08/02/2010 05:59 pm ET | Updated May 25, 2011

The Regulator Franchise, or the Alan Blinder Problem

I recently had a lunch conversation with Arianna that was mostly about ethics; so I suddenly felt ashamed of not having publicly denounced what appears to be a blatant generator of moral hazard. As someone who claims to be as independent as one can possibly be, with nothing to lose, and fear of nobody (except my mother's occasional reprimands), I am even more obligated than anyone else to expose hidden scams.

The story is as follows. Last year, in Davos, during a private coffee conversation that I thought aimed at saving the world from, among other things, moral hazard, I was interrupted by Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States, who tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and Prof. Blinder's company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.

I blurted out: "isn't this unethical?" I was told in response, "We have plenty of former regulators on the staff," implying that what was legal was ethical.

It has taken me so long (18 months) to react to the event partly because Prof. Blinder is scholarly, gentle in manners, the kind of likable person with whom I would have an intellectual conversation on occasion. In addition, having spent the last few years immersed in the classics, a certain sense of grandeur (from which I am looking for a cure) inhibited me from the reporting of journalistic anecdotes -- Alan Blinder is certainly not the worst violation of my sense of ethics; he probably irritated me because of the prominence of his previous public position and due to the context of the Davos conversation, which was meant to save the world. But I have to transcend my human proclivities and swallow my sense of grandeur: someone used public office to, at some point, legally profit from the public.

Tell me if you understand the problem in its full simplicity: former regulators and public officials who were employed by the citizens to represent their best interests can use the expertise and contacts acquired on the job to benefit from glitches in the system upon joining private employment -- law firms, etc.

Think about it a bit further: the more complex the regulation, the more bureaucratic the network, the more a regulator who knows the loops and glitches would benefit from it later, as his regulator edge would be a convex function of his differential knowledge. This is a franchise. (Note that this franchise is not limited to finance; the car company Toyota hired former U.S. regulators and used their "expertise" to handle investigations of its car defects).
I have several remarks.

First, the more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.

Second, the difference between letter and spirit of regulation is harder to detect in a complex system. The point is technical, but complex environments with nonlinearities are easier to game than linear ones with a small number of variables. The same applies to the gap between legal and ethical.

Third, regulation, like drugs, has side effects, and like drugs, it can harm the patient -- something in my work I call the iatrogenics (harm done by the healer). People do not mention that regulation helped promote the Value-at-Risk method of risk measurement in replacement to age-tested heuristics -- these methods blew up banks.

Fourth, we need a more severe monitoring of the activities of public officials and a solution to the following conflict. In African countries, government officials get explicit bribes. In the United States they have the implicit, never mentioned, promise to go work for a bank at a later date with a sinecure offering, say $5 million a year, if they are seen favorably by the industry. And the "regulations" of such activities are easily skirted.

Fifth, and more philosophically: during the lunch with Arianna, the conversation kept sliding into the ethical basin of attraction, the compatibility of some professions and service of the public. The Greeks had respect for the banausoi, those who had to make a living in the professions, but many argued against trusting them in running the affairs of the city on grounds that "a funeral goods merchant would not be trusted to wish for the good health of his fellow citizens." The point has been debated through the ages, from Xenophon to Seneca (who took the opposing point), but it is even starker today in the age of lobbyists and a shift in middle class values that tolerates the "everyone needs to make a living" even when the means to "make a living" are harmful to society.

These accumulated moral hazards have blown up banks and will keep blowing up the system.
In an antique city state, or a modern municipality, shame is the penalty for the violation of ethics; in larger organisms like the mega Nation-State, with a smaller role for face to face encounters, shame ceases to play its duties of disciplinarian. We need to re-establish it. (This is one of the causes of the fragility of the nation state).

Cleon, the hero of the Peloponnesian war, advocated the public renouncement of friends upon dealing with public affairs -- he paid for it with some revilement by historians. Sorry, Alan Blinder, you are a nice guy, but I have duties.

P.S. Why is this on the Huffington Post and not the New York Times? This is part of a broader discussion of journalistic ethics to come later.