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The Long View 2002-07-02: Innocence is no Excuse

John's specialty was business law: boring things like securities and the UCC. I can see why he turned to millennialism [kidding!]. In passing, he notes the securities law has a great deal more to do with regulation than legistation per se. This is true in my field as well. For example, 21 CFR 820, which governs current good manufacturing practice for medical device companies, is actually rather terse.

Later, John mentions one of the persistent, yet unremarked scandals of modern American finance, the 401k. It took me a long time to understand what John was getting at here. Comprehension finally dawned when I was reading about the former physicists turned programmers, known as quants, who make exorbitant amounts of money in Manhattan.

These physicists create ever more complicated models of asset pricing which are then fed into equally complicated trading programs that watch the market and continuously make trades based on the models. At first, I assumed that the various hedge funds were competing against each other. This seemed bizarre, they were all doing the same thing, and no one seemed to have a competitive advantage, yet they are all making money. Then I realized: they aren't making money off each other, they are making money off you [and me].

This is why John called the 401k a bubble machine; by privileging this kind of investment accout with tax-deferred status [and perhaps more importantly, legitimizing it as the way middle-class Americans save money], a continual inflow of money to the stock market was ensured. 401k programs get money every two weeks [or whatever pay period you have], and then that money is invested per whatever plan the fund managers set out. I imagine there is a great deal of discretion involved, but to the high-volume traders, this must seem like easy pickings.

When I realized this, I did the only rational thing: I hired some quants to be my financial gladiators.

Innocence is No Excuse

Sometime in the mid-1980s, I was writing an article about a new regulation from the Securities and Exchange Commission having to do with the Glass-Steagall Act, the Depression Era law that separated the businesses of commercial and investment banking. I did not know much about the subject, so I called the SEC for clarification. They were actually very helpful. Toward the end of the conversation, however, I asked for a citation to the Act in the US Code. It was as if I had asked for a citation to the Code of Hammurabi. "We don't have information like that!" the woman at the legal division said in shocked annoyance. She hung up on me.

It is notoriously the case that the law dealing with securities has little to do with actual legislation and everything to do with regulation. The whole edifice of insider-trading law was based on a short, cryptic statute prohibiting "fraud." The Congresses that passed the bulk of financial regulation legislation favored broad terminology. The reason was explicit: a precise law would let traders ignore the broader policies of the regulators. It is, by the way, no accident that the Congresses in question are called "Depression Era": federal policy probably extended what would have been a short, sharp slump after 1929 to cover the following decade.

The chattering classes are in the mood for a replay. Both the president and vice president are hounded in public for acts not normally considered illegal. The vice president, indeed, is being sued by pretty much the same people who made Bill Clinton's life a litigious misery. Reams of legislation are rolling through Congress to criminalize "schemes" and "devices" that defraud investors in no very precise way. There was a moment, during the Congressional panic over the collapse of the savings & loan industry, when some nitwit introduced a bill to mandate life imprisonment for "S&L kingpins." We are approaching that level of inanity now, but the real danger is not more vindictive criminal law.

The class-action bar wants a piece of this. There was good money to be made during the early '90s in suits brought in the name of shareholders. Corporations were shaken down for hundreds of millions of dollars because their officers made remarks that did not perfectly predict the future behavior of the stock. Some shareholders may have gotten a cut, but the suits were essentially rackets operated by lawyers in search of class-action fees. In a fit of sanity, Congress made it harder to bring such actions. Now there is serious pressure to put things back the way they were, or make them even worse.

I can only repeat that there is nothing mysterious about what is being called the "accounting scandals." John Kenneth Galbraith once remarked that recessions reveal what the auditors missed. They also reveal what the auditors tried to cover up. When equity prices rise, businessmen are geniuses. When prices fall, businessmen are crooks. The crookedness this time around is that some businessmen used accounting and other devices to prevent their companies' stock from falling.

There are systemic problems with the financial system, but they are not the ones that people are talking about. Frankly, there is too much money in it. Ordinary people should not be using equities markets as a savings vehicle. Consistent high rates of return are possible when only a small fraction of the people are in the market. When more money is invested, it's worth less. The extreme case is Japan, which is drowning from overinvestment.