobbying efforts to squelch competition, because that is really the only way for non-innovative organizations to make profits.

There's an East German joke that goes "What would happen if the desert became communist? Nothing for a while, and then there would be a sand shortage." An important part of this joke is the 'nothing for a while'. Bad policies don't usually produce an immediate catastrophe, rather, they weaken the trend, barely observable when initially implemented. Only after a long while do people notice that the new system is a morass of dysfunctional duties that are done mostly out of precedent, no efficiency. For example, the socialist countries started to great enthusiasm by western intellectuals; so too with busing in schools, large scale public housing, the Department of Education. At best these are wasted resources, more often they create unintended consequences at the root of the next crisis.

A friend of mine lost his job in the financial sector. He got a new job with the FDIC. As a country we have decided to allocate more resources to government, more power to government, at all levels. I fail to see how moving more people out of private firms, that create wealth and pay taxes, to regulators, that impose costs and cost taxes, will make our financial system more robust. From the Great Depression, to the Carter Credit Controls of 1980:3Q, to the S&L crisis, to the Subprime Crisis, Government was not standing athwart history saying 'stop', rather, it was encouraging the very behavior that turned out, with hindsight, to be the root of the problem.