Re-educated Horses

So how do we tackle the problem of rationality in the market place? Do we want to? Can we without a deleterious effect on the principles of the free market? 

In his blog, (here) Senator Christopher Dodd D-Conn., aka the Dodd in Dodd-Frank, writes “Our financial sector has evolved rapidly, and the watchdogs haven't kept up. They didn't realize that the emerging subprime lending sector posed such danger to our economic stability until it was too late. And, they lacked the ability to stop it.” He makes a valid point. The financial sector is rapidly evolving and one of the strengths of Dodd-Frank is it does require the Securities and Exchange Commission and other regulatory agencies to draft regulations on previously unregulated areas. These actions include increasing the transparency of asset-backed securities, making them subject to SEC scrutiny.  The SEC is also working on implementing new rules to increase the transparency in the securities swap market and derivatives trading.

Transparency is the key to capitalism under the principle of laissez-faire, which calls for minimal government intervention into the market. If we know what we are buying, we can make better decisions. Could a security still make sense with a few toxic assets thrown in? Sure, as long as the price of the security accurately reflects the risk and that risk is factored in when including the security in a mutual fund or pension plan. The only solution to hyper-rationality is a better rationale. Of course, the financial institutions would and do oppose these measures, because it is likely to decrease the price of their products. But the higher a risk a security is determined to have the less it will appeal to certain investors, most especially those about to retire, who need safer investments. This lessens the herd effect to jump on these securities, easing up the demand curve. 

We cannot legislate investment decisions because of the ever evolving nature of the financial sector. Evolution serves a purpose—it is how we seek out new investment and grow as an industry. New investment opportunities could mean diversification if we allow it. While I am generally hesitant to call for regulation, there is no productive economic value lost if we increase transparency for investors. The role of the SEC must be to keep on top of these changes in the market and draft transparency regulations as new products emerge, which can be done quickly and regularly. Since Dodd-Frank was implemented less than six months ago, the SEC has already established and set effective dates for about a half a dozen new regulations under the Act and have proposed many more.  

It’s not a perfect solution but in a capitalist market, risk is part of the game. We cannot fight rational behavior. Rational behavior is necessary. It drives up the prices for people can make a profit when they sell. We can only do our best to give it a fighting chance.