Arnold Kling  

Technocratic Fundamentalism

Bond Bubble Watch... Mortgage Credit and the Housin...

Barry Eichengreen writes,

Those root causes were an ideology of market fundamentalism and the policies flowing from it. The idea that markets get it right and governments only get in the way, what I refer to here as market fundamentalism, is a powerful current in American thought...Even before the Reagan revolution, American anti-regulationist ideology had reasserted itself, and the policy pendulum had begun to swing in the other direction with the removal of Regulation Q ceilings on interest on the deposits and the elimination of regulatory restrictions on stock brokers' commissions. The Reagan Administration pushed the deregulatory envelope, albeit more in the nonfinancial than the financial sphere. In the second half of the 1990s the Clinton Administration and Greenspan Fed then rejected proposals for regulating financial derivatives. This was followed after the turn of the century by Bush policies weakening oversight of the financial-services industry and limiting the resources provided the overseers.

The upshot was a situation where mortgage brokers were allowed to originate subprime mortgages in the absence of meaningful regulatory oversight. Banks were permitted to minimize costly capital cushions and raise leverage to dangerous heights. They were allowed to further economize on the need for capital by shopping for ratings on complex derivative instruments concocted from those subprime mortgages. They were able to enhance those ratings further by wrapping the resulting securities in credit default swaps obtained from lightly regulated and poorly capitalized nonbank financial firms like the American International Group. None of this was socially-redeeming business practice, as we now appreciate. But the temptation was irresistible given the heads-I-win-tails-you-lose structure of executive compensation and absence of adequate regulatory oversight.

Given their inadequate resources, it is not surprising that the Securities and Exchange Commission and other regulators were unable to detect even blatant frauds like Harry Madoff...

Thanks to Mark Thoma for the pointer.

So, there you have it. One minute, you take away regulations that limit the amount that banks can pay on deposits, and next thing you know as surely as night follows day you've got mortgage brokers making shaky loans and AIG issuing credit default swaps.

I want to suggest that Eichengreen is an exemplar of the ideology of technocratic fundamentalism, which is the belief that progressive-minded experts get it right and free-market principles only get in the way.

Incidentally, I Googled "SEC budget history" to see if I could check up on the claim that Bush had starved the SEC and I found that Robert Murphy had done this eighteen months ago, and it turns out that the SEC funding and staff increased spectacularly under President Bush. Eichengreen never looked at the data, he just inferred, based on his technocratic fundamentalism, that if the SEC failed to catch Madoff, it must be because it lacked resources.

And is Eichengreen in favor of restoring interest-rate ceilings on bank deposits and re-regulating stock brokerage commissions? If so, then he should make such proposals explicit. If not, then he has no business talking about those deregulations as if they illustrate that market fundamentalists were running amok.

In my view, the most important regulatory failures were in housing policy and in bank capital policy. In neither case was there a clear-cut role for free-market fundamentalism. Housing policy had a variety of ideological influences. And in my view, bank capital policy went wrong primarily because of "cognitive capture" of the regulators. Both the private-sector and public-sector experts were in agreement that financial innovations, primarily securitization, allowed institutions to manage risk in ways that permitted higher leverage without threatening safety. That turned out to be wrong.

Was it that the regulators placed too much trust in the private sector, as Alan Greenspan testified? That may be part of the story. But government was heavily involved in making securitization central to mortgage finance and in making credit rating agencies central to the regulatory process.

If Eichengreen and others of who share his political outlook wish to make any headway with people like me, they will have to show that they have some indication that technocrats can make honest mistakes. Instead, if you blame all of the mistakes on free-market ideology, you come across to me as a technocratic fundamentalist, and you are only writing for people who share your ideological bubble.

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COMMENTS (21 to date)
Daniel Kuehn writes:

Three thoughts on the Murphy numbers (and I haven't read the article closely yet) -

1. He only presents a nominal dollar budget

2. We usually compare government spending to GDP - the relevant comparison here is probably the finance industry's share of GDP - which I believe grew considerably faster than GDP in this period, and

3. Note that the biggest jump is in 2003 and even Murphy points out that there was a discontinuity in 2003 in the way it was reported. I have no idea what that entailed, but if you look at the change before 2003 and the change after 2003 it's considerably milder (and again - this is before taking into account growth in finance or inflation) than the 2002-2003 change which may be all attributable to the reporting change.

I'm not sure how all this shakes out - I'm not saying Eichengreen is right, simply saying that some leg work cleaning up what Murphy started might be worthwhile.

Steve writes:

Who's Harry Madoff?

David R. Henderson writes:

"Who's Harry Madoff?" LOL.

John Hall writes:

Let's be clear, the SEC had received evidence from Harry Markopolos years before the Bernie Madoff fraud was eventually discovered. The SEC never "detected" the fraud; they willfully ignored it. They only did something about it because he came out and admitted it.

david writes:

He calls it "ideology of market fundamentalism", you call it cognitive capture. Is there a difference?

david writes:

"Let's be clear, the SEC had received evidence from Harry Markopolos years before the Bernie Madoff fraud was eventually discovered. The SEC never "detected" the fraud; they willfully ignored it. They only did something about it because he came out and admitted it."

That's right - Madoff's head was delivered to them on a platter. Their failure to act in that case might be sign of SEC incompetence, general fecklessness or regulatory capture, but I would suggest it's ultimately the result of something else - timidity. Anyone whose ever worked in a regultory agency knows that bravely striking out on their own is not something that they are temperamentally suited to.

Rob writes:

I'm more sympathetic to your side of this issue ("markets fail, use markets") than to Eichengreen's, but I find your tone much more flippant and snarky than Eichengreen's.

"If Eichengreen and others of who share his political outlook wish to make any headway with people like me…" - who said they wanted to make any headway with folks like you (us?) in the first place?

I'm disappointed.

guthrie writes:

Harry Markopolos + Bernie Madoff = Harry Madoff?

fundamentalist writes:
One minute, you take away regulations that limit the amount that banks can pay on deposits, and next thing you know as surely as night follows day you've got mortgage brokers making shaky loans and AIG issuing credit default swaps.

That's the same attitude I got from Sargent in the interview posted earlier.

The truth is that no free marketeer thinks the market gets anything right with massive state intervention. But technical fundamentalists do believe that the state always gets things right, unless it allows the market (the people) any freedom at all.

Justin writes:

@Daniel Kuehn,

1. Sure, but the SEC budget more than doubled from 2001-2005. That's way faster than inflation. Staffing rose by several hundred as well.

2. Given the data available, the SEC budget grew much faster than GDP over the Bush years.

3. Eyeballing the SEC budget chart, the growth rates for 2002, 2004 and 2005 were all double digits - 2002 looks to be ~25%. Much of 2003 spending surge was probably not related to the discontinuity given the 20% surge in full-time SEC staff.

At any rate, it's hard to see how we can accept "Given their inadequate resources, it is not surprising that the Securities and Exchange Commission and other regulators were unable to detect even blatant frauds like Harry Madoff..." as the correct reason for why the SEC failed to detect Madoff because:

1. Resources available to the SEC increased considerably during the Bush years, even allowing for some uncertainty surrounding the reporting change in 2003.

2. As david puts it, "Madoff's head was delivered to them on a platter". Very little resources were needed to detect Madoff, but those resources did need to be employed effectively and they clearly were not.

rpl writes:


The SEC's annualized nominal budget growth during the George W. Bush administration, according to Murphy, was over 11%. Just what do you imagine the inflation rate to have been during that time, such that it negates the apparent conclusion that the Bush administration gave the SEC a lot more resources than it had had previously?


Arnold's tone may be a little counterproductive, but I sympathize with the frustration he's expressing. It's a bit too much to listen to someone accuse you of ignoring the facts when they don't suit your narrative, only to do a bit of digging and find out that the speaker is (wait for it) ignoring the facts when they don't suit his narrative. I'm willing to forgive Arnold for venting a little bit of spleen over the matter.

What I'd really like to hear is what sort of response Eichengreen makes to Arnold's criticism. Would he acknowledge his error regarding SEC funding? Would it change his mind at all? Would he be willing to admit that technocrats have their fundamentalists, just like free marketers do?

Ted writes:

Market failure is always subject to the 'monday night quarterback' phenomena. Every time there is a clear market failure it's always easy to say after the fact that if the government did "x preferred policy" this could have been avoided. But that's pretty much useless. Anybody can do that. The reason I lean libertarian is not because I think markets work perfect. I don't. I think there are tremendous problems with markets. Disequilibrium, asymmetric information, credit frictions, bubbles, externalities and all of that. It's just I don't believe a government is either capable of making improvements and when it may be I lack the confidence it would be able to do so effectively (either due to information problems a la Hayek or due to special interest capture).

Floccina writes:

Don't Madoff's crime go back to before Bush was elected?

Pierpaolo Sommacal writes:

I don't understand how much money and people the SEC should have to do its job according to Eichengreen.
The OFHEO has more than 200 employees and $65 million a year of budget, and its job is just to look over Fanny and Freddy. As Warren Buffett aptly commented, "I mean, you know, I look at more than two companies."

According to wikipedia, the SEC had 3,798 employees in 2007. Since the Wilshire 5000 contains about 4000 companies (I believe), in proportion the SEC could have 400000 employees, and still be gamed.

They already seem to have about one person per stock.

Hyena writes:

He's right about market fundamentalists, though. The market often can't get something right and so it disappears from the market altogether or has only noisy price signals.

The notion that markets get everything right simply can't be true; we'd run into an EMH paradox the size of human history.

James writes:

By Eichengreen's definition, market fundamentalists are really rare! Odd that he should write as though the view he describes is so common.

I wonder what the pejorative is for the group who believe that humans, in or out of the government, often get things wrong and who also recognize that the consequences of humans in government getting things wrong are typically orders of magnitude worse that the consequences of humans outside of government getting things wrong.

Frank writes:

You here explain bank regulatory failures in terms of cognitive capture, but that concept by itself seems to provide only an ambiguous defense against the claim that the crisis was due to the market. The phenomenon of cognitive capture is an objection to the idea that regulators always know better than the market, but not so much to the idea that they know better than the market unless the prevalence of "neo-liberal ideology" inhibits them from doing their job, by convincing them that interference with the market must be counterproductive. It makes a difference in this context what "ideology" the regulators are captured by.

I understood the detailed reasoning of your explanation of the crisis to provide a stronger defense: If the problem with the capital requirements had been just that they were too low, this might come under the heading of "not enough regulation". But the central problem was less the absolute level of the requirements than the discrepancy between the requirements for two kinds of mortgages, traditional and securitized, with the riskier kind requiring less capital. It is hard to see this discrepancy as a matter of the quantity of regulation; it's just bad regulation.

The other important idea is that securitized mortgages have no natural buyer. Even if capital requirements were too low, the market left to itself would never have resulted in massive investment in securitized mortgages; that required the artificial incentive created by regulation.

fundamentalist writes:


The idea that markets get it right and governments only get in the way, what I refer to here as market fundamentalism


The reason I lean libertarian is not because I think markets work perfect. I don't.

Hyena: "The market often can't get something right..."

These all deal with straw men, which is a philosophical way of saying they're dishonest. No one in the history of fee market economics ever claimed that the market always gets things right. Market fundamentalists claim that a FREE market always gets things right. But they would all agree that a market distorted by state intervention will always get things wrong. There is no disagreement between market fundamentalists and technical fundamentalists on the efficiency of a distorted market: it is very innefficient and faulty.

fundamentalist writes:

PS, the whole point of the Austrian business cycle theory is that distorted markets fail. When the central bank distorts prices by manipulating the money supply (which changes all prices) then markets fail. The ABCT is a market failure theory. For technical fundamentalists to assert that market fundamentalists believe markets are always right is simply dishonest.

Jim writes:

My plumber neighbor runs a small business. Even his house is subject to forfeiture if his book keeper absconds with the money due to her cocaine habit. He gets hired because he does great and honest work; not greedy work, or selfish, screw you, you didn't think of it so I billed you more, work. That's the free market at work.

The banking system is in no way a free market, and it has not been so for a very long time.

I have 3 very simple suggestions that free markets, I believe, imply:
1) Anyone at Director or above, puts their private assets on the line if the company goes bankrupt. They are owners by proxy. That Skilling or Lay could plead ignorance is beyond the pale of free markets.
2) Raise bank capital requirements. Alot. Wholesale loans don't count.
3) Free markets depend on information. All transactions MUST be accounted for on the financial statements. Any OTC transactions therefore must be quantified and detailed. It really is that simple.

Some things can be argued. It doesn't mean they should be done. Elites are playing games with control, Balance sheet measurements, communication, and legaleze. These are all obfuscations of markets.

Beware if Joe the Plumber psychologically perceives the system is no longer fair. He will take his money out of the stock market and the level of corruption will explode. The economy will never recover. Word on the street is that it is already beginning.

I humbly encourage Mr. Eichengreen to reconsider. We don't need more regulation. We need transparent, fair, simple regulation. For banks, that also means boring, safe regulation. And it means failure means failure so that the rest of the organism remains engaged and the complex system can learn and adapt.

Milton Recht writes:

The SEC has structural, cultural and incentive problems, which lead the commission and its staff to focus on the wrong aspects of the securities and investment industry. These problems also make the SEC look understaffed and insufficiently funded. In medicine, the best medical care is preventive care, which stops an illness from starting. At the SEC, prevention is secondary to the number of enforcement actions and the amount of fines and penalties imposed on wrongdoers. Actions and fines against wrongdoers is the primary measure of the SEC's success. The SEC does not have any incentive to look at its fraud cases and develop any efficient algorithmic type of analysis that would prevent future fraud.

Congress rewards the SEC for the quantity of frauds it finds in a year, but not for preventive measures that deter the occurrence of fraud. Bernie Madoff is a good example of the structural problems at the commission that prevent the most effective use of SEC's resources to prevent fraud.

Madoff was an affinity fraud. An affinity investment fraud occurs when the duped investors are part of a cohesive group, such as members of a particular church, a local religious group, a charity, a social club, an immigrant group, a union local, a specific country or golf club, etc., and another member of the group refers them to the fraudster.

The referral by other members of the group to a specific investment adviser or investment vehicle allows the fraud to grow because new investors trust the referring members' judgment and that trust overcomes any incredulity, inhibitions and qualms that may exist.

Affinity fraud did not begin with Madoff and it will continue as a common fraud problem for the SEC. The SEC has prosecuted, fined and ended affinity frauds years before Madoff came along.

In all the years of affinity frauds prior to Madoff, the SEC did not implement procedures as part of its examinations of investment firms and advisers to detect affinity fraud. Simple questions could act as warning flags for affinity fraud, such as how do you get new clients? Do you rely on referrals? Where do most of referrals come from? Making these questions and verifying the answers as part of an SEC examination would deter numerous cases of affinity fraud because swindlers would understand that affinity group referral would create a warning sign to the SEC of potential fraud and open that adviser up to intensive scrutiny.

Similarly, in any year, about 80 percent of professional investors do not beat their investment vehicle benchmark index, such as S&P 500, etc. The odds of a professional investor beating the relevant investment index in multiple consecutive years are even lower. A string of several years of better than comparison returns should indicate to the SEC that things are too good to be true and that the SEC needs to conduct an in depth examination of that investment adviser. Advisers showing unbelievable returns would trigger intensive SEC scrutiny. Yet, the SEC does not compare the historical adviser's returns with a comparable index or even ask the adviser to report the comparison.

The SEC as currently structured will always need more resources and there will always be undetected large investment frauds because the SEC has little if any incentive to prevent fraud or to become efficient in its methods to detect fraud.

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