Thursday, January 7, 2010

Good Idea Coming

Original posted on the Baseline Scenario by Simon Johnson:

One striking aspect of the public debate about the future of derivatives – and how best to regulate them – is that almost all the available experts work for one of the major broker-dealers.

There are a couple of prominent and credible voices among people who used to work in the industry, including Frank Partnoy and Satyajit Das. And there are a number of top academics, but if they help run trading operations they are often unwilling to go on-the-record and if they don’t trade, they lack legitimacy on Capitol Hill and in the media.

The Obama administration is criticized from various angles – including by me and, even more pointedly, by Matt Taibbi – for employing so many people from the finance sector in prominent policy positions. But, the administration pushes back: Where else can we find people with sufficient expertise?

The defense sector faced a similar problem after World War II. The rising importance of technology in combat meant that the military needed specialized suppliers who would invest large amounts of private capital in developing tanks, airplanes, radar, and other types of equipment. But there was – and still is – a real danger that these companies would capture the Defense Department and push it to buy overly expensive and ineffective technologies (or worse).

President Eisenhower famously warned in 1960, as he was leaving office, about the military-industrial complex. His concise remarks were brilliant – look at the text or YouTube versions. And C. Wright Mills’ influential The Power Elite, published in 1956, put weapons suppliers at the center of our national power structure. (link: ; but this may be copyright violation.)

Constraining the power of defense contractors is a hard problem – and you might say that we have not completely succeeded, depending on your view of Vietnam, Iraq, and Afghanistan.

But, at least in terms of weapons design and procurement, we have made some progress in developing a set of highly skilled independent engineers – as argued by Larry Candell in the latest issue of Harvard Business Review (now on-line, but there’s an awkward page break; here’s an alternative link – look for idea #3).

Larry is an interested party – from a leadership role at Lincoln Labs, he explains that this organization provides an independent design and evaluation capability that is not government bureaucracy and definitely not a profit-oriented defense contractor. (Disclosure: Lincoln is part of MIT, where I work.)

Irrespective of what you think about the defense business, Larry’s proposal vis-à-vis finance is intriguing. He thinks the government should set up its own arms-length labs (or sponsor nonprofit research organizations to do the same) that would concentrate on testing financial derivative products in test bed-type settings.

This would not, of course, be the same as trading in real markets. But with today’s computer resources and plenty of unemployed finance talent at hand, it should be possible to develop individual people and a broader organizational capacity able to test the effects of various kinds of derivatives on customers, as well as on overall financial system stability.

The proposed National Institute of Finance (NIF) would have similar broad goals – and the National Institutes of Health is an appealing model – but as NIF is currently proceeding with industry-backing (e.g., Morgan Stanley, Bank of America), we should be skeptical.

We definitely need independent derivatives experts who can be called to testify before Congress or work in an administration. They must have a deep understanding of financial markets, as well as hands-on experience with products that are dangerous to our economic health.

It would be great if people from hedge funds or other financial institutions were willing to step forward and play this role – many of our best experts don’t actually work for the big banks. But while these independent people criticize eloquently the major broker-dealers in private, very few of them are willing to step forward in public.

Initial responses (e.g., by Stefan Stern, writing in the Financial Times) suggest that Larry’s idea may get some traction.

No comments: