more on Mallaby

Robert Waldmann

Looks like I should have put the post to which the post below links here. Thanks for clicking the link. I will try to add up by adding a point here.

Sebastian Mallaby argues that deregulation did not cause the crisis, because hedge funds are regulated even less than investment banks. Based on something I read somewhere on the web, I noted that it is hard for hedge funds to get in trouble during a quarter as their investors can’t pull out money (it can be done LTCM managed but it is hard).

Now I will make another argument. The anti Sebastian (let’s call him archer) argues that regulations were fine on January 20 1993 and that the changes from then till now made the crisis possible (or at least worse than it would otherwise be). The changes would be de-regulation and a failure to create new regulations to deal with new financial instruments. Roughly the Commodities Futures modernization act of 2000 and the 2004 decision to allow investment banks to increase leverage.

Now this has nothing to do with hedge funds. They existed and were regulated in 1993 and they exist under roughly ?) the same regulations now.

The point is that regulations do not fall out of the sky. They are created because of a perceived need for regulation. A type of firm might be lightly regulated because of neglect. If so, relatively good performance by that type of firm is a sign that regulation is bad. Rather more likely a type of firm might be lightly regulated because legislators and regulators think that it is not dangerous. Mom and pop book stores have played a minor role in the crisis. They are lightly regulated. Does this prove Mallaby’s point ? I think the answer is obviously no.

So, if hedge funds played a minor role in the crisis, would that prove Mallaby’s point ? I would say it is just as obviously no.

Banks are highly regulated, because, by their nature, they are at risk of bank runs. They borrow short term and invest long term. Their creditors make small investments and, rationally, do not invest large amounts of money in looking out for their investment.

Hedge funds borrow medium term and in huge chunks of at least $100 million. Therefore the logic of banking regulation implies (and has implied since the first hedge fund was founded) that there is little need to regulate hedge funds.

The change in regulation concerns banks and insurance companies. If the crisis were confined to sectors where regulation changed, that would tend to be evidence that the change in regulation contributed to the problem.

If the crisis also affected firms which no one had ever argued should be regulated (as we will probably learn it did) that would tend to be evidence against the hypothesis of the advocates of keeping regulation the way it was in 1992.

The idea that support for the logic of the old regulatory strategy is proof that it was no good is so silly that only a top pundit could think of it.