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.


  1. It is worthwhile to note that people in general are excellent at self-policing when allowed to do so.

    LOL. No.

    Your theories are nice and all, but they fall apart where they meet reality.

  2. You're completely wrong. By definition, in a free environment, the people are forced to come up with an effective system. People won't invest until they feel safe.

  3. And for a second there I thought you were actually going to write about The Fountainhead. :-/

    Still waiting for that post, ahem.

  4. People won't invest until they feel safe.

    1) Demonstrably untrue.
    2) Even if it were true, feeling safe and being safe are wildly different.

    Your theories are pretty and I know the Austrians have fun deducing them from first principles, but empirically, they're full of BS.

    Also, government regulation IS the (relatively) effective system the people came up with. The people freely chose representatives who came up with the systems we have now, and they freely chose to vote for Obama, knowing that he would be more likely to increase government regulation. That's freedom right there.

  5. Howard Roark, in the Fountainhead, epitomizes what the earliest American settlers discovered that did not exist in the world at the time. It was the ability for each individual to think, imagine, create, build and change the environment with their sweat, even disturbing the established and accepted way things were done, and without fear of punishment. That was America, and what set her apart from all other nations, as cited in Save Pebble Droppers & Prosperity at Amazon and Individual freedom caused local government, close to the governed within a day’s horseback ride. The governed ruled, and they could change government in Town Halls, voting or by vigilante movements, much like the Tea Party movement today. It is the tradition rising from a Howard Roark kind of people.

  6. JA - What the heck are you talking about?? You clearly know nothing about economics ("demonstrably untrue"?! Where?? Empirically?!?! When??), and have shown that repeatedly in discussions on this blog and on yours.

    As for the idea that people voted in Obama for increased financial regulations, that's incredibly laughable - almost as much as the idea that they wanted him to revamp healthcare.

  7. hey,

    kraut here. glad you enjoyed the interview. and you're certainly correct about my amateur status in the field (which i mention).

    i think i do (and did) understand the claim that in a freer market, companies could compete for customers/investors based on safety, transparency, etc. however, i could imagine a few problematic issues would arise:

    (1)it seems like, by nature, there can always be someone (or some company) that can push the envelope and offer slightly higher returns. and then a bit more. and then a bit more. and even failed money managers seem to be able to attract large amounts of capital.

    (2) as someone else commented to me, if depositors are really looking for safety, they will probably congregate around the biggest banks. this could effectively re-create too-big-to-fail conditions.

    (3) Just as a point of fact, the transition between regulated and unregulated markets could be very difficult. i'm curious how free-marketers would suggest this transition be managed.

    but again, i'll emphasize that i don't know the answers to my questions. that's why i ask them. and i really appreciate thoughtful contributions to the discussion.

    take care,
    jay kraut

  8. Jay -

    Hey, thanks so much for commenting. I definitely enjoyed, and didn't mean to sound critical of the amateur status - I was just noting how that led to a great discussion because it had to lay the foundation for the theories. It was a great interview.

    It's not so much that they compete based on transparency and safety, but that by definition without a cushion companies would be forced to be transparent to encourage investment. This would force a race of transparency, and once all banks would be forced to full transparency, it will simply be a question of which investment strategies people prefer.

    1) Nobody can offer higher returns. They can offer stronger investment strategies and use past returns as evidence. As is true even with current investment, it comes down to risk/reward. The problem with regulation is that it encourages unnecessary or extra risk without that being clear to investors, who assume the regulations cover their risk. This is clear from the past meltdown and what Brooks explained well in the interview.

    2) That's actually untrue. They will congregate around banks with the highest *percentage* of capital, rather, than the highest gross. The larger a bank is, the more they are leveraging by definition, thereby creating greater risk to an individual investor or depositor. If anything, "safe" investors or regular depositors will be more likely to put their money in small local banks which are less likely to make any risky investments, not only because they simply aren't in a position to make them.

    3) I've often wondered this myself, but I actually don't think this would be the case, particularly if there is a set date for regulations to be lifted. It will allow people to plan in advance what they would like to do with their money, and would allow the various banks and companies to start showing how they will protect and invest their clients' capital before that date hits. It will essentially create that race to transparency before the regulations are lifted. It will also allow banks and investors to slowly de-leverage in the lead-up while avoiding new risky ventures for a short while at least.

  9. thanks for the response. good stuff.

    no worries, no offense taken. i'm always happy if people are interested in something i work on.

    take care,


  10. For serious Jewish Jews, "Ayn Rand" should be the opposite of a role model.

  11. Ezzie,

    While you may be correct about sophisticated investors, it is simply not true that "nobody would invest in a company unless they were closely watching [the] risk."

    Most people don't understand risk. Look at your example:

    "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?"

    Maybe you wouldn't and maybe I wouldn't, but many, many people have no idea what leverage is, never mind how banks should properly use it.

    You should really read Nudge by Thayler and Sunstein. It advocates libertarian paternalism -- a form of soft paternalism that takes into account real life, where people have serious cognitive flaws which reduce their ability to make good decisions.

    The book actually deals with the type of transparency solution that you are proposing. Studies have shown that giving people more choices actually reduces the quality of their decisions. That is, the more information you throw in front of someone, the less likely they are going to make a good decision. Sounds counterintuitive, but it has been shown time and time again.

    Transparency works for the educated elite, but the average investor is either going to forgo investing entirely or is going to make decisions based on the advice of his broker, who we all know is not a non-self interested individual.

    Btw, have you read Richard Posner's a Failure of Capitalism? Posner basically explains how unregulated capitalism necessarily leads to depressions of the sort we are in.

  12. Self-policing?

    You would perhaps want to eliminate Wells Notice regulation for scammy little penny stocks?