July 13, 2010
The other side of the coin
When the pendulum swings it’s worth considering where it has swung from. That brought me to this youtube video showing the late Nobel Prize winner Milton Friedman arguing that the Consumer Products Safety Commission – a U.S. federal agency that works to ensure consumer product safety – is a wasteful government boondoggle filled with snooping bureaucrats. (Elsewhere he gave the same treatment to the US Food and Drug Administration, the FDA.)
Even if his disciple Alan Greenspan is contrite, Friedman, if he were alive, would probably still not approve the idea of government bureaucracies to protect consumers against the financial industry. Toward the end of the video he says why:
“Consumers don’t have to be hemmed in by rules and regulations. They’re protected by the market itself. They want the best possible products at the lowest price. And the self interest of the producer leads him to provide those products in order to keep customers satisfied. After all, if they bring goods of low quality here, you’re not going to keep coming back to buy. If they bring goods that don’t serve your needs, you’re not going to buy them. And therefore they search out, all over the world, the products that might serve your needs and might appeal to you. And they stand in back of them, because if they don’t, they’re going to go out of business.”
This sounds ludicrous now when applied to the financial industry. Why is it so ludicrous? Why can’t the consumers of financial products regularly reject the bad and embrace the good, driving purveyors of bad products in the financial industry out of business and patronizing only the providers of good products?
Again the culprit appears to be the principal-agent problem – as Roubini and Mihm partially point out. But to see that, we must ask exactly who is the principal?
That question is answered in part in a recent article by Roger Lowenstein in The New York Times titled, The Next Crisis: Public Pension Funds. The principal is of course investors, who paid all the fees to all the mortgage originators, appraisers, packagers, ratings agencies, distributors and what-not, on the chain of intermediaries in the subprime debt house of cards. They also suffered the losses when the investments failed. A large number of the investors were participants in pension funds and other retirement funds. Those funds and their participants are now in deep trouble.
Those investors entrusted their investments to agents: the administrators of the funds, their consultants, and the money managers and investment vehicles that the consultants picked for the administrators. It’s a cozy group of agents who all make good livings, while the investors lose. They’re the ones who decided that the investors should invest in CDOs. They’re the ones who claim – or pretend – to have arcane information about which they are expert, and who represent themselves as qualified to make choices for the investors for very substantial fees.
Something is wrong with this situation, but the solution is not obvious. There’s a lack of good information in the hands of actual investors, and too much misinformation. Some advisors act in the best interests of investors and others don’t, but the investors can’t tell the difference.
I like the way Roubini and Mihm dispose of one piece of misinformation, the “alpha” scam, by simply calling it “schmalpha.” The alpha scam is the implication that smart and well-paid financial advisors and managers will procure “alpha” – above-average returns – for their fees. But how many investors know that they’re being sold “schmalpha”? Precious few, unfortunately.
This situation will require more than just government regulation. It will require an entire change of mind-set. How this change in mind-set will come about I don’t know. Perhaps it needs to be led by creatively destructive government regulation. But it will have to go well beyond that.
In my view, what the financial industry needs is another C. Everett Koop – the U.S. Surgeon General who looked like a wrathful God in uniform, and pushed a major government-led crackdown on the mendacious and injurious tobacco industry. The crackdown included outlawing misleading forms of advertising, as well as requiring very forceful warnings on cigarette packs. Somebody with great moral authority and backed up by clout – perhaps legislative or regulatory authority – needs to start calling a spade a spade in the financial industry, not just once but repeatedly, over and over again.
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