Regulation vs transparency

Your number one friend is yourself! This is pretty much also the basic tenet of “the dismal science”, economics.

I am mildly surprised to hear demands for “more” regulation of the financial sector, as if that would make things better instead of worse. Some regulation is necessary, but we also have to consider the problem of corruption. As you increase the power of government over business decisions, you increase the benefit of corruption.

Let us take the polar opposite situations. In one scenario, the government has no particular influence on a sector of business. In this scenario, corruption is a waste of money. The various businesses involved could not care less what the government agencies think, and would not spend a dime to influence them.

Now look at the opposite situation, where government has total control over day to day operations. This government sets quota for all kinds of activities, and have nebulous powers to Just Say No to any activity they may find suspicious or not promoting the wellbeing of society, as they see it. In this case, the best investment anyone could do in that branch of business would be to influence the government agencies in any way possible, whether by targeted information campaigns, generous gifts, or good old blackmail. Creativity abounds. But the motivation is certainly there.

By estimating how much influence government has on business operations, we can estimate how strong the pressure toward corruption is. But will this necessarily lead to actual corruption?

The answer to this is that human nature remains human even with the best possible intentions. In other words, corruption WILL happen unless there is a system for watching the watchmen, and then watching the watchers of the watchmen and so on. For each level of overseers it becomes more expensive to corrupt them all. (We must assure that the watchers don’t have the power to actually instruct the executive level, or it would be enough to bribe the watchers.) Of course, adding levels of overseers will cost money which drains society of other resources. Still, it is probably better than corruption.

In other words, what we don’t need is generic “more” regulation. That is worse than nothing. We need more transparency. That is to say, we need to organize things so that correct information is available to as many people as possible.

One way of doing this is to have the participants watch each other. In many countries, sales tax is organized as VAT, Value Added Tax. This means that the final seller collects the sales tax, yes, but also pays sales tax to the previous link in the chain. So a customer may pay sales tax to the retail store, but the retail store pays sales tax to the wholesale business, which again pays sales tax to the factory, and so on. If one of these chains have a completely different set of numbers, something is off. Say the factory and the retailer both sell a lot, but the middleman has much less business. That should ring bells pretty quickly. Same with the other way around, of course.

In contrast, look at the recent financial crisis, the so-called “subprime crisis”. This was caused by packaged loans. What happened was that a few dubious loans were mixed into a batch of pretty solid loans. There was no outright lying about it – probably – but since most of the loans were solid, the total package was considered solid as well. Then such packages were sold again, and each time more rotten loans were added to a package that was deemed “solid”. You can see where this ends. It’s like letting an alcoholic add just a little brandy to the punch. He’ll add a little so often that in the end it is all indistinguishable from brandy.

If one had rules of transparency, so that the content of subprime loans could have been identified at a glance, the crisis could have been averted. But if so, we would also not have had the heady boom years before, when cheap credit was everywhere. Because rotten loans are not cheap. If there is a big risk involved, investors require a “risk premium” to lend you money. This is why, for instance, credit cards have higher interest than mortgages, normally. So the interest rates on loans would have been climbing steadily, and the wild rush into property speculation would not have been possible. People simply would not have been willing to pay that much interest, or conversely, not been willing to lend at that risk.

In this high-transparency scenario, we would not have had the boom of the early 2000s. There would not have been cheap credit to use for consumers, and they would have noticed that their standard of living was not rising (because wages and salaries weren’t). But the thing is, people LIKED to have cheap credit. The banks liked it, but also the government that oversaw the banks liked it, because the voters liked it. Even if the government had been given absolute powers to do whatever they wanted with the financial sector in the year 2000, chances are the result would have been WORSE, since the government not only had the exact same goal (economic growth) but less insight in what was actually going on.

So, not “more regulation”. More transparency. More truth, to put it bluntly.