Skin in the Game

Picking just one quote for this post was not easy!

The post hoc rationalizations accompanying the tenth anniversary of the invasion of Iraq got me thinking about ways to discourage conflict except in the most serious instances. Given the necessary (for classified source reasons) information gulf between our leaders and the general public, any such disincentive must occur at that level. I propose the following: a chance of death. Once the conflict is over, those in our government that voted for war should have to go through a lottery in which they may be picked for execution. The likelihood should be linked to the costs of the war (both human and financial) and perhaps any disparity on that score from what the public was told to anticipate. Obviously, such metrics would need to be very careful considered, and the exact details are beyond the scope of this post, which assumes for the sake of discussion that such a formula is possible. This measure would have a chilling effect on entering into war lightly and discourage optimistic portrayals of the sacrifice being considered. It seems entirely reasonable to expect those asking others to potentially lay down down their lives to risk their own.

Well Regulated Militia

Flawed though the test may be, the takeaway is valid.

I have previously blogged about crowd shootings and even touched on the topic of this post, but feel it warrants expansion. While I am choosing for the purposes of brevity to ignore increased regulation of access and storage of firearms and also improving our mental health system, I wish to make it clear that this is not because I discount them. When tackling complex issues, one should consider all the available tools. What I am choosing to focus upon is the frequently mentioned notion that having more armed individuals will somehow reduce deaths from gun violence overall. This concept is usually accepted uncritically by gun advocates and rejected as unrealistic (based on statistics showing a small number of justifiable shootings relative to accidental ones) by proponents of greater gun control; what I wish to consider is what it would take for this to actually be a credible notion.

What seems to be frequently absent from such conversations is proper emphasis on the need for training; just carrying a weapon will not make you a competent combatant. The ability to keep calm and accurately engage an armed opponent, let alone several, is extremely demanding, necessitating a high degree of training. That is true even in a home defense scenario, and if one considers the context of public defense, the difficulty is magnified many times. Your opponent may well have superior firepower (and other equipment) to what you can reasonably have with you all the time and the safety of bystanders is vital. Indeed, there will be some situations where no responsible armed option by a lone individual is possible for fear of injuring others. Gun owners who seriously intend to act in such a capacity need to have training on a par with police and it needs to be ongoing since such skills are perishable. This would be a significant commitment, which would seem at odds with the number of individuals required so that their presence would significantly add response capacity; if they can’t respond appreciably quicker than the police, it makes little difference. So we'd need a large number of highly trained, certified, armed citizens for it to make much of an impact. This sounds very much like the "well regulated militia" the second amendment references (save for the for the fact that they would usually be acting alone) and would represent a great departure from the status quo of often casual gun ownership. One could argue that dedicated security guards might fulfill this role, but that gets away from the idea of armed citizenry and thus is beyond the scope of this post.

It would be easy to interpret my observations as an outright dismissal of the entire prospect, but that is not the case: while all options should be considered, there is no value in unrealistic schemes. The ratio of good actors to bad would have to be very high for it to be a significant net positive, which makes improvements in the other areas I mentioned in my introduction vital for any such possibility, as it takes virtually no training to attack unarmed civilians and accidents do happen. Human lives are not like a Wikipedia article: you cannot simply undo the damage of a malicious few with a well intentioned many (especially if they’re not qualified), and even Wikipedia must impose barriers to access from time to time.

Bandwidth Anti Net Neutraility Argument is Flawed

Network providers who oppose net neutrality claim that without the ability to prioritize traffic based on content their networks will be overwhelmed. Of course there are serious conflicts of interest that go along with that capability such as banning Skype traffic so as to encourage sales of the provides VOIP service. If the problem is a crowded network, it makes more sense to charge users based on the amount of bandwidth the use. Since many providers are already exeperimenting with such schemes, their argument against net neutrality appears disingenuous.

Should Financial Reform Have Come First?

The Obama administration has attempted to use the financial crisis as leverage towards tackling health care reform, but it's possible that financial reform should've come first. With the economy improving a lot of the impetus for reform is already waning and a recovery of some kind was not entirely unexpected. Additionally, all the expenditure on bailouts has made the discussion of further public funding of any large initiative more difficult. Health care under the current system is only going to get worse, so time isn't a factor on that score. These factors seem to indicate that regulatory reform should've preceded health care and we're already seeing a considerable retreat on my areas of reform. Perhaps the Obama administration was counting on continued high unemployment (as it's a lagging indicator) to keep up voter outrage and maintain pressure on legislators. Since large deficits and an aversion to spending will persist for some time, it may have been seen that there was no benefit to waiting on health care reform and capitalizing on honeymoon period popularity was the best strategy. I find myself extremely skeptical that their decision was the correct one.

Executive Pay is a Multi-Part Issue

There are several problems with executive pay as it currently exists:

1) Too great as a percentage of company expenditures
2) Rewards short term risk taking
3) Punishes failure unreasonably

I would argue that the first isn't a subject of typical financial regulation, despite the fact that it gets the most popular press. It's mostly a question of competition and efficiency, which I think should be addressed in another manner (bigger post to come, I promise). Linking pay to long term performance is discussed somewhat, and while there are a variety of mechanisms to achieve this, the important feature is that a sufficiently large percentage of compensation is to linked short term performance, which allows fraud and risky behaviour to prosper. The third issue receives the least attention and relates to the ubiquitous practice of "one strike and your out" seen throughout most of the financial industry. While many attempt to defend this approach as a feature of a true meritocracy, it ignores the effect of chance. Investing is far from an exact science and luck undoubtedly plays a huge part in success. By overemphasizing any mistake whatsoever, the reward incentives are skewed in an nonconstructive and possibly risky manner.

News and Opinion Separation & News Accreditation

Like you didn't already know who I had in mind?

It is now common practice for opinion pieces and news stories to be closely juxtaposed and this has the effect of confusing less sophisticated viewers about what is actually fact. There should be strict limits on the placement of the two types of content (disclaimers wouldn't be adequate), ideally limiting them to entirely different programs. Additionally, outlets claiming to present news should have to be certified. On a regular basis polls should be taken about their viewership's knowledge of current events, much as some private studies do now. They'd have to be properly sized and controlled for statistical significance, of course. Any program failing to meet a minimum threshold could not call itself a news program. They could still present any content they like, so it's not really censorship, but rather much more like truth in advertising.

As a further extension, news programs shouldn't be allowed to generate revenue in the usual manner. Instead, any compensation received should be a function of not only audience size, but also accuracy measures. Any program labelled as news should be required to use this system. The gating accuracy measures mentioned previously would still be needed, as there can be motives other than profit for disseminating false information.

Financial "Prescriptions"

The recently enacted consumer protections for financial products seek to outlaw deceptive or difficult to understand investment vehicles, but they have drawn criticism for limiting the choices available to more sophisticated investors. One common analogy used in reporting the restrictions is to liken them to prescription drug controls. If we extend that analogy, I think that there should be three classes of investment products: simple, transparent ones (over the counter), controlled ones requiring a certified financial advisor's written approval (prescription), and those that are simply outlawed (snake oil). Having an inbetween classification would help ease the difficult decisions as to what is and isn't acceptable and still gives companies an incentive to simplify products as the need to seek financial advice constitutes a barrier to entry. I see it as an attempt at demand side financial reform, rather than supply side, which usually gets the most scrutiny. Had such a system existed prior to the housing boom, not many sub prime mortgages would have been sold.

Microsecond Trades = Insanity Indicator

There is extreme competition to execute stock trades in less and less time. The small changes in value that can occur while an order is pending can add up to serious money. This has become an arms race because as the ability to cram more trades into less time increases, the amount of fluctuation that can occur over brief periods becomes greater. Execution times on the order of microseconds are now possible, with no sign that further decreases aren't on the way. Ignoring for the moment the unfair competitive edge such systems give the large institutions that can afford them, I see the entire drive as proof positive that our speculation markets are insane. There is no way to interpret buying and selling that holds times that tiny as being anything in the slightest bit constructive, caring at all about the development of companies, products, or technology. It is gambling (at best, insider trading at worst) in its most naked form and should be eliminated. Not only should quick turnaround on stock be discouraged, but the trades themselves should be randomized and delayed in order to make extremely time sensitive trading impossible. I would like to see minimum delays of a least a day or two, with a random component of the same order. Another possibility is that orders are sold off across an interval so that the sale price is effectively time averaged. Many will complain that limiting transaction speed will reduce liquidity, but how is that beneficial in this instance? Because it allows more people to make extremely speculative and fundamentally unproductive exchanges faster?

What If Striking a Balance with Traditional Regulation Isn't Possible?

This is a combination and extension of posts on my private blog from February 16th and April 9th, 2009.

A common concern in devising financial regulation is that you want to make it comprehensive enough to cover future instruments that may be developed and to eliminate loopholes, while not destroying the opportunity for innovation. By grouping financial instruments by similarity of principles you can make some broad generalizations, but since investors are extremely adept at exploiting loopholes, I think this approach is doomed. Clamp down to cover all contingencies and you stifle innovation, ease up and the loopholes undermine your original intent. Since it's so difficult, I decided to explore the situation where one assumes that it is in fact impossible and then see where that led in devising a regulatory framework. What follows is one possible approach.

Those mechanisms that have a proven track record and are well understood can have tailor made controls, but I'm constrained by my working premise from specifying controls on less well established financial instruments. That being the case, I have no choice but to concentrate on limiting their potential for damage. One way to do that is to require that unregulated investments be backstopped by holdings in the regulated sphere. This is similar in spirit to the capital requirements imposed on banks now and guarantees that even if things blow up the bulk of the market will not be crippled. Completely exempting some instruments from oversight may seem extreme, but remember the working premise is that this is effectively what occurs anyway via loopholes. Over time new innovations that are fully explored and have well developed track records can have appropriate regulation crafted for them, not only removing the backstopping requirement, but allowing them to backstop other unproven investments.

The incentives for firms is changed under this arrangement. Rather than trying to come up with opaque ways around existing regulations, there is benefit to providing a clear theoretical explanation and real world data for new inventions in order to expedite their regulation and official sanction. Obviously companies could attempt to evade the backstopping requirement by hiding economic activity, but since that's theoretically a way to evade any system of regulation I'm not going to explore it specifically.

There is a practical advantage to having a specific ratio of regulated to unregulated assets as it's an easily manipulated parameter that can be changed with market conditions. Compare this to the current system: having congress change whole regulation systems in very specific and involved ways. Usually, small changes are introduced as complete overhauls are too difficult to achieve, leading to a patchwork of complicated laws that are onerous to comply with, have unintended consequences, and leave plenty of loopholes. If the Fed were in control of the ratio (perhaps within certain limits without congressional authorization), it could provide another powerful tool for fine tuning regulatory requirements as well as adapting to changes in the economic situation.

Opposing Goals as a Method of Regulation

The rating agencies that failed so spectacularly during the recent housing boom have a serious conflict of interest problem: if they don't rate bonds highly, the bond owners will take their business elsewhere. Since they're funded by the companies whose products they rate, this is a serious problem. There are many proposed ways to address this, such as changing who funds them or basing rewards on prediction accuracy, but I was also thinking that requiring them to offer another service that creates a bias in the opposite direction could also work. If a rating agency were required to offer insurance on a product based on their own rating, then they'd have a powerful financial stake in its accuracy. Of course they'd need to have enough capital requirements to ensure their insurance was viable, and the two competing areas of business need to be roughly matched in value. This is fundamentally different than having third party insurance entities, because the rating agency has complete knowledge of the internal mechanisms used to arrive at their ratings. I feel a fundamental overall of the entire system is more appropriate, but still found this idea rather intriguing.

I couldn't think of a good picture to accompany this. Any suggestions?