A Fine Madness in the Washington Air

To borrow Niall Ferguson’s metaphor, if finance is an evolutionary process, then regulation is its intelligent design — which, I would add, is a cognate of faith, not science.

Or, to take the observation of former Federal Reserve Governor Frederic Mishkin, if "the financial system (is) the brain of the economy," then, I would suggest, heavy regulation is its lobotomy; while it removes the emotional highs and lows, it also dulls the perception, facility and adroitness. (Disclosure: In keeping with my long-held public view, I give professional advice to financial institutions seeking low regulation and taxation.)

A century ago, medical science had faith in lobotomies. Today, it seems, Washington political science has faith in new financial regulation.

Medical science began to gain wisdom when it learned what previously unrealized damage it caused when it lobotomized human brains. We must hope that the "experts" today who are drafting new regulations by which they would impair our financial system gain wisdom soon by recognizing how little they understand the effects of these new regulations on our economy’s future health.

However, the current financial regulatory efforts in Washington may not even deserve the honor of being compared to intelligent design or a lobotomy. At least with those two processes, each has the intellectual dignity of an internal logic — even if that logic does not accurately describe the reality it attempts to explain and manipulate.

Rather, the current likely financial regulatory efforts have an almost random nature to them, as the legislative logrolling is collecting unrelated and sometimes-inconsistent ideas that eventually will be called, I assume, the Frank/Dodd Comprehensive and Rationalized National Financial Redemption Act of 2009.

The final bill will be the compilation of the results of various political battles being fought among the president, his various White House economic and political advisers, the Treasury and various powerful committee and subcommittee chairmen in the House versus their equivalents in the Senate, as well as the successful interventions of various interests, the institutional partial victories that are gained in the battles among the half-dozen or so overlapping financial regulatory agencies in existence, plus whatever the whimsical effects are of the backbenchers, the states, the commentators, the media and, of course, the public.

Even if 10 of the smartest financial regulation experts in the world got in a room and wrote an internally consistent set of regulations, if history is any guide, it would not be likely to anticipate, avoid or mitigate whatever the next financial crisis would be. As Ferguson wrote in "The Ascent of Money," "It seems that, for all our ingenuity, we are doomed to be ‘fooled by randomness’ and surprised by ‘black swans.’" (See — and read — two of Nassim Nicholas Taleb’s intriguing books, "Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets" and "The Black Swan: The Impact of the Highly Improbable.")

According to a study of financial data of the past two centuries, there is a 3.6% per annum probability of a financial disaster and, statistically, a 100% probability of a new financial disaster within 33 years.

Treasury Secretary Timothy Geithner — who is the lead executive-branch figure designing new regulations to protect us from the kind of systemic risk of failures by large institutions that we have just experienced and are trying to work our way through — inadvertently captured perfectly the madness of the current Washington moment.

Geithner was quoted in last Wednesday’s Financial Times: "I think this has been a searing experience for financial institutions across the world. The great risk we’re going to live with for a very long time is that risk aversion remains very high."

I happen to agree with him and made a similar observation in a column last month. But I wonder when it will dawn on the secretary that he is leading the team designing a regulatory system to protect us from "greedy" and impetus-excessive financial risk takers destroying the world economy, when, as he himself pointed out, the real next risk is probably "risk-averse" bankers failing to make even sufficient prudent loans and investments.

In other words, he is designing regulations that will force more prudence and even slower and less circulation of needed money on a system that he believes is already predisposed to be too prudent and too slow and will circulate too little money to keep our economy humming.

Realists like to point out that most generals think they are fighting the last war and thus lose the one they are in. So today, Washington is busy preparing to protect our future economy — which is likely to be stagnant, risk-averse and weighted down with excessive debt, high taxes, expensive energy and industrial policy crony capitalism inefficiencies — from yesterday’s financial impetuosity and excessive risk taking. Thereby, we will increase the stagnation, risk aversion and middle-class poverty such habits will cause. Washington isn’t writing a financial regulation; it is weaving an economic shroud.