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Tuesday, June 3, 2008

Can the Government Prevent Speculative Markets?

That will ultimately be at the heart of the domestic policy debate in the general election. It will likely rarely if ever be addressed, and it's even possible that the two sides won't realize that this is the heart of the debate. Yet, the answer to this question is ultimately the main difference between the two sides. Barack Obama talks about a new "regulatory framework". He wants to create all sorts of new regulations in mortgages, health care, and beyond. Barack Obama is clearly of the mindset that the mortgage crisis, along with previous speculative markets, happened because government was asleep at the wheel while players took advantage or acted irresponsibly. John McCain, on the other hand, proposes smaller government and lower taxes prefering a philosophy that allows the free market to deal with speculative markets.

Looking back, each of the three speculative markets I am most familiar with, the crash of 1929, internet bubble, and the current mortgage crisis, could each have been avoided through simple if not concrete government regulation. The crash of 1929 was perpetuated by loose margin rules that allowed investors to buy stock while only putting up 10% of the money. When the market turned most of these investors didn't have the rest to call the margin, and stocks began to get sold en masse. The internet bubble could have been avoided by simply forbidding companies from going public without at least a three year history of PROFITS. This was in fact the generally accepted unwritten rule for years. The internet changed all that and it became commonplace for paper thin companies with barely any sales let alone profits from going public. As such, many company's stock prices were built up solely on hype. Once the hype was exposed so was the speculative market. The mortgage crisis could have been avoided by eliminating stated, no money down, and interest only loans.

At its core, rules and regulations are a response to human failings. There would need to be no regulations if humans weren't by nature flawed. All rules and regulations are supposed to control human's deepest flaws: greed, fear, excitement, etc. As such, if the players in any market are flawed, thus in need of control through oversight and regulation. Then, too, we could make the same judgement about the politicians controlling them.

It is easy in hindsight to say what we should have done to avoid the three speculative markets I speak of. Thus, the question is why wasn't it done. The simple fact of the matter is that realistically there was no way the government was going to create the regulations necessary to stop these speculative markets. Imagine a politician in the 1920's proposing higher limits on margins. That politician would not only have been run out of office but tarred and feathered on top of it. The low margins allowed commoners to share in the huge wealth of the rolling twenties. There was no way the public was going to stand for some politician putting an end to that.

Imagine in th height of the internet boom if a politician suddenly proposed a new regulation that forced companies to have three years worth of profits before going public. That would have eliminated 95% of the internet stocks about to go public. People were making obscene amounts of money in the nineties on exactly these stocks. This would have gotten about as much traction as the proposal to limit marging.

Now, imagine in 2004-2005, if a politician proposed eliminating the exact loan programs that were allowing all of these new folks to buy property. This politician would have had the same kind of success as the other two theoretical politicians. The simple fact of the matter is that regulation needs political will.

Therein lies the rub, as Shakespeare would say. There is almost no way that government can prevent speculative markets because it requires government to cut off exactly that which is bringing everyone wealth just as it brings them wealth. The exact same thing that caused the crash also caused obscene wealth in the ten years prior. The same concept goes for the other two economic periods.

Barack Obama will get plenty of political traction over the nebulous concept of "regulatory framework". As long as he is creating regulations to subvert past failings, he will continue to have support. The problem is that the next speculative market is NOT going to happen because of stated loans. We have already learned from that, just like low margin and proiftless IPO's. He needs to predict the next one, and move to stop it just as it is making everyone fabulously wealthy. Maybe in his own idealistic world he can do that, however in the real world it would never pass.

There is simply no way that any politician would create enough political capital to curb the exact practice that is currently making everyone fabulously wealthy. To me, this is the naive thought of any politician that thinks that regulations could stop the next speculative market. Mortgages are among the most regulated industries in the world. Yet, all of the obscene amounts of regulation did nothing to curb the speculative market that it was in. That's because the politicians had no will to stop the very practice that was making everyone fabulously wealthy. That is the fallacy of anyone that thinks that government can stop a speculative market.

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