Weekend Economists Tickle the Ivories September 20-22, 2013

[Demeter]

2. Larry Summers’ Take on Efficient Markets and Regulators: Brilliance v. Idiots

IN WHICH BILL BLACK DEMONSTRATES WHO THE REAL IDIOT IS...STARTS WITH AN L, RHYMES WITH HAIRY...

http://neweconomicperspectives.org/2013/09/larry-summers-take-on-efficient-markets-and-regulators-brilliance-v-idiots.html

...Here is the preliminary reality test that any candidate to run the Fed should be asked: Do you agree that it is an untenable conflict of interest for examiners and supervisors to be employees of the regional Federal Reserve Banks, which are owned and controlled by the banks that the regional banks examine and supervise? Note that our Nation has already reached a policy decision that this type of conflict is untenable, which is why we ended the analogous role of the Federal Home Loan Banks as the employers of the examiners and supervisors. The long-time former head of Fed supervision told the Financial Crisis Inquiry Commission that the close ties to the member banks that the regional Federal Reserve Banks maintain harms supervisory vigor (Spillenkothen white paper). Any candidate who answers “no” to the reality test question has, at a minimum, failed to think serious about effective supervision. The crisis should have taught any thoughtful person that such gratuitous conflicts of interest are intolerably destructive.

In reading the arguments of economists who urge that Summers would be a superior regulator and supervisor I have discovered a common theme. Summers thinks the critical issue for a range of topics related to regulation is brilliance v. stupidity.

The key advantages of effective examination, supervision, enforcement, regulation, and assistance to prosecutions come when each of these functions is integrated under a comprehensive understanding of avoiding or terminating the criminogenic environments that produce the perverse incentives that drive our epidemics of control fraud and the resultant financial crises. This allows the regulators to avoid financial crises (as we did in 1990-1991 by ending an incipient epidemic of fraudulent liar’s loans in California). It also allows regulators to contain existing epidemics as we did with the overall S&L debacle. I’ll mention only four of the scores of steps we took because we understood control fraud mechanisms. We adopted a rule restricting growth. This struck the Achilles’ “heel” of every accounting control fraud. We also understood the distinctive traits that lenders engaged in accounting control fraud exhibit and used them to identify the worst frauds, and prioritize them for enforcement actions and closure, while they were still reporting record (albeit fictional) profits. We deliberately popped the bubble in Southwest real estate by cracking down on the frauds that were hyper-inflating that bubble. We ended the regulatory race to the bottom by prohibiting states from engaging in competitive regulatory laxity.

Summers, according to his supporters, sees none of these points. He comes from a very different perspective in which comparative IQ is the key explanatory variable.

“Mr. Summers is known for perhaps the most efficient rejoinder to the efficient-markets theory. ‘THERE ARE IDIOTS. Look around,’ he famously wrote in an unpublished paper.”

MORE AT LINK...WELL WORTH THE READ, IF YOU WANT TO UNDERSTAND TODAY, YESTERDAY, AND TOMORROW