Wednesday, January 27, 2010


Having (finally) recently read Ayn Rand's classic, The Fountainhead, it was easy to appreciate an interesting link Benny sent me earlier in the day. Jay Kraut, who I believe is a candidate for a PhD in Bible, interviewed Dr. Yaron Brook, President of the Ayn Rand Institute, to ask some questions regarding what Rand's approach would have been over the last few years and in general. It was somewhat disheartening at first to see that Kraut, in his own separate post-interview piece, clearly entered the discussion not understanding some basic economic principles, but in truth, the need to explain some of those principles lead to Brooks detailing extremely clearly just how an ideal financial sector should function. This helps turn the interview into a great presentation of ideas, rather than a typical, dull debate on public policy.

Both the interview and the postscript are good, worthwhile reads. One point very much worth discussing is an error that both the interviewer and perhaps a couple commenters on the piece seem to be making, addressed well by another commenter on the interview piece. Kraut writes:
I believe he accords too much of a presumption of good faith to the financial sector as a whole. I give Brook credit for condemning financiers who focus on short-term gains and – in the case of mortgage-backed securities, in particular – ignore the welfare of investors and consumers in order to reap quick profits. However, I think that he is overly kind in presuming that the primary source of such rapacious behavior is government coercion. To my mind, such a stance unfairly discounts the simple possibility that immoral people – under the current system, or in a purely capitalistic society – will seek personal gain at all costs, even if it entails cheating or engaging in dishonest, manipulative behavior. Brook seems to imply that, were government regulation to disappear, the pure (and honest) capitalists would naturally run the show. However, I am not sure that such an assumption is realistic. I would be interested in learning how – in Brook’s view – the danger of bad faith in the financial sector might be obviated.
What is often missed when discussing deregulation is what a deregulated economy would create in order to function properly. Without regulation, people become initially more hesitant to make an investment. The way companies can coax others to invest their money with them is by showing them how that investment could or would be worthwhile. The only way a rational investor would invest money in a company is if they felt they could trust that company's claims regarding its strategies - and the only way a company will earn that trust is through a rigorous combination of independent observers, auditors, and perhaps most importantly, transparency. In such a world, companies would literally compete with one another on measures of transparency, on ensuring that they are hiring the top independent reviewers, and the like, as each mitigation of risk would make investment in the company that much more likely. As Brooks commented, in a modern market, the debt-holders have no reason to watch the risk, because the government will cover the risk regardless. But without that coverage, nobody would invest in a company unless they were closely watching that risk.

The strongest antidote to corruption in finance is not regulation, but transparency. When everyone can see exactly what's happening, it becomes far more difficult to hide issues. Dishonest people have a much harder time trying to pull a fast one when the ability to do business is not dependent on the seal of a(n often inept) government organization, but on building a strong reputation through transparency and independent confirmation.

One of the best examples of this is from the housing bubble burst. Banks were leveraging assets at outrageous levels - for every dollar deposited in their banks, they were buying up to thirty-five dollars worth of investments. When a few of those went bad, it led to a rapid crumbling of those banks' stability - eventually shutting a number of them down. When Bear Stearns failed, the government bailed them out - and the other banks felt safe to continue this over-leveraging. Had the government let Bear Stearns fail, it is almost impossible to imagine that the other banks wouldn't have quickly reduced their leveraging to ensure capital stability.

In fact, as I was discussing with another friend on the subway home from work today, imagine if there were no FDIC insurance on our bank account deposits. Would you put your money into a bank unless you were extremely confident that they weren't over-leveraging your assets, placing your savings at risk? Now, one might argue that without insurance, nobody would use banks at all, placing the ability to invest in general in jeopardy; therefore, as Brooks notes, it isn't crazy to argue for FDIC insurance - but with capital requirements to match, and that's it. The absolute expectation by investors that their money is safe with a company would be constantly confirmed in such a society via transparency and independent, private organizations.

It is worthwhile to note that people in general are excellent at self-policing when allowed to do so. When people rely on government to regulate, invariably government falls well behind those who commit crimes in the first place. When people do not rely on government, they make sure to understand as much as they can, and where they cannot, they find someone who can. Randian philosophy would certainly be interesting to watch in today's times - it's too bad we're heading far off in the other direction.