Regulatory Overhaul

Here is how Alan Rappeport summarized for the Financial Times Web site the speech that Ben Bernanke gave this morning:

Ben Bernanke, Federal Reserve chairman, on Tuesday urged an overhaul of “financial infrastructure” to help blunt future crises and said that new reforms would require global co-ordination.

The Fed chief, in a speech to the Council on Foreign Relations, stressed the importance of finding new ways of handling groups that are deemed too big to fail and acknowledged that some policies were magnifying global volatility.

My guess is that this was designed as language to impress Main Street without rankling Wall Street too much, but it is hard to walk down that middle road without waffling. It is difficult to find anyone who does not want reform these days; but it is unlikely that this same "everyone" will come to an agreement over what that reform should be. (The disagreements currently surfacing in the Congress make for a good case in point.) I was reminded of what I wrote that last time I tried to take on the issue of economic reform about a month ago:

When one listens to "the voice of the people," rather than any government-based "official story," one quickly comes to realize than there is a tight coupling between the security of the economic framework and the effectiveness of governmental authority. This is why any strategy for recovery must not be confined to the "engines of the economy." Rather, it needs to address the broader scope of political economy, whether that scope rests on foundations of Adam Smith or Karl Marx.

Like it or not, Bernanke's head is deep in the gear-works of those "engines of the economy;" and it is unclear that he recognizes that the sociopolitical side of the problem is as important as the economic framework. This one-sided perspective may be illustrated by one of the details addressed in Rappeport's report:

Delving into the roots of the current downturn, Mr Bernanke argued for a retooling of the “financial plumbing”, the institutions that support trading, payments, clearing and settlement. He highlighted the repurchase agreement market and the money market mutual fund sector as soft spots in the financial system.

Except for Bernanke's preference to the plumbing metaphor over that of a mechanical engine, this pretty much makes my case.

Ironically, Bernanke came very close to sociopolitical ground in another part of his speech:

He also suggested the creation of an authority charged with monitoring systemic risks to help protect the financial system from crises, which he said should be co-ordinated internationally “to the greatest extent possible”.

“The risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested,” Mr Bernanke said, explaining that the failure had led to “a powerful reversal in investor sentiment and a seizing-up of credit markets”.

Mr Bernanke explained that companies considered too big to fail bring many undesirable effects, such as moral hazard and excessive risk-taking. Such companies, he said, needed special oversight and consolidated supervision. Moreover, a system needs to be developed to allow for “orderly resolution” if such companies become insolvent.

Thus, while risk-management systems may definitely be numbered among those "engines of the economy," the decision to take a risk and the possibility of "moral hazard" cannot be abstracted out of the social world into the mechanical metaphors of the objective world. (In my own current medical condition, both the physicians treating me and I have to make decisions about risk, even if none of us are skating onto thin moral ice, so to speak. So I now have first-hand experience with trying to keep the concerns of the social world from getting lost in the abstractions of the objective world.)

I was once involved with a project on fault-tolerant software that gave me an opportunity to collaborate with Peter Neumann at SRI International. Neumann was fond of saying that you can only program your software to tolerate the faults you know about, leaving you vulnerable to the faults you had not considered. "Systemic risks" in the engines (or plumbing) of our economic framework are no different from spam in our electronic mail. Udi Manber's metaphorical view of the problem of spam filtering as an arms race also applies to those "systemic risks." While Neumann was concerned with faults in an engineering system that had not yet revealed themselves, economic regulation has to deal with risks that may not yet have been invented by virtue of those trying to avoid the regulatory framework!

The flaw in Bernanke's position may be that "systemic risk" presumes a "static system." However, in the social world no system is ever static. The structure of the system is always changing to reflect the practices of those who are part of that system. This is the fundamental principle of Anthony Giddens' structuration theory; and Bernanke's myopic view of structure could well impede any progress towards a reform based on political economy, rather than those "engines of the economy."