A HINDOO FABLE.
IT was six men of Indostan
To learning much inclined,
Who went to see the Elephant
(Though all of them were blind),
That each by observation
Might satisfy his mind.
The First approached the Elephant,
And happening to fall
Against his broad and sturdy side,
At once began to bawl:
"God bless me!—but the Elephant
Is very like a wall!"
The Second, feeling of the tusk,
Cried:"Ho!—what have we here
So very round and smooth and sharp?
To me 't is mighty clear
This wonder of an Elephant
Is very like a spear!"
The Third approached the animal,
And happening to take
The squirming trunk within his hands,
Thus boldly up and spake:
"I see," quoth he, "the Elephant
Is very like a snake!"
The Fourth reached out his eager hand,
And felt about the knee.
"What most this wondrous beast is like
Is mighty plain," quoth he;
"'T is clear enough the Elephant
Is very like a tree!"
The Fifth, who chanced to touch the ear,
Said: "E'en the blindest man
Can tell what this resembles most;
Deny the fact who can,
This marvel of an Elephant
Is very like a fan!"
The Sixth no sooner had begun
About the beast to grope,
Than, seizing on the swinging tail
That fell within his scope,
"I see," quoth he, "the Elephant
Is very like a rope!"
And so these men of Indostan
Disputed loud and long,
Each in his own opinion
Exceeding stiff and strong,
Though each was partly in the right,
And all were in the wrong!
So, oft in theologic wars
The disputants, I ween,
Rail on in utter ignorance
Of what each other mean,
And prate about an Elephant
Not one of them has seen!
— John Godfrey Saxe, The Blind Men and the Elephant
Beware, O Dearly Beloved, those endlessly multiplying pundits who propose single-method solutions to the problem of financial reform. "The" answer is not minimum equity capital requirements, liquidity controls, return on equity caps, compensation reform, leverage or size limits, portfolio risk monitoring, or even slipping saltpeter into the lattes of testosterone-addled traders so they act more like risk-averse women. The answer—pace the sexual lobotomization of traders which many in society may wish for other reasons—is likely to be a combination of all of those reforms (and more), implemented in a dynamic and flexible regulatory structure which can respond and adapt to changing conditions.
For the fundamental truth which most commentators continue to overlook is that the global financial system is much more like our illustrative friend Panic Pete than an elephant. When you squeeze Mr. Pete in one spot, the squishy gel inside his rubbery body causes his other parts to bulge out. Squeeze him in those newly bulging areas, and he will return to his original form or bulge unexpectedly in new directions. Why? Because the gel inside of him is incompressible. Squeezing the flexible outer skin does not cause the toy to shrink. It just forces it into a new configuration. Likewise, the fundamental quantity in the global financial system which we are concerned with, and which we properly wish to control, is risk. But, given any specific level of return, risk is incompressible.
If you want to achieve a particular return, you necessarily assume a commensurate and ineluctable level of risk, whether the instrument of your investment is a single stock, a capital project, an individual business operation, an asset class, or indeed an entire economy. And what does return mean in the context of an economy? It means growth, increase in productivity, and real economic returns in addition to secondary (or even potentially illusory) investment returns. Investing in a business, an industry, or an economy is risky. There is no guarantee you will achieve your aims or desired returns, whatever those returns may be. There are no guarantees, period.
So part of the conversation we continue not to have in the public domain is what kind of returns—in the broadest sense—we desire for our economy and society, and therefore what level of risk we are willing to tolerate. Sure, we could turn the entire banking industry into a regulated utility, with mandated minimum equity levels, maximum allowed returns on equity, and limits on institutional size and interconnectedness (assuming we can understand, monitor, and control such parameters, which may be a slightly heroic assumption). But what knock-on effects would that have on investors, on businesses in search of risk capital for their growth projects, on consumers, and on the economy at large? Dampen the incentives and ability of financial intermediaries to originate, take on, and distribute investment risk, and it is not clear to me that overall risk-taking (i.e., investment) in the economy will not go down.1 But if that happens, are we not explicitly or implicitly settling for less growth and fewer wealth creation opportunities in the economy overall? 2 Is that really the outcome we are seeking?
By this, I do not mean to say our current system works well, or that the level of risk inherent in the financial system is appropriate or even efficiently distributed given our overall economic return objectives. But it does mean that we need to be a little more thorough, and a little more honest with ourselves and our opponents in debate, in thinking about the consequences of individual actions or "solutions" we advocate imposing on financial intermediaries. For consequences will flow inexorably in directions we do not—and perhaps even cannot—anticipate, and we will be remiss—and even no less irresponsible than the people who allowed the recent financial crisis to happen in the first place 3—if we do not make provision to address them.
Squeezing Panic Pete is fun. It's a great stress-reliever, too. It just so happens to be a lousy regulatory reform agenda.
1 "Go down" = become more expensive, less frequent, less available, more difficult, etc.
2 I do not speak of wealth distribution here, which is another socioeconomic debate admitting of other solutions which are not necessarily connected to the measures we decide to implement in financial reform.
3 Wait. That was all of us, wasn't it? Oops.
© 2011 The Epicurean Dealmaker. All rights reserved.