Who would be the best systemic risk regulator?

Don’t let the title fool you. The focus is changing.

Previous postings addressed a variety of proposed financial regulatory reforms. It seems it is impossible to keep up with the inventive mind in Washington. They can come up with new schemes at a dizzying pace. So, here’s a totally different approach. What could eliminate the systemic risk, at least as most of us experience it?

Previous discussions, especially the discussion of too big to fail, mentioned that stopping a cascade failure required that one of two conditions be met. But, only one really works.

One way a cascade stops is it reaches that proverbial immovable object. For a picturesque image, think of a big wave rolling across a beach and crashing against a seawall. In the recent crisis, the seawall was the Fed and Treasury. But, as I argued in the discussion of too big to fail, the notion of an immovable object is an illusion. To continue with the analogy, the wave bounces off the wall and only loses energy to the extent the impact absorbs the energy. It can then surface as a nasty back flow or a dangerous undertow.

The second way to stop a cascade is for something outside the run of the cascade to intervene. For those who think of the government as outside the financial system, my only comment is “get real.” The government is the world largest debtor, I believe, and if that isn’t participating, what is? Alexander Hamilton almost created Wall Street. He clearly understood the need for the Treasury to have a place to borrow. The Fed, in turn, creates the money we all play with. Money also seems rather central to the financial system.

Well, if the government isn’t an external source of a potentially stabilize impact, who is? Are you ready for a shocker? Don’t laugh until you hear me out: it’s the consumer and the investor. Your thinking that consumers are also debtors (or, believe it or not, potential investors), and investors seem to be in the middle of things. Well, I said that they can be the external source, not that they were or are.

“How?” you might ask could consumers stabilize the system. Well, people keep pointing out that consumption is about 70% percent of the economy. That certainly makes them important enough. Further, traditionally, consumption has been one of the more stable components of GDP (i.e., the economy).

There’s another point people often overlook. Let’s call it the JBQ effect, after Jane Bryant Quinn since that’s where I first came across it, but it could as easily be the Dave Ramsey, Jonathan Ponds or Suze Orman effect. It’s this; people who have a liquid reserve of some numbers of months of expenses tend to be financially stable. They tend to be robust to both macroeconomic and financial market volatility.

But, you say: “investors are in the thick of it.” Well, recently, the Vanguard Group surveyed their accounts and found: “Most mutual fund investors did not abandon stocks during the market decline of 2008-09…. The equity abandonment report analyzed the activity of 2.7 million IRA investors from the beginning of 2007 through October 2009, and found results in Vanguard’s administrative data that are consistent with a spring 2009 Vanguard survey of U.S. investors” (see http://onlinepressroom.net/vanguard/ ).

Similarly, a recent Charles Schwab’s “On Investing” ( http://oninvesting.texterity.com/oninvesting/2010spring/?u1=texterity ) contained interviews of a couple of retired investors. They described their attitudes toward the recent market declines. While hardly a sample, the interviews add flavor. To summarize, the interviewees, they felt concern, but didn’t react as if, or express a view that, they were at the mercy of forces beyond their control.

So, not all investors felt vulnerable to the crisis we recently went through, or, at least, didn’t feel that it justified a major change. How “in the thick of it” investors are seems to be either a function of why they invest or how “in it” they think they are. The point being that investor attitudes determine whether they exert a stabilizing or destabilizing influence.

Now you ask: “why are they the best systemic risk regulator?” First, as argued elsewhere, they may be best by default if too big to fail is the illusion described on March 5, “by default” because they may be the only true systemic risk regulator. The second reason is because they may be able to fill that role simply by believing they can, or I’ll argue in a future posting, realizing they can. Another reason is they may already be doing what is required to fill that role, and finally, the steps that would make them the systemic risk regulator make sense anyway.

There’s plenty of material for future postings in that last paragraph. But, for now let’s just say they’re there and can only play lumps at their own risk. If they don’t act, someone else will, and consumers and borrower may not like the results.