Quis custodiet ipsos custodes (after they retire)?

Nassim Taleb has a thought provoking blog on the subject of gamekeepers turned poachers at the Huffington Post. Specifically he deals with regulators who use their in-depth knowledge of government regulations to secure extremely well paid employment, helping firms sail as close to the regulatory wind as possible, upon leaving public service. At Davos last year, Taleb was approached by Alan Blinder, a former Vice Chairman of the Federal Reserve Bank, who attempted to sell him a financial product that in effect leveraged regulatory arbitrage.

Tell me if you understand the problem in its full simplicity: former regulators and public officials who were employed by the citizens to represent their best interests can use the expertise and contacts acquired on the job to benefit from glitches in the system upon joining private employment — law firms, etc.

Think about it a bit further: the more complex the regulation, the more bureaucratic the network, the more a regulator who knows the loops and glitches would benefit from it later, as his regulator edge would be a convex function of his differential knowledge. This is a franchise. (Note that this franchise is not limited to finance; the car company Toyota hired former U.S. regulators and used their “expertise” to handle investigations of its car defects).

Taleb gives some insight into why this is a serious issue. It not only allows private companies to subvert the spirit of regulations, but also skews incentives for regulators while they are still working for the state.

First, the more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.

Second, the difference between letter and spirit of regulation is harder to detect in a complex system. The point is technical, but complex environments with nonlinearities are easier to game than linear ones with a small number of variables. The same applies to the gap between legal and ethical.

Third, regulation, like drugs, has side effects, and like drugs, it can harm the patient — something in my work I call the iatrogenics (harm done by the healer). People do not mention that regulation helped promote the Value-at-Risk method of risk measurement in replacement to age-tested heuristics — these methods blew up banks.

Fourth, we need a more severe monitoring of the activities of public officials and a solution to the following conflict. In African countries, government officials get explicit bribes. In the United States they have the implicit, never mentioned, promise to go work for a bank at a later date with a sinecure offering, say $5 million a year, if they are seen favorably by the industry. And the “regulations” of such activities are easily skirted.

The financial crisis we have just lived through, and are struggling to recover from, was caused in large part by regulatory failure. These issues matter. Given that, what should we do about them?

Should regulators and other government officials be prohibited from taking up private sector employment on retirement? If not, should an internal team monitor the activities of former government employees for ethics breaches? And, if so, who will guard the guards?

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  • Alias

    “The financial crisis we have just lived through, and are struggling to recover from, was caused in large part by regulatory failure.”

    Actually, it was caused by regulatory success. The system worked as it was designed to work. The EC decided that the EU needed extensive economic growth to counterbalance the emergence of progressive economies that prosper through policies and conditions that no longer apply within the backward EU. The EU’s share of global GDP is in free-fall, collapsing from 27% in 2000 to a projected 15% by 2018. According to the EC, the EU’s share of global GDP will be 10% by 2050. In other words, 90% of the world’s GDP will be generated outside the EU. Hence, the little scamps panicked.

    The result of the panic was expansionist monetary policies from the ECB aimed at promoting economic growth within the EU by flooding consumers with cheap credit. This required the EC to allow EU banks to overleverage from an undercapitalised base in order to supply the demand for cheap credit that was to be engineered by the ECB. How did they do this? Very simple. The issued the European Capital Requirements Directive (EC directives have the status of law in all EU states) that allowed EU banks to borrow as much as they liked irrespective of their undercapitalised base. Hence, EU banks are now the most overleveraged in the world and EU consumers are the most indebted in the world.

    It’s just a shame that consumer demand is now curtailed by restricted credit and consumer debt, so the policies of the EC and the ECB will accelerate the projected economic decline within the backward EU rather than reverse it.

    While the outcome may have been the opposite of what the unelected regime intended, the system undoubtedly worked exactly as it was designed to work, i.e. folks borrowed the cheap credit and consumer demanded increased while the cheap credit was in supply (a 7 year period).

    “Should regulators and other government officials be prohibited from taking up private sector employment on retirement?”

    The state has no right to direct folks toward particular career choices or away from them.

    “And, if so, who will guard the guards?”

    No one will guard the guards because folks have made that post-democratic. The EC and the ECB are not elected by Irish people and are not accountable to them for their policies, practices and regulation.

  • Anon

    @Alias

    Actually, it was caused by regulatory success. The system worked as it was designed to work. The EC decided that the EU needed extensive economic growth to counterbalance the emergence of progressive economies that prosper through policies and conditions that no longer apply within the backward EU. The EU’s share of global GDP is in free-fall, collapsing from 27% in 2000 to a projected 15% by 2018. According to the EC, the EU’s share of global GDP will be 10% by 2050. In other words, 90% of the world’s GDP will be generated outside the EU. Hence, the little scamps panicked.

    Fantastic way to manipulate a statistic, there. If China is growing at a fast rate from a low base, and India is growing at a fast pace from a low base and all sorts of other palces are doign the same thing then

    1. There is literally *no* way a mature economy can keep up with that pace
    2. This obvious results in Europe accounting for a smaller share of the World Economy
    3. The pie that Europe is a percentage of is much bigger, and that smaller percentage could still imply better living standards.

    Maybe it won’t, but stop abusing stats. It’s tantamount ot lying.

    @Mack

    Things are actually worse than that. I’m reading Gillian Trent’s “Fool’s Gold” at the moment, which is an account of how the crisis developed. One of the ratings agencies released their modelling software to show how transparent they were, and the banks proceeded to game it. Some hedge funds were essentially reverse engineering and gaming the banks models. There is roughly nothign that wont be gamed in pursuit of a buck.

    Paul Krugman (sorry Alias) had a great analogy on reulation I thought:
    http://krugman.blogs.nytimes.com/2010/03/26/greeks-romans-and-financial-reform/

    Greek armies theoritically had advantages that better commanders could use but the Romans had a system that was more easily applied even by poor ones. The Romans won out.

    We know that

    (1) There will be another crisis
    (2) Banks and other players will try to game the system
    (3) The mechanism will be different from last time
    (4) Complexity and conflict of interest are dangerous
    (5) There will be constant pressure to cave on / cut regulation.

    We need to work a set of generalised principles from that dampen generally, are hard simple enough they are difficult to game and are restant to pressure. There might be a cost in terms of growth for it, and ti won’t catch absolutely everything but it would be worth the price for stopping the most catastrophic effects.

    There are some analogies to testing big IT systems, I think 🙂

  • Alias

    “Maybe it won’t, but stop abusing stats. It’s tantamount ot lying.”

    And stop making hysterical accusations. It’s tantamount to being a tit.

    There is no abuse of statistics whatsoever. The statement is absolutely factual: “The EU’s share of global GDP is in free-fall, collapsing from 27% in 2000 to a projected 15% by 2018. According to the EC, the EU’s share of global GDP will be 10% by 2050. In other words, 90% of the world’s GDP will be generated outside the EU.”

  • Alias

    To add to that. One of the reasons why the EU has failed to capitalise on the subtantial head-start that developed states gave to it in dominance of global GDP is its dismal fetish for regulation that renders once innovative and dynamic industy uncompetive and uneconomical. That handicap imposed on European business by the EU makes them as backward as the EU itself. For example, the cost of regulating the single market adds 600 billion euros a year onto business costs in member states while the benefit of the single market to business only amounts to 160 billion euros, so the disadvantages of the EU to European business outweigh its advantages by a factor for 4 to 1. That additional cost of 440 billion a year makes European uncompetitive, with the cost of EU regulation being carried by the consumers of EU goods and services.

  • Anon

    Simple example

    A 5 trillion 50%
    B 4 trillion 40%
    C 1 trillion 10%

    C is the rest of the world, more people but small economies. 10 years of extraordinary growth there but low, medium growth in the others:

    A 8 trillion – 40%
    B 6 trillion – 30%
    C 6 trillion – 30%

    B lost 10%! OMG!! Yet it still grew and people may be better off in per head figures. All you have said is that China, India and other developing economies are growing rapidly. Maybe that drop is bad; maybe it isn’t. You haven’t provided enough to judge.

    So yeah, abuse.

  • Alias

    Anon, you sound a little, emm, odd. If you are trying to make the argument that the reason the EU’s share of global GDP will have collapsed by 40% in under two decades is because the rest of the world’s GDP will have expanded by a corresponding percentage then why don’t you produce the data to support your claim?

    It isn’t much of a counterargument to merely suggest such a thing is possible and leave it at that. Indeed it is possible. At any rate, you would still be refuting a claim that was only made in your little head and projected into my text if you bothered your backside to surpass your voodoo thinking and produce said data.

    My claim is that the EU’s share of global GDP is collapsing because the EU is a backward region of the world that has failed to capitalise on its substantial head-start over the global competition with its fetish for over-regulation making its industry uncompetitive and stifling innovation, and that the 600 billion a year that its regulation imposes on European businesses ensures that consumers of good and services look to non-EU regions which do not have such an expensive fetish to supply those goods and services. Indeed, it if wasn’t for naked protectionism disguised as certification (the CE mark) preventing the free import of goods into the EU then the EU would have virtually zero manufacturing left. Plus, of course, its bad regulation – and not the absence of regulation – that led directly to the perilous state of its banking system.

    Now ponder this: if injecting 1.67 trillion of cheap eurosystem credit into the Irish economy floated all boats, where will those boats be when extracting that 1.67 trillion of cheap eurosystem credit from the Irish economy plus interest in debt repayment leave those boats? The ECB has been telling us for most of the decade that borrowing money from the eurosystem and spending it creates wealth in the borrowing economy. That’s grand. So what does paying it all back do to an economy? Of course if the ECB got it wrong and its macroeconomic policy didn’t create the wealth but rather caused the vast bulk of it to vanish in a plethora of expansionist bubbles, then does the ECB have a theory about that? Let’s hope so since this country now needs to generate several hundred billion of wealth in order to replaced the vanished wealth. Isn’t the ECB wonderful? 😉

  • Alias

    Incidentally, a good example of the stagnancy that is created by EU integration is observed in the Irish economy. It’s exports are now more than half the level in real terms than they were before it joined the Eurozone. The non-EU regions of the world soar ahead in the last decade while the EU falls further and further down the global rankings to the point of utter irrelevancy in the new world order.

  • Alias

    Incidentally, talk about what type of banking regulation is needed to prevent a recuurance of the last decade of cheap ECB credit is so far detached from economic reality as to be sublimely comical. There is some undercurrent there that sssumes that Irish credit consumers could enjoy another decade of cheap ECB credit wherein the external debt of 1.67 trillion could double or treble. In reality, the Irish banking system will only be leant money that is needed to repay the short-term debt its owes to the eurosystem and whatever the government can guarantee so it is very much self-regulating on the lines of ‘there is no money and we can’t give you what we don’t have.’ That is how it will be for the next 30 or 50 years – which is the lenght of time that it will take the economy to partially recover from the ECB’s expansionist monetary policies.

  • slappymcgroundout

    “The incentive of a regulator is to have complex regulation.”

    False. The incentive of the regulator is to have the regulation(s) a tad vague so that there’s room to argue that what is claimed to be prohibited is indeed prohibited. For the irony, such is precisely owing to the reality that the tad bit vague allows the “spirit” of the law to triumph over the (vague) “letter” of the law.

    Lastly, Alias is right re the credit expansion. See:

    http://www.moneyweek.com/news-and-charts/economics/why-the-us-credit-machine-is-running-amok.aspx

    Note the date. Our friend saw this one coming from a mile away.

  • Munsterview

    George Bernard Shaw described all professions as a conspiracy against the laity!

    Some years ago in Cork University in the course of a question and answer session following a lecture on property law, a bright young thing ( obviously not from a legal background) queried the lecturer as to why ” these laws could not be drafted in layman’s language ”

    There was a moments stunned silence, the guy was seated towards the rear of the theater, most there were from law families, all turned around to see this odd ball, then all hell broke loose.

    In a few minutes the lecturer scathingly informed him of the need to keep the language arcane and the procedure complex to basically fleece the public as the property area was the bedrock of most legal practices and consequently there was a need to keep it as financially lucrative as it was possible to be! The reasons were not legal but financial.

    Public gamekeepers turned poachers have a long history in Southern Irish politics in particular, it is not unknown for a former financial ministers, especially those of legal background once in opposition and while still in the Dail to begin advising on ways to circumvent the very acts they sponsored while in office.

    Most of the general public would consider a TD to have their first loyalties to the State that pay their wages and that they are legislators for, yet there is no acknowledged conflict of interest!

    I do not know what the current conventions are or how long ‘decency’ require a former minister to refrain from these practicesonce out of office. While the Late John Kelly former AG had grave reservations about the practice of such immediate changing sides on changing office, he was a lone voice and he readily admitted to me that there was no appetite to alter the system.

    On vested interests, how many of the public are aware of a practice where at the start of the year, a commercial company will give a retainer for a ‘consultation’ to not alone a Senior Council or Council but to all specialized legals on that particular field?

    This means that when a member of the public want to sue a major commercial firm they quickly find that the best in the field have already been ‘consulted’ by the firm concerned and cannot act because on a conflict of interest!

    The ‘Big Beasts’ can command equally big ‘retainers’ and these nice little earners effectively buy out the top expertise leaving only the mediocre and the harmless available for complex case. The beauty of this system for the top tier legals concerned is that in the absence of their involvement in actual live cases they may be ‘consulted’ by dozens of commercial or other concerns at the same time.

    No surprise then that the law in Ireland, in financial or other areas, far from serving the public is the possession of the super rich and that there is such widespread corruption when recourse to law is stymied by complicit law practitioners themselves.

    What are these ‘retainers’ if not institutionalised bribery and corruption ? Same with most other professions where there is an interface with money and politics. Excluding these areas how much public life remains?

    Real curbing regulations in this area anytime soon? We are far more likely to see a United Ireland first!

  • Anon

    You are confused, Alias. You are asserting, not me. Note the “My claim is….” section. European growth is typically lacklustre but it remains a fact that other parts of the world are expanding rapidly from a low base. Show me the money rather than a rant, boss.

    Do your own research.

  • Mack

    Indeed, it if wasn’t for naked protectionism disguised as certification (the CE mark) preventing the free import of goods into the EU then the EU would have virtually zero manufacturing left.

    Unlikely. You can’t protect export markets with internal standards.

    Export figures for 2009

    $1.057 trillion USA
    $1.202 trillion China
    $1.74 trillion Eurozone

  • Mack

    There is far too much protectionism in that area. In the UK you don’t need to be a lawyer to do conveyancing. The costs are fraction of what they are in Ireland.

    Why do we need to pay lawyers several thousand euro to buy and sell a house?

    God forbid they ever get in on the groceries market!