resilience, not stability

Financial Market Regulation and The Art of War

with 14 comments

“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.

  1. 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 []
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Written by Ashwin Parameswaran

April 4th, 2011 at 10:29 am

14 Responses to 'Financial Market Regulation and The Art of War'

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  1. Brilliant post. Did you read President Lacker’s testimony to Congress last week?

    In Richmond they’re keen to correct the mismatch between the size of the safety net and the scope of regulation. There are only two ways to do that: shrink the net or expand supervision. Although they’d agree we need to do a mix of both, my impression is Lacker and Hetzel and Weinberg would (much) prefer the focus be on the former.


    4 Apr 11 at 4:01 pm

  2. John – Thanks.

    I did read Jeff Lacker’s testimony and I tend to agree with his views. If throughout the last cycle, the regulator had credibly avoided any bailouts then we’d in a much better position.

    But now that repeated interventions have made the system so fragile, will the regulator have the stomach to credibly shrink the size of the safety net? I’m not convinced that they do.


    4 Apr 11 at 5:24 pm

  3. A fine and instructive analysis. Like Bookstaber, unfortunately, this analysis is brilliant in its dissection of the problem, looking for the moment like a splayed tree frog on a lab table, but falls significantly short of an insightful solution. Reminds me of a wise and telling question-and-response of old: “A: How do I get to Missouri? B: You can’t get there from here.” These analyses seem unwilling to change the givens, for example, property rights. The underlying assumption seems to be that property ownership is sanctified, regardless of how ownership has been acquired or what end that ownership serves. I think we need to expand this debate. We need to weigh the social value of family home ownership against the oligarchy’s ownership of a near-majority of the nation’s wealth. I’d like to test the notion that not all property is created equal and that the inter-generational grip on property is a fundamental source of inequality, exploitation, and social instability. If perpetual and unending war is the inevitable relationship between the wealthy and the regulators of wealth, then perhaps our most realistic and noble ambition should be to negotiate a state of war in which neither side can be subjected to any form of moral genocide. Perhaps we need a financial equivalent of the no-fly zone currently in effect over Libya. When the elites become too obscenely greedy and self-serving, it’s time for collective and large-scale intervention. Of course, that begs the question, “And when the no-fly zone proves insufficient, what then?”

    Garth Brown

    5 Apr 11 at 10:56 am

  4. In connection with your point about credibility, Lacker’s stance on inflation targeting is interesting. He’d welcome the change if Congress ended the dual mandate and gave the Fed a numerical objective for price stability. But (publicly, at least) he doesn’t put a high priority on amending Humphrey-Hawkins.

    His reason, I imagine, is that the legislative remit has only a minor role in influencing expectations–and virtually none if credibility hasn’t already been earned by taking tough decisions. Often the rules versus discretion debate gets stylized, as though there were a sharp discontinuity between the two. But in practice there’s always a continuum, since it’s impossible to eliminate all discretion.

    When the next crisis comes, suppose governments and central banks somehow manage to give a consistent “no” to the corporations and bond holders crying for a rescue package. How sharp do you think the pain would be in the short term? Would there be a correction on the order of what was needed to break inflationary psychology a generation ago, or something more intense?


    5 Apr 11 at 8:41 pm

  5. Garth – to put it in your language, my point is that there is no well-defined ‘no-fly zone’ that will ever prove sufficient.


    6 Apr 11 at 3:10 am

  6. John – again thanks for an excellent comment.

    Exactly – the legislative body, no matter how hard it tries, cannot eliminate the discretionary powers of the regulator. And the time consistency problem always holds which will tempt the regulator to intervene in some way or another.


    6 Apr 11 at 3:16 am

  7. If you want the regulator to be a “free” player in the system, and, therefore, in control, then the regulator has to stay out of the fight. Another way to say this, is that regulation has to create an architecture for the sector to be regulated, which reliably pits the regulated against one another. Divisa et impera.

    A corollary with application to the currently existing financial industry is: an international universal bank cannot be regulated. (The obvious solution is a regulatory architecture, which does not permit such entities to exist.)

    Building persistent conflict into the system architecture would require the deliberate creation and granting of rents. Rents are necessary, in any case, to attenuate risks. Better to create and distribute them with an eye to their incentive effects, than to do what we did over the last 30 years, which is imagine that “competition” would eliminate rents, while allowing a mad competition for size and power to emerge.

    Bruce Wilder

    9 Apr 11 at 5:51 pm

  8. Bruce – That’s an interesting perspective!

    As I see it, the problem with either granting rents or assuming that increased competition will make things better is that in the presence of an implicit guarantee to bank creditors, the amount of rents that banks can extract is essentially unlimited as I discussed in a previous post


    10 Apr 11 at 10:28 am

  9. Pre-1980, the U.S. had workable solution. I’m not saying it would be workable in its particulars now, but it does show how it can be done, by the artful combination of dumb regulations (arbitrary, bright-line rules with no regulator discretion) and a narrow focus for regulator scrutiny.

    First, a variety of dumb rules, each of which carried a small rent, created a diversity of banking institutions, which competed enough around the edges to keep the grant of a small rent, limited. There were categories of institutions: investment banks, commercial banks, thrifts (aka S&Ls), mutual and for-profit insurance companies, etc. There were rules against interstate banking. There was a rule limiting interest rates on demand deposits, which favored the thrifts over commercial banks, balanced by stricter limits on the scope of S&L lending. S&Ls were almost uniformly organized on a mutual basis; commercial banks as for-profit firms with a marketable equity/bonds capital structure; investment banks as private partnerships.

    This diversity of business models and capital structures, a product of non-discretionary limits on geographic and business scope, obviated both the TBTF problem and the Herd-of-Lemmings problem. It also meant that the Financial sector provided few opportunities for an individual to make a large fortune from “innovation”, and when a Michael Milken did “innovate” the thicket of legal strictures meant — rightly or wrongly, I’m somewhat agnostic on the justice of this feature — that the innovation would be suspected as a species of control fraud.

    The disintermediation that accompanied Volcker’s high-interest rate policy created a crisis for the S&Ls, and deregulation created an evidentiary proof of your point, about the hazards of guaranteeing bank creditors, without other strong limits, leading to (your phrase) unlimited rent extraction.

    My general complaint about the language of “rent extraction” etc, taken from public choice theory, is that it makes “rent” such a strong pejorative, that people seem to have difficulty remembering that rents can be a feature, not a bug, of a stable, economic structure. In fact, having any economic structure, which includes the use of extensive private business bureaucracy, implies the existence of rents. If the regulatory regime does not deliberately prescribe those rents as part of its architectural design, “natural” strategic competition will find or create rents from untrammelled power.

    Sorry for the long comment, but one last point: financial and banking regulation is just a subspecies of monetary regulation. The base goal is to stabilize the value of money, and minimize the dead-weight losses that arise from financial risk endogenous to the financial/monetary system. In other words, we want people to use money to make deals and to invest in real productive projects with a positive net-present value, no matter how minimal; we don’t want risks of financial or monetary fluctuation raising real interest rates, and preventing such investments or taxing such investments.

    Given the imperative need of the monetary authority to stabilize the payments system, guaranteeing some class of “demand deposits” is inevitable, and all the rest of financial regulation follows. The Sovereign must monopolize the creation of violence and of money. Lose control of either one, and things get ugly. I think the Fed lost control of money creation (broadly understood) to mortgage-backed securitization, and that created the GFC. The inability of the present U.S. regulatory regime to define, let alone detect and punish, control fraud implies that they have not secured their monopoly. That’s my perspective.

    Really, really have enjoyed your blog; looking forward to more.

    Bruce Wilder

    14 Apr 11 at 1:46 pm

  10. Bruce – wow, to reply to that comment I probably need to write a new post. But just some quick thoughts.

    I completely agree on the pre-1980 situation being a lot more resilient. My main contention is that we can’t rewind the clock without an intermediate financial sector collapse. For what its worth, I think we’ll eventually get one anyway which will be the catalyst for reform.

    I would add however that some of what happened post-1980 had been building up for a while and was inevitable. The market tends to find a way around regulations. Having said that, the early 80s deregulation was a disaster – a fact that the Fed recognised even then (John Kareken of the Minneapolis Fed wrote a paper in the early 80s on the dangers of combining deposit insurance with deregulation). But even after all this, if the Fed and the FDIC had even occasionally inflicted losses on atleast uninsured creditors and avoided using monetary policy as a backdoor bailout mechanism we’d have been a lot better off.

    On rents, again I don’t disagree. In a Schumpeterian world, rents are not always a bad thing. My use of the term in its pejorative sense is simply meant to emphasise how much I oppose the present architecture of rents.

    On monetary policy, again the problem is that the state cannot regain control without an intermediate implosion of our present financial/banking system which IMO is inevitable anyway.

    Thanks for all the comments – your thoughts are invaluable.


    14 Apr 11 at 3:45 pm

  11. I think the completely non-discretionary route does have something to say on its behalf. If in the wake of the international long term capital management failure, the regulators of the world had taken a hands-off approach, none of this would have happened.


    23 Apr 11 at 10:58 pm

  12. Ashwin, Have you seen the sequel to last year’s Keynes-Hayek rap video?


    28 Apr 11 at 12:39 pm

  13. Prakash – the problem is that the commitment to not intervene or bail out is not credible i.e. when things like LTCM happen, the incentives are always aligned for the central bank to intervene and stall off a recession, no matter how minor.


    28 Apr 11 at 3:37 pm

  14. John – I have. It’s excellent.


    28 Apr 11 at 3:37 pm

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