To their credit, lawmakers, regulators and the media have not yet begun to frame the story of the subprime mortgage mess in criminal terms. Forget Ben Stein because his antics have now made him forgettable. Even Gretchen Morgenson had to note in her Sunday column that the story of subprime profiteering was one of greed and not criminality. (Strangely, the entire Sunday Business section of the Times wasn’t available online this morning.)
But the call for criminalization has already begun on the fringes and we wouldn’t be surprised if before long we start hearing this from more mainstream publications. And if not criminalization, we expect the call for regulation to grow louder with each pasing day. It’s a familiar dynamic, where market failure is addressed with regulation.
We’re sometimes accused to have a knee-jerk reaction against regulation. This is unfair. Our problem seems to be a stubborn refusal to subscribe to the double standard that sees market failures and assumes available government solutions. But unless a plan for regulation addresses why the mechanisms and incentives proposed will result in effective regulation at acceptable costs, we think it best to avoid handing power over to government clerks.
Take the proposals to further regulate the ratings agencies. Sure they seem to have catastrophically failed to assess the risk in many credit products tied to mortgages. And, yes, they are rife with conflicts of interest. But we’ve heard precious little by way of practical solutions to these problems more detailed than abstract calls for “oversight” and “transparency.” If wishing were a strategy, this would be enough. But the good intentions of those who see the market as an imperfect process is unlikely to transform the government into an effective institution.
There’s a specter haunting these discussions, the specter of Sarbanes-Oxley. Our last round of financial scandal produced a clumsy and costly regulatory structure of unproven effectiveness. It would be a shame to repeat that mistake after this round of market failure.

One thing you can always count on is that as geographic scope of businesses and finance grow, someone will call for the harmonization of the relevant legal and regulatory structures. Roger Ehrenberg blasts that familiar horn today, calling for “common regulatory frameworks” in order to minimize regulatory arbitrage and cut down on the “immense friction [involved in] operating regulated businesses across markets due to different rules and standards.” Felix Salmon applauds him, and calls for even more of the same. Somehow this is meant to be a lesson from our current credit crisis.
This is a terrible idea. Competing, conflicting regulatory frameworks may not be as efficient as an ideally-designed comprehensive system but it avoids many of the mistakes and oversights of the kind of harmonized regulatory framework we are ever likely to get. The availability of exit and avoidance, experimentation and local checks on corruption and capture are under-rated sources of regulatory strength. A harmonized system with do away with the nimbleness we praised earlier, and there’s little reason to suspect we’d get a system better able to catch abuses, fraud, waste and errors than that we have now. Less abstractly, if none of the regulators saw our current credit crisis coming, how would having a common framework have helped them avoid it?
We wrote about this ages ago in the context of European takeover law, and what we said still applies: let a thousand regulatory regimes bloom.
What has the Credit Crisis Taught Us? [Information Arbitrage]
Dreaming of Regulatory Cooperation [Portfolio]

In the demonological pantheon of the subprime crisis orthodoxy, the deepest level of hell are reserved for unscrupulous lenders. Uncreditworthy borrowers live at a slightly higher plane, nearby unvigiliant regulators. But the cant and caterwauling of the orthodox overlooks that much of the world was focused on quite different concerns before the mortgage bills for the ownership society came due.
Despite our best efforts, we’re still cursed with a memory that reaches past this morning’s headlines. We cannot forget that the problem with the CDO market was supposed to be insider trading instead of the weakness of the underlying financial assets. And it was meant to be hedge funds that posed a systemic risk to the financial system rather than our venerable investment banks, money centers, trading houses and brokerages. The great accounting scandal was backdated stock options rather than marked-to-model financial products. In short, all the heat and light generated by our various guardians was aimed in the wrong direction.
Yet so strongly held was the belief in the old orthodoxy that, if you listen closely or read the New York Times business section on Sunday, you can still hear those who wonder whether or not insider trading or hedge fund manipulation is somehow behind our current troubles. There is not much evidence of this, as SEC Commissioner Paul Atkins pointed out recently.
“Although we and our counterparts in government are monitoring and looking into the origins of the events of the last year, it does not seem that hedge funds were the origin of the subprime problems,” Atkins said. If anything, some hedge funds and their investors seem to have been the first casualties of the current debacle rather than the causes.
We don’t mean this as a criticism of those guardians. Rather, it seems to us an indication that the actual risks in our innovative financial world are difficult to detect and that none of our journalistic and political institutions are particularly well-adapted to early detection. What we need is modesty in forward looking, crisis-avoiding regulations—often we may be aiming our resources where they are not needed, and diverting our attention from where they are. As the fellows at Goldman used to say, since we can’t tell where things are going, we’d best stay nimble. There’s a very good chance that once again the orthodoxy is hunting down imaginary demons.