Regulation and the Second Law of Thermodynamics

stephen_hawkingAt first blush, one would not think that Barney Frank and Stephen Hawking would have anything in common.  The first is the Chairman of the House Financial Services Committee, and is currently conducting hearings on the regulatory reform of the financial markets.  The second is the noted University of Cambridge professor of theoretical physics and the author of the best selling book A Brief History of Time.

 However, in my mind both men are associated with the Second Law of Thermodynamics.  This law of physics states that the entropy of an isolated system always increases over time.  Stephen Hawking described it in more comprehensible terms in A Brief History of Time:

It is a common experience that disorder will increase if things are left to themselves.  . . .  In any closed system disorder, or entropy, always increases with time.

 Therefore, when I think of Hawking, I think of someone who can explain the Second Law of Thermodynamics.  When I think of Barney Frank, I think of someone who is desperately trying to avoid its operation.

I would contend that all forms of market regulation follow the Second Law of Thermodynamics.  In each case, a comprehensive statutory scheme is enacted as law, it imposes a closed system of rules on market actors, and over time the scheme inexorably breaks down.  Federal securities regulation, which began with the Securities Act of 1933 and the Securities Exchange Act of 1934, provides the perfect case history of this principle in action.

The federal securities laws were designed to force companies selling their securities to the public to make certain basic disclosures about their finances and business prospects to the potential purchasers of these securities.  The policy goal was to even the playing field so that the buyers of the securities had at least some of the information that the sellers possessed, and the buyers could then make an informed purchase decision.  Federal law therefore created a system of regulation to ensure that specific documents were prepared, and disclosed to the public, before securities transactions were allowed to take place.

This regulatory scheme was imposed on the world as it existed in 1933.  This was a world where the fastest form of communication for a written text was the United States mail.  It was also a world where all information was compiled and stored in a document-centric format: if you sought a particular piece of information you had to search for it by reading through an entire book or a report.  This was also a world where the types of securities sold to the public were comprised mostly of the vanilla variety of stocks and bonds that buyers (and sellers) knew and understood.

 We live today in a very different world.  Technology has changed.  A written text can be sent anywhere in the world instantaneously via the internet.  In addition, information is stored very differently in the digital age.  We enter search terms into Google and Lexis, thereby allowing us to extract specific nuggets of information directly, without having to read through an entire book or document to find them.

 The markets where securities are bought and sold have also changed dramatically.  Virtually anything can be “securitized” and turned into a product that can be traded over the market – from the right to receive future mortgage payments to the risk that the same mortgage holders will default on those payments.   Financial institutions were initially forced to confine their trading to a single line of business: whether securities trading, banking, or insurance.  Over time, however, these rules were relaxed and firms became “financial supermarkets” that were allowed to take on multiple market risks at the same time.  The same company can now take the simultaneous risk that the securities it underwrites will not sell, that the loans it makes will not be repaid, and that its cash flow will not be sufficient to meet its obligations to policyholders.  A single company can survive one bad bet; it cannot survive losing all three.

 These changes in information technology and market behavior all occurred at the same time that economists were radically changing their theories about the way that prices for securities are determined by the market.  The SEC has long embraced the Efficient Capital Markets Hypothesis, which holds that the price of a financial asset reflects all available information that is relevant to its value.  If this theory holds true, then it is proper for regulators to focus their attention on ensuring that companies quickly and accurately disclose new information relevant to their future prospects.  However, behavioral economists have come to the conclusion that investors are often swayed by irrational factors unconnected to objective data about the company, such as an unjustified optimism that a past price rise will continue into the future (the “bubble” effect).  New theories of evolutionary economics posit that investors adopt trading practices in a process of trial and error, keeping strategies that work and dropping strategies that cease to create profit.  The implication is that investment decisions are neither purely rational nor purely irrational, and that the SEC’s single-minded pursuit of information disclosure can never foreclose the possibility of future market bubbles and meltdowns.

It has become plain that the original regulatory scheme of 1933 is beyond the point where minor patching will work anymore, and is probably beyond the point where even serious repair can rescue the original model.  Entropy has overtaken federal securities regulation.  Some might argue that this fact demonstrates that any attempt to regulate the financial markets is ultimately futile.  However, I believe that our experience with securities regulation merely proves that every regulatory scheme has a natural lifespan.

 Our current model for the regulation of financial markets has reached the end of its useful life.  The world we live in has changed to such an extent that the original model should be discarded and a new regulatory scheme embraced.  While it may not be feasible to replace all of our current market regulators, at a minimum those regulatory bodies should be consolidated and given a new mission.

 If financial institutions are going to be allowed to operate in multiple market sectors, then the focus of our financial regulation should be on systemic risk (the risk that conditions across several different market sectors will lead large financial institutions to fail).  In addition, the content of financial regulation should be determined less by the characteristics of the financial product being sold (securities for the SEC, commodities futures for the CFTC, loans for the Treasury Department and the Federal Reserve) and more on the financial stability of companies that sell financial products.  This would entail the enforcement of minimum capital requirements and prohibitions on excessive leverage so that the managers of large financial institutions do not bet the company’s very existence on risky trading strategies.  Finally, the mission of our financial regulators needs to shift away from policing whether sellers have disclosed information and focus on the needs of the public as the consumers of a product.  Are buyers being given a variety of choices?  Does the information being made available allow consumers to make meaningful comparisons between products?  A new Consumer Financial Protection Agency could be created to undertake this last task.

 What I have described are the very premises that underlie the Obama Administration’s proposals to reform financial regulation.  Barney Frank and the House Financial Services Committee have been holding hearings on these ideas.  You can read more about the Administration’s proposals in this report from the Brookings Institution.  I agree with the report’s author that these measures are sensible and overdue.

However, politics always gets in the way.  Each existing financial regulator is jealously guarding its own turf, to ensure that a new system of market regulation does not diminish its authority.  Powerful congressmen, who possess their power due to their seniority on the committees that oversee different segments of the market, do not want to see the old system of regulation abolished.  And financial institutions that have learned how to operate around and between the interstices of multiple regulatory bodies do not want a comprehensive reform that eliminates or even blurs these lines of demarcation.

As a result, any legislation enacting these reform proposals will probably be significantly watered down and the original 1933 model of securities regulation is likely to persist.  According to the Second Law of Thermodynamics, leaving the original model of regulation to itself will result in increasing disorder in the financial markets.  Someone once said that “you can’t fight the laws of physics.”  I think it was either Stephen Hawking or Barney Frank.

This Post Has 2 Comments

  1. Jonathan Leininger

    I, for one, always enjoy a good second law of thermodynamics post (just as I enjoyed the Derrida/deconstruction reference a few weeks ago in another post).

    For all the systems theory that exists, economists, legislators and the regulators they empower seem to have very poor conceptions of what it takes to keep the structure of a system perpetuating in a stable way. Instead, they just poke it haphazardly with individual and often disjointed policies (that vary drastically depending which ideology dominates at the particular moment) in hopes that they can somehow coax the market into doing whatever they want it to do at a specific moment. It’s only during intense times of crisis that we see exactly how inadequate this approach is.

    What Professor Fallone described above appears to be proof and the sad end result of what I view as both a widespread failure to understand complex systems (in this case economic or legal) and the further failure to understand how human beings can intentionally influence them (hopefully to positive effect). All of this brings to mind the work of Nobel Laureate in Economics, Friedrich Hayek, (specifically Law and Legislation Volume 1: Rules and Order 1973). He wrote specifically on the subject of when legislation should be used, so as to create its desired result and avoid fighting against the very internal structure of the system one is trying to legislate/influence. I find that line of thought has particular relevance in times like these, when the call to regulation has been so enthusiastically renewed. Anyone with even remote interest in law and legislation (since this is a law school, I’d think that would be most) should definitely spend some time getting to know his work.

  2. Ed Fallone

    Update: Legislation to implement the reforms discussed in this post seems to be hopelessly stalled in Congress, due to aggressive lobbying by financial firms. As I predicted, the exisiting regulatory model seems likely to persist, with a few token cosmetic changes. See the New York Times February 6, 2010:

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