Asymmetrical Information

From the desk of Mindles H. Dreck:

On Regulation

Following up on my "impending verbose blog warning" entry yesterday, here is an attempt to provide a fuller answer to Thomas' first question:

1) Is there any form of regulation of which you would approve?

Central to my own belief system is the idea of the "Invisible Hand". Individuals, acting fairly rationally in their own interests will collectively spur us towards a greater good. Necessary to these individuals acting rationally in one's own interests, however, is a system of laws that:

1) frees individuals from coercion by the state

2) allows them to act independently in their own interests, including the assumption of personal risk

3) protects property - the tangible rewards for acting in one's own interests and the central mechanism of capitalism.

Regulations (as opposed to criminal laws), for the purposes of this argument, are laws that seek to protect a system from the risk of an individual or protect an individual from a risk he/she does not understand. So, by definition, regulations limit individuals' ability to assume risk, and compliance with them extracts a net cost to productivity.

Corporations, organizations and communities are groups of people freely associated (ahem). "Associations", as I will call them, come after individuals in my belief system, but they are important actors in society, and need the same property and freedom as individuals to function productively.

Our dynamic economy and free society are based on individuals and associations having the ability to innovate, enter into contracts and assume risk, including the risk of failure. Most great new ideas sound nutty (a personal computer?, said the IBM Watsons in 1979, following up on their earlier prediction of a world market for eight computers), and many are. The road called progress is bumpy indeed, because it is so often that we improve through failure and adaptation. Bankruptcies are a sign that associations are assuming risk. Schumpeter called it "creative destruction", Virginia Postrel incorporates this idea into her concept of "dynamism." No matter what you call it, I subscribe to a body of thought that suggests progress is obtained in a messy way, with much stochastic variation, or "noise", around an improving trend. In markets, we say prices are "discovered" in the short-term volatility of transactions and information dissemination. The discovery won't happen without the "noise", they depend on each other. One never achieves an absolute or final price; the market is only "correct" in that it moves in a jagged path towards a mutating truth. It gets better, it never achieves "best."

The development of this messy dynamism is responsible for at least 25 Miraculous Trends of the 20th Century. The assumption of risk and accompanying "creative destruction" conveys tremendous benefits to the general public. For example, Telecommunications investors (and employees) took tremendous risk and have suffered the consequences. But now the entire country, with a little shopping around, can get long distance at 2.2 cents per minute, as opposed to 15 cents six or seven years ago. Because these investors assumed great risk by buying and installing all that fibre, they ended up transferring almost the entire profits of the industry directly to consumers over a period of a few years. Companies beat each others' brains out and the consumer benefits. Employees find other jobs and it begins again. That's why I maintain that capitalism is the best friend the little guy ever had.

So my acid test for regulation is:

1) Does it interfere with the regulated individual or association's ability to take risk and reap the rewards?

If the answer is yes, the regulation better be a) to avoid a massive systemic calamity or b) protect other individuals from something amounting to theft.

The first category of acceptable regulations are those that improve transparency. If the parties to a contract have all the facts available to them, that actually facilitates the risk taking process. So regulations that improve transparency are positive. They have two drawbacks:

1) They can become cumbersome to the disclosing party (ever written a prospectus?)

2) At times the disclosed information may be a proprietary business advantage, so the disclosure regulation may amount to a taking of property. This is a subject for another day, but as an example, the disclosure of Long Term Capital Management's positions to the investment banking community substantially accelerated its demise.

The second category of good regulations are those that prevent theft. These are really criminal laws, but insider trading is an example. If you trade securities based on information that could not reasonably be obtained by a hypothetical New York Times reporter (that's the phrase they have used in insider trading cases to describe the standard, I don't know why they chose the Times) you have stolen from those who were not in possession of that information.

Regulations I find useless, almost without exception, are those that prescribe behavior. These actually hamper the individual's ability to take risk, as I suggested in my derivatives entry. An example I gave there was the insurance company facing the choice of buying credit risk directly, or buying a packaged security that transforms credit risk into a different form of price volatility - a portfolio of low grade bonds directly, or a portfolio of low-grade bonds packaged and enhanced in a Collateralized Bond Obligation. Regulations make the choice academic, they encourage the CBO purchase. Regulations say "junk bonds bad, CBOs good!".

In a rational world, this choice isn't about the type of security, it's about the price for crying out loud! Depending on the price, the low-grade bonds may pay more per unit of risk than the CBO or vice versa. In fact, if enough investors were to arbitrarily eliminate any one category of security, that security will, as a direct result, offer tremendous relative risk-adjusted returns due to its distorted demand curve. If nobody wants rex cats but you, you are going to find great deals on rex cats - at least as long as there is a supply.

What you want is investors trying to figure out what the price for risk is and finding the best deal. Then the market works. We need individuals out there intelligently assuming risk, rather than having the choice dictated by an all-foreseeing regulation.

Otherwise regulation produces a kind of reversion to the minimum, or a lack of competition on quality. When the government prescribes certain behaviors, you tend to get only as much as is required to get the official seal of approval (i.e. in banks, the deposit insurance or the charter). The gradations of risk by which some customers might judge a bank go out the window and risk becomes binary - risky/not risky; government-approved or not government approved.

Behavior-prescribing rules and regulations tend to cultivate the bad behavior they implicitly expect. In a way that's what's happened to audits - the market began sort of checking the box - "clean opinion from major firm"? OK, books are good, next question.

On the other hand, if companies start to compete on how transparent their books are (and that process is underway with a vengeance), the sky's the limit, and the bar will be raised for the whole population. So I think behavior-prescribing, risk-reducing regulations assure static equality more than dynamic improvement.

I reject as destructive regulations that attempt to protect individuals from themselves, i.e., tell them what risks they can assume (how to invest their retirement funds), with whom they may enter into associations, whom they may hire to perform certain services, how the governance of their associations must work, what sorts of people they have to hire, or how they must interact with customers. Rules should not pervert the behavior of individual actors by limiting their risks or rewards in a material way. In attempt to achieve a social agenda or "smooth the ride", these regulations interfere with risk assumption, personal freedom and the proper functioning of the market. So they interfere with progress.

I hope that makes a little sense. On to international rules and treaties, and the importance of sovereignty later….

Posted by Mindles H. Dreck at February 6, 2002 10:31 PM | Technorati inbound links