Stress Tests, Regulatory Capture, and the Fatal Flaw of Capitalism

Let's deal with the last-named item first. The fatal flaw of capitalism is that it is fundamentally beyond regulation. Advocates of laissez faire have always recognized this, arguing that in order for capitalism to work it must be allowed to proceed free from external constraints. The theory has always been that "the market," driven by "enlightened self-interest" (aka "greed is good"), will naturally regulate itself, because self-regulation is in the interest of all market players. External regulation, so the argument goes, will only introduce distortions that interfere with the natural balance of an inherently self-regulating system. As has long been known, however, laissez faire capitalism works only for the benefit of the few, with maybe some degree of trickle-down to the rest of us, if we're really lucky. And as we've only recently learned, laissez faire capitalism, when carried to an extreme, can be so self-destructive as to put everyone at risk.

So if capitalism cannot be relied on to regulate itself, then government needs to step in and regulate it, right? Wrong. The "free market liberals" were in fact correct in arguing that external regulation won't work -- though probably for the wrong reasons. Which brings me to the second topic in my title: regulatory capture.

Regulatory capture refers to a situation in which a regulator becomes so entangled in the mechanisms he is attempting to regulate that he can no longer perform his duties effectively. The assumption is that such a person can become co-opted in one way or another, to the point that he develops a conflict of interest. This is what happened to the institutions, such as Standard & Poor, Moody's, etc. that gave so many of our failing banks triple A ratings. In this instance the evaluators became dependent on the good-will of the bankers, who were, after all, paying their salaries.

In theory, a completely independent regulator ought not be vulnerable to co-option and ought not, therefore, develop conflicts of interest. A government regulator would be paid by the government, not the banks or investment houses, and would thus, in theory, be in a position to offer a completely independent, unbiased and honest assessment. The setting up of such an independent regulatory system is, of course, an essential part of the Obama-Geithner-Bernanke-Summers plan.

Which brings me to the first element in my title: the stress tests (forgive me folks, I seem to be going bass-ackwards here). Here's what one of our most knowledgeable and widely quoted bloggers, Yves Smith, had to say, in a piece pointedly invoking one of my favorite heroes, The Banks and Orwell:

I'd prefer an open sales effort to this mingling of hucksterism with supposed regulatory policy. And they have clearly been intermingled. Note how the prime objective of the stress tests has been above all to restore confidence. Huh? The most important aim should be to assess their condition so as to determine what if anything needs to be done. To subordinate proper regulatory action to reassuring "the markets" is backwards. If the public had faith in the integrity of the process, the need for a confidence exercise would vanish.

Herein lies the crux of the problem, because the stress tests have two contradictory goals: first, to objectively assess the condition of the banks; but second, as Obama and Geithner have repeatedly insisted, to restore public confidence in the banking system. As everyone knows, most if not all of these banks would have failed had there been no bailout. What would have been expected from an honest stress test would, therefore, have been a dire assessment indeed. But that would hardly have restored confidence in the system. Consequently, the stress tests were compromised, serious problems were papered over, and a truly Orwellian process of doublethink came into play. Think two contrary thoughts at the same time, first the unpalatable truth that our financial system has been ruined; second the necessary lie that everything is really OK, that with a little tweaking the system is going to recover quite nicely. Because the primary goal of the exercise was not proper regulation of the banking industry, but the restoration of confidence.

While so many economists are expressing irritation and disdain, few seem to realize that the fundamental flaw at the heart of the tests cuts also to the heart of any hope for regulatory reform. Over and over again the pattern repeats itself. Some institution becomes hopelessly overextended, for whatever reason, legal or illegal, by choice or by chance. Everyone at the top sees what is going on, knows very well exactly how terrible things are -- and yet, the whistle never gets blown. I'm thinking, for example, of that famous speech by Enron CEO Ken Lay, declaring Enron was doing great at a moment when he knew full well it was on the rocks, that all was lost. Why would he make such a speech at such a time? Well, what other choice did he have? If he had told the truth, the company would have tanked then and there. And he'd have been blamed. Lay was in a classic lose-lose situation. If he told the truth, his words would have precipitated a run for the exits and he'd have been blamed for Enron's fall; by forcing a smile and insisting all was well (as he did), he bought himself some time -- knowing in his heart that it was just a matter of time before his lies would be exposed.

I think it highly significant that no one with any real influence blew the whistle on Bernie Madoff, despite all the many alarm signals going off for so many years. It's hard to believe that no one, none of the experienced traders he did business with, none of his alleged victims, not even anyone at the SEC, was aware that he was perpetrating an outrageous scam. Regardless, he was simply too hot to handle, the consequences of exposing him would have been too disastrous, not only for his associates and those invested with him, but even the functionairies at the SEC, who would certainly have been blamed for the billions in losses.

Something similar must have been at work with the agencies rating the banks, as they began to realize how serious a situation their clients were in. When things reach a certain pass it's not so much a feeling of loyalty or obligation to the guys who write your checks, as a feeling of responsibility for the entire financial edifice, which could collapse to the ground if you said the wrong thing at the wrong time. What sort of courage would it have taken for some functionary at Moodys or S&P to get up one fine morning and announce to the world that Lehman Brothers must be downgraded from AAA to ZZZ? If that had happened and Lehman had gone bust, guess who would have been blamed? When one gets into a situation of this sort, ones mind must definitely incline toward magical thinking. Because being realistic and hard nosed is going to get you exactly nowhere. Let someone else take the hit when all goes bust.

Obama, Geithner and Bernanke are in essentially the same untenable situation. And in fact any regulator or regulatory agency would inevitably be placed in the same untenable situation. So long as all goes well and there is nothing to regulate, then you can do your job of regulation really well. As soon as something goes wrong, however, then, simply by exercising your regulatory responsibilities, you run the horrible risk of precipitating the calamity you were hired to avert.

And hence: the fatal flaw of capitalism is that it is fundamentally beyond regulation. QED.

(Of course, for some, that is its supreme strength.)