Regulation that works

It seems that everyone wants to know how anyone could be so clever as to run a fifty-billion-dollar Ponzi scheme without the SEC — which has seemingly limitless power and resources at its disposal — ever noticing. After all, if the government couldn't protect people who could? The answer is simple: the free market.

This is not a case in which free-market proponents are forced to theorize countless what-if scenarios regarding a solution that would not involve the government. The free market did spot the problem; it even reported it to the SEC. Perhaps unsurprisingly, all of the warnings were ignored by the SEC, which failed its fiduciary obligation to investors.

Due to the lack of government intervention and regulation with respect to hedge funds, consumers demanded some sort of policing of hedge funds in order to protect investors who lack the knowledge or resources to properly investigate the funds in which they plan to entrust their money. The free market responded to the consumer demand and so-called "due-diligence firms" emerged. Individuals seeking to invest in a hedge fund frequently pay one of these due-diligence firms for their opinion about specific hedge funds.

Due-diligence firms use the fees collected from their clients to hire professionals to meticulously review hedge firms for signs of deceit. One such firm is Aksia LLC. After painstakingly investigating the operations of Madoff's operation, they found several red flags. A brief summary of some of the red flags uncovered by Aksia can be found here. Shockingly, Aksia even uncovered a letter to the SEC dating from 2005 which claimed that Madoff was running a Ponzi scheme. As a result of its investigation, Aksia advised all of its clients not to invest their money in Madoff's hedge fund.

Private regulation works. Government regulation works once in awhile but very rarely.

What really doesn't work is pretend government regulation. When the regulators don't regulate everyone gets screwed.

I want to invent a term: defensive capitalism. You must assume every transaction could be rigged, every deal could go sour, and that in every instance you must take defensive measures.

This is the only way capitalism can work. It doesn't "just work" as if by magic or the "invisible hand of the market". It works because people exercise care and due diligence when they know they are taking risks. It's when we get complacent and think that the markets "just work" without our own individual involvement that things go sour.

What about the bond rating agencies? Wasn't that private due-diligence?

Indeed it was but with one key difference. The bond rating companies were paid by the people creating the bonds. That's called a "conflict of interest." So you can't just trust anyone who claims to be doing due-diligence. You need to understand where they get their money. Underwriter's Laboratories doesn't take any money from anyone who has a product they might test. The UL seal has value. But just because it's reliable today does not mean it will be reliable tomorrow! UL might start taking money from the companies whose products they test.

Bernie Madoff had a stellar reputation. But you have to be like W.C. Fields: "Trust everyone but always cut the cards." The bond rating agencies were reliable until they started taking money from the wrong people.

The biggest risk of all is allowing the government to print money. Fed Chairman Ben Bernanke has used similar language before, explaining in a 2002 speech—when he was a governor on the Federal Reserve Board—that "the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

Unfortunately Mr. Bernanke is wrong - there is a cost and the people that pay that cost are the ones at the end of the supply chain. The people that benefit from the printing press are those that receive the money first. By the time that money reaches you and me it has "trickled down" so much it has lost value. This is inflation - prices go up faster than your wages go up and you end up way behind the curve.

I don't know if you remember, but it was not always the case that it took two wage earners to maintain a family. The reason that is the case now is that inflation has gone up 100% since about 1984. Wages have not gone up 100%. Instead, most households have two income earners.

I know talking about money sounds very hypothetical and perhaps even nonsensical. Money is just money, you think. We have to have money, and obviously it has to be controlled by the government! It just seems like common sense. Unfortunately it is wrong.

There is a long history of government failure caused by simply printing too much money. It appears to solve some problems in the short term but the result is always another bubble and as each bubble pops there is less and less real value in the money you hold.

Inflation encourages people to borrow - let's buy something now before the price goes up. I've heard this statement so often recently that it is taken for granted that this is somehow a good thing - that it stimulates the economy. Well, caffeine stimulates you, but you'd better catch up on your sleep later. You can't just keep taking more and more caffeine and the economy can't just keep having money pumped into it.

If it was true that no one would buy anything without the threat of the price going up in the future then the computer business as we know it would not exist. Computer value per dollar goes up at least 100% ever 18 months and still people buy computers even though they know the price will go down. Nobody has to trick anybody into buying a computer.

If the Fed or the Treasury or the Congress is creating money (primarily by allowing huge amounts of leverage) then it is inevitable that some de-leveraging must take place, just as you can't keep breathing in without breathing out. The people close to the money printers don't much care what happens until they get killed by deleveraging. Then they want a bailout. And they get it.

This is wrong and you should be outraged! I know you're not. It all sounds esoteric. I don't want a crash - who does? But would you rather crash your car going 10 mph or 60 mph? The Fed wants to increase the velocity of money. This sounds good but it is bad. People in markets trade at the rate that they feel comfortable. If some people are artificially stimulated to push money around then we get an artificial bubble. It's that simple.

I have no way to end this rant ... except to say ... inflation is not good! Don't believe it when someone tells you that it stimulates the economy in a good way! It's not true.

It's just not true.

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© 2005-2008 Stephen Clarke-Willson, Ph.D. - All Rights Reserved.