“The interaction between the market participants, and for that matter between the market participants and the regulators, is not a game, but a war.”
Rick Bookstaber recently compared the complexity of the financial marketplace to that observed in military warfare. Bookstaber focuses primarily on the interaction between market participants but as he mentions, the same analogy also holds for the interaction between market participants and the regulator. In this post, I analyse the role of the financial market regulator within this context. Bookstaber primarily draws upon the work of John Boyd but I will focus on Sun Tzu’s ‘Art of War’.
Much like John Boyd, Sun Tzu emphasised the role of deception in war: “All warfare is based on deception”. In the context of regulation, “deception” is best understood as the need for the regulator to be unpredictable. This is not uncommon in other war-like economic domains. Google, for example, must maintain the secrecy and ambiguity of its search algorithms in order to stay one step ahead of the SEO firms’ attempts to game them. An unpredictable regulator may seem like a crazy idea but in fact it is a well-researched option in the central banking policy arsenal. In a paper for the Federal Reserve bank of Richmond in 1999, Jeffrey Lacker and Marvin Goodfriend analysed the merits of a regulator adopting a stance of ‘constructive ambiguity’. They concluded that a stance of constructive ambiguity was unworkable and could not prevent the moral hazard that arose from the central bank’s commitment to backstop banks in times of crisis. The reasoning was simple: constructive ambiguity is not time-consistent. As Lacker and Goodfriend note: “The problem with adding variability to central bank lending policy is that the central bank would have trouble sticking to it, for the same reason that central banks tend to overextend lending to begin with. An announced policy of constructive ambiguity does nothing to alter the ex post incentives that cause central banks to lend in the ﬁrst place. In any particular instance the central bank would want to ignore the spin of the wheel.” Steve Waldman summed up the time-consistency problem in regulation well when he noted: “Given the discretion to do so, financial regulators will always do the wrong thing.” In fact, Lacker has argued that it was this stance of constructive ambiguity combined with the creditor bailouts since Continental Illinois that the market understood to be an implicit commitment to bailout TBTF banks.
As is clear from the war analogy, a predictable adversary is easily defeated. This of course is why Goodhart’s Law is such a big problem in regulation. Lacker’s suggestion that the regulator follow a “simple decision rule” is fatally flawed for the same reason. Lacker also suggests that “legal constraints limiting policymakers’ actions” could be imposed to mitigate the moral hazard problem. But attempting to lay out a comprehensive list of constraints suffers from the same problem i.e. they can be easily circumvented by a determined regulator. If the relationship between a regulator and the regulated is akin to war, then so is the relationship between the rule-making legislative body and the regulator. Bank bailouts can and have been carried out over the last thirty years under many different guises: explicit creditor bailouts, asset backstops a la Bear Stearns, “liquidity” support via expanded and lenient collateral standards, interest rate cuts as a bank recapitalisation mechanism etc.
Bookstaber asserts quite rightly that the military analogy stems from a view of human rationality that is at odds with both neoclassical and behavioural economics, a point that Gerd Gigerenzer has repeatedly emphasised. Homo economicus relies on a strangely simplistic version of the ‘computational theory of the mind’ that assumes man to be an optimising computer. Behavioural economics then compares the reality of human rationality to this computational ideal and finds man to be an inferior version of a computer, riddled with biases and errors. As Gigerenzer has argued, many heuristics and biases that appear to be irrational or illogical are entirely rational responses to an uncertain world. But clearly deception and unpredictability go beyond simply substituting the rationality of homo economicus with simple heuristics. In the ‘Art of War’, Sun Tzu insists that a successful general must “respond to circumstances in an infinite variety of ways”. Each battle must be fought in its unique context and “when victory is won, one’s tactics are not repeated”. To Sun Tzu, the expert general must be “serene and inscrutable”. In one of the most fascinating passages in the book, he describes the actions and decisions of the expert general: “How subtle and insubstantial, that the expert leaves no trace. How divinely mysterious, that he is inaudible.”
As Robert Wilkinson notes, in order to make any sense of these comments, one needs to appreciate the Taoist underpinnings of the ‘Art of War’. The “infinite variety” of tactics is not the variety that comes from making decisions based on the “spin of a roulette wheel” that Goodfriend and Lacker take to provide constructive ambiguity. It comes from an appreciation of the unique context in which each situation is placed and the flexibility, adaptability and novelty required to succeed. The “inaudibility” refers to the inability to translate such expertise into rules, algorithms or even heuristics. The ‘Taoist adept’ relies on the same intuitive tacit understanding that lies at the heart of what Hubert and Stuart Dreyfus call “expert know-how”1. In fact, rules and algorithms may paralyse the expert rather than aid him. Hubert/Stuart Dreyfus noticed of expert pilots that “rather than being aware that they are flying an airplane, they have the experience that they are flying. The magnitude and importance of this change from analytic thought to intuitive response is evident to any expert pilot who has had the experience of suddenly reflecting upon what he is doing, with an accompanying degradation of his performance and the disconcerting realization that rather than simply flying, he is controlling a complicated mechanism.” The same sentiment was expressed rather more succinctly by Laozi when he said:
“Having some knowledge
When walking the Great Tao
Only brings fear.”
I’m not suggesting that financial markets regulation would work well if only we could hire “expert” regulators. The regulatory capture and the revolving door between the government and Wall Street that is typical of late-stage Olsonian demosclerosis means that the real relationship between the regulator and the regulated is anything but adversarial. I’m simply asserting that there is no magical regulatory recipe or formula that will prevent Wall Street from gaming and arbitraging the system. This is the unresolvable tension in financial markets regulation: Discretionary policy falls prey to the time-consistency problem. The alternative, a systematic and predictable set of rules, is the worst possible way to fight a war.
- This Taoist slant to Hubert Dreyfus’ work is not a coincidence. Dreyfus was deeply influenced by the philosophy of Martin Heidegger who, although he never acknowledged it, was almost certainly influenced by Taoist thought [↩]