The crash of 2008 exposed deep-rooted scandals and few have yet gone to jail for them. One financial felon has even claimed that cheating is essential to succeed on Wall Street, while another said most insider trading to too subtle to catch. Markets are competitive arenas that reward the pursuit of self-interest, yet they rely on a moral infrastructure.
By Daniel Friedman and Daniel McNeill
June 24, 2013, 6:31 a.m. EDT
LOS ANGELES (MarketWatch) — “Is the entire stock market (and the system it supports) completely corrupted?”
When that question appeared in a recent MarketWatch poll, 76% of the nearly 1,400 respondents agreed with: “Yes, it’s legalized theft.”
Legalized theft? Like the bribes Mexican police demand or the taxes dictators seize to build villas? Investors think the stock market is theft?
Sure. And it’s easy to see why.
The Crash of 2008 exposed deep-rooted chicanery and few have yet gone to jail for it. Follow-on scandals have won wide press. In another MarketWatch piece, one financial felon claimed cheating is essential to succeed on Wall Street. Another said most insider trading is too subtle to catch; the SEC is hunting microbes with a toy magnifying glass. These crooks may be projecting, or seeking the excuse of the crowd: I got the ticket, but everyone was speeding! Yet they also have little to lose. Moreover, Sen. Elizabeth Warren has echoed them, and Neil Barofsky, former TARP inspector general, wrote, “The suspicions that the system is rigged . . . are true.”
The problem goes to the essence of morals and markets themselves. The two need to work together, yet easily get out of sync.
Morals enable sophisticated cooperation. Morals tend to reward selfless traits like generosity, trustworthiness, and esprit de corps, and punish selfish ones like betrayal and theft.
Markets have made us lords of the earth. They are competitive arenas that reward pursuit of self-interest — yet they rely on a moral infrastructure. When participants vie fairly, and buyers and sellers trust each other, they can work magic.
For instance, finance is in essence an exchange of promises. Hence large financial markets require widespread trust, in the promises themselves (like the scheduled payments on a bond or a loan), in third-party guarantees, and in the trading procedure. That kind of trust helped make the U.S. the top economic power in the 20th Century. Our financial markets were among the world’s most open, honest, and credible — and global investment flowed in.
But when cheaters skew the competition or rip-off buyers, markets suffer. Investors grow leery and stay away. Indeed, the MarketWatch poll may explain why the retail investor has yet to return in force. And in the extreme, as in Russia in the 1990s or some African nations, financial markets essentially disappear.
Right the balance
So markets need morals. Yet the two live in a dangerous balance, and we have to understand their complex relationship to avoid calamities.
Here’s what government, investors, and Wall Street can do to right the balance in U.S. financial markets.
First, government. No moral system can function without penalties. As former SEC chair Christopher Cox noted about the 2008 meltdown, “Voluntary regulation does not work.” Self-interest is the engine of markets, and we can’t merely hope the best players will put the moral infrastructure ahead of it. So we have to beef up enforcement (via the SEC and the new Financial Stability Oversight Council or FOSC) to make cheating less attractive, and to help companies thrive when they offer better value to investors.
The SEC and FOSC clearly need more funding. For one thing, the SEC has to implement Dodd-Frank, which itself is behind schedule. (Just 38% of the required 398 rules have been finalized by now, though the target was 70%.) In 2012, the SEC had the budget to examine only 8% of registered investment advisors, and it said 40% had never been examined. Of course, its funding is not a tax, but comes from fees on securities transactions.
With more backing, the SEC can better safeguard society. It can buy technology and investigate more thoroughly. It can hire top professionals to monitor market risks, and can perhaps end the drain of regulators to Wall Street itself. Indeed, if the SEC gains respect for serving the public good, it may spur migration from Wall Street. It can harness the moral fervor of experts who have already earned enough and want their lives to matter in a different way.
Bolstering the SEC is a smart idea. If done well, it will pay for itself many times over by minimizing costly frauds and crashes. It will increase market size. And if cheaters reasonably fear the mug shot, or even just pangs of guilt, we will deter hard-to-detect offenses.
So regulators must get the moral balance right. If they are too heavy-handed, they drive markets off course. And if they are too hands-off, cheaters prosper, trust falls, and economies can lose their way.
Concerned investors can take steps. Insider trading, for instance, has little affect on passive index funds or Warren Buffett-style long-term investment. Indeed, if more people held longer, they would ease pressure on companies for consistent quarterly jackpots and reward deeper planning.
Wall Street can help itself. Though it may seem contrarian, the Street will benefit from tougher regulation — including jail terms rather than just company fines. The last crash bred populist outrage. Another one will fuel a moral firestorm that could get out of control. Wall Street has the statesmen for this work — the new J.P. Morgans whom history may remember. They’re simply waiting.
The best regulation makes cheating less profitable and yet harmonizes with practitioners’ inner moral codes. If turning in cheaters is part of the corporate culture, and regulators are respected, as they were in the 1950s through the 1970s, we don’t need a heavy hand.
And people may feel happier about financial markets again.
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