Wednesday, March 30, 2011

Peltzman Effect

I learned about the Peltzman Effect today. It's when people react to a safety measure by engaging in riskier behavior. That riskier behavior leads to outcomes that offset the benefit of the safety measures.

Today, there was also this article in the NY Times about TARP. The article talks about the unfinished work of TARP, but I see the problem more as the unfinished work of financial reform as a whole. There were some bills introduced and passed that enacted some small measure of financial reform, but the regulations in the bills are small compared to the power of the institutions that they regulate. The uncompleted nature of this work is clear from the conflict that Elizabeth Warren is having with republicans right now. The idea that the consumers don't need some protection from the predatory practices of the financial sector is astonishing to me.

I finished No One Would Listen by Harry Markopolis and The Big Short by Michael Lewis recently. If these books made anything clear it was the total failure of regulation by the SEC or the private sector. The rating agencies appear to be no more than a joke. Ideally the negative outcomes of poor decisions are supposed to cause the financial institutes to self regulate, but that clearly did not happen. We factually know that this does not work because we witnessed it repeatedly during the Bush II administration.

I believe TARP eliminated the idea of moral hazard, which didn't work anyway but was supposed to have some effect, and now might be causing a Peltzman Effect. Markopolis argued that it would be better to have no government regulation than the current system because it misleads investors to think there is some form of competent oversight, but as Madoff showed, there isn't. So it would be better for investors to understand that noone makes sure the information they receive is accurate and correct, that statements they get are forged, and that the investments they make are real. If they went in knowing at any moment all their money could disappear b/c the whole thing was cooked up, it would be more honest and give investors the opportunity to assess the real risks of their investments.

But we haven't done that. The SEC seems to be amazingly incompetent, and somewhat corrupt. Its legal counsel was recently investigated b/c his investments in Madoff may have created a conflict of interests. It seems in the case of Madoff specifically, and CDO's in general, that there is an actual Peltzman Effect going on b/c of attempts to regulate the industry.

I don't think this means there needs to be less regulations, but I think regulatory agencies should lose their immunity from suit for failure to perform their jobs. I think there should be more ways for private enforcement of these regulations, and I think we need a new regulatory regime with people like Elizabeth Warren running them.


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