One of the other areas where there is tight supply & demand and no transparency is the energy market...

If it were found that the "reserves" thought to exist really did not, or if the implication "for every barrel of oil discovered we are consuming between 3 and 4 barrels of oil" would also shock the economy.

The energy system too cannot last.

Actually the reverse, I'm in favor of catching things before they land and break, and forcing overhaul with the threat of what happens if they break.

Repeal the Bankruptcy Act of 2005.
A credit card company’s unilateral amendment of the terms of agreement should constitute breach of contract.
Credit card companies should not be able to arbitrarily raise interest rates, and maximum rates should be capped at Fed Funds plus a reasonable amount. At a time when the Fed charges 1% and credit card companies charge longtime customers with no history or prospect of default and sterling bill paying histories, credit card companies should not be able to charge 25%.
Institute a law that in no instance can a corporation enjoy more legal rights, protections, or tax advantages than any individual, and that penalties and sentences for criminal acts or nonadherence to regulations undertaken by, or on behalf of, a corporation shall be borne personally by its executive officers and boards of directors.
Public ownership of private financial institutions should require those institutions to divulge their holdings to the public.
Private institutions receiving public capital infusions cannot lobby the government, as it would be an instance of the government lobbying itself.
Institutions that receive public capital infusions and subsequently fail to lend shall be placed into receivership, as they no longer function as lending institutions and are for all intents and purposes insolvent.
Regulate Credit Default Swaps as insurance instruments with attendant reserve requirements, limit their use to only those who hold the securities thus insured, and limit their size to the direct amount of securities held. Or eliminate them altogether.

This is as comprehensive a list of necessary reforms as I have seen anywhere. It is a good bet that many of these reforms will be put in place over the next five to seven years, but only after Congress and the new administration finally grasp the magnitude of what has happened. I too have been discouraged by the complete lack of interest by the Congress in where this was all heading. I tried in the summer to get someone in the Obama campaign to realize that a stock market crash was going to occur before the election and would change both the policy discussions of the campaign and the whole tenor of voter attitudes. No one wanted to hear about this. They still don't want to hear that an even worse crash is possible next year.

As an overarching theme to your list of reforms, we should state that finance needs to serve the productive requirements of society, and should not be an economic end in itself. The days of buccaneer finance where the banker as superstar trades pieces of paper for profit are coming to an end. Financial companies need to fall from 20% of total S&P 500 profit to a more traditional 5%.

I would add to your list some discipline for Federal Reserve monetary policy. The Europeans have been harping on this for years, and now that it is too late Bernanke is talking about some way to limit asset growth before it turns into an asset bubble. That's one thing the Fed must do: target both asset and price inflation. But another thing is to get back to controlling money supply. If we are going to have a fiat currency we need to be disciplined about growth in that currency, and be prepared to tighten interest rates if growth goes beyond an agreed level like 4% per annum (including M3, which needs to be restored).

There will be some important nuances to consider in reforming mark to model. I realize you are talking about the sort of junk that is reposing in bank's L3 asset categories, but technically all option trading is marked to model (Black-Scholes), which requires estimates of volatility and an assumed discount rate. Ultimately this problem should take care of itself if we implement your other reform to place these products into a clearing house. A clearing house requires price discovery, including all key component's of a model's price. I suspect if a product doesn't qualify, it will not be allowed to be booked at a bank in the first place.

There is a way to jump-start your licensing requirement for bankers, and that is to use the GARP exams as a requirement for anyone trading or marketing derivatives. Teaching banks ethics, however, is a much harder task. You can't license ethics, but you will have to start at the top by weeding out the Gordon Gekkos of the world. I suppose a certain natural selection will occur here anyway. Finance has overnight become a very unattractive career. There is no place for these bankers to go to be able to continue earning million dollar bonuses. Hedge funds are imploding, and Wall Street investment firms are now banks themselves forced to disgorge their leverage. These guys will not be able to turn their paper-churning skills into some other job in the economy that would earn them as much as they used to. The game is over.

The only change I would make would be to place a higher priority on a Tobin / Pigou tax, and apply it to ALL financial transactions, noy just cross-border. And it must be determined exactly what percentage the tax works to discourage short-term trading, and encourage long term holding, especially of equities and debt that is going directly into the creation of new, physical capacity.

But a large part of the problem we face is cultural. Someone here - I think it was Sean=Paul, but excuse if I'm wrong, wrote an excellent piece on how Walter Wriston unleashed some unrealistic expectations about the rates of return. Fundamentally, you simply cannot expect such high rates of returns when you're actually building real factories, roads, bridges, ships, rail lines, wind turbines, and so on.

James Crotty has explained how a "portfolio" view of industrial assets arose. This "portfolio" view must be attacked head-on. Part of the solution is to begin teaching real economics again. The following is the first two paragraphs from
Economics for Executives, Vol. II, The Primary Industries (A Series of Twenty–Four Reading Texts Which Constitute an Interpretation of the Underlying Principles of Economics and Business for Men and Women in Practical Life), Edited by George E. Roberts, American Chamber Of Economics Incorporated, New York, NY. Copyright 1921, The Benjamin Franklin Institute.

It is logical to begin a study of the fundamentals of economics with a consideration of how mankind satisfies its wants. The activities of society in providing for its
desires are termed "production." Our discussion of the principles of economics, therefore, begins with a survey of the sources of production.

Fundamentally, all of the products upon which society is dependent come from the earth. Food, fuel, and raw materials spring either directly or indirectly from this source. The industries, therefore, which extract our food, fuel, and raw materials from the soil or the deposits of nature, may appropriately be termed the "primary industries." Agriculture, mining, lumbering, and fishing are the most important of these industries.

Unfortunately, today's economic heterodoxy
http://www.thenation.com/docprint.mhtml?i=20070611&s=hayes
is hostile to real economics. That needs to be changed. And we will have to find some way to impose remedial education on business managers and economists. Maybe by forcing to read Henry Carey's 1851 The Harmony of Interests: Agricultural, Manufacturing & Commercial:

Much is said on ``the mission'' of the people of these United States, and most of it is said by persons who appear to limit themselves to the consideration of the powers of the nation, and rarely to think of its duties. By such men the grandeur of the national position is held to be greatly increased by having expended sixty or eighty millions upon a war with a weak neighbour....

The English doctrine of ``ships, colonies, and commerce'' is thus reproduced on this side of the Atlantic, and its adoption by the nation will be followed by effects similar to those which have been already described as existing in England. There, for a time, it gave the power to tax the world for the maintenance of fleets and armies, as had before been done by Athens and by Rome, and there it is now producing the same results that have elsewhere resulted from the same system: poverty, depopulation, exhaustion, and weakness. (p. 227)

Two systems are before the world; the one looks to increasing the proportion of persons and of capital engaged in trade and transportation, and therefore to diminishing the proportion engaged in producing commodities with which to trade, with necessarily diminished return to the labour of all; while the other looks to increasing the proportion engaged in the work of production, and diminishing that engaged in trade and transportation, with increased return to all, giving the labourer good wages, and to the owner of capital good profits. One looks to increasing the quantity of raw materials to be exported, and diminishing the inducements to imports of men, thus impoverishing both farmer and planter by throwing on them the burden of freight; while the other looks to increasing the import of men, and diminishing the export of raw materials, thereby enriching both planter and farmer by relieving them from payment of freight. One looks to giving the {products} of millions of acres of land and of the labour of millions of men for the {services} of hundreds of thousands of distant men; the other to bringing the distant men to consume on the land the products of the land, exchanging day's labour for day's labour. One looks to compelling the farmers and planters of the Union to continue their contributions for the support of the fleets and the armies, the paupers, the nobles, and the sovereigns of Europe; the other to enabling ourselves to apply the same means to the moral and intellectual improvement of the sovereigns of America. One looks to the continuance of that {bastard} freedom of trade which denies the principle of protection, yet doles it out as revenue duties; the other by extending the area of legitimate free trade by the establishment of perfect protection, followed by the annexation of individuals and communities, and ultimately by the abolition of customs-houses. One looks to exporting men to occupy desert tracts, the sovereignty of which is obtained by aid of diplomacy or war; the other to increasing the value of an immense extent of vacant land by importing men by millions for their occupation. One looks to the centralization of wealth and power in a great commercial city that shall rival the great cities of modern times, which have been and are being supported by aid of contributions which have exhausted every nation subjected to them; the other to concentration, by aid of which a market shall be made upon the land for the products of the land, and the farmer and planter be enriched. One looks to increasing the necessity of commerce; the other to increasing the power to maintain it. One looks to underworking the Hindoo, and sinking the rest of the world to his level; the other to raising the standard of man throughout the world to our level. One looks to pauperism, ignorance, depopulation, and barbarism; the other to increasing wealth, comfort, intelligence, combination of action, and civilization. One looks towards universal war; the other towards universal peace. One is the English system; the other we may be proud to call the American system, for it is the only one ever devised the tendency of which was that of ELEVATING while EQUALIZING the condition of man throughout the world.

Fifth: enforce anti-trust laws. If it is too big to fail, it is too big to exist. I repeat: if it is too big to fail, it is too big to exist!

While I agree with this in principle, the real problem, as others have discussed previously, is systemic risk. What we are discovering is that the possibility of systemic breakdown is not the outlier it was supposed. An entity's being too big to fail and a situation's becoming too big to bail involve systemic risk. Systemic risk is very real, and it needs to be priced into the equation.

While systemic risk can be reduced with anti-trust and similar legislation, it cannot be regulated out of existence. Therefore, it has to be priced. If the system is going to have to be "saved" by the lenders of last resort, then they need to be compensated for assuming this risk.

One means of levying for this risk once it is priced is a Tobin/Pigou (type) tax, and systemic risk justifies such a tax. The real problem now is that systemic risk has gone global, and it therefore needs to be treated internationally.

I have been listening to Bill Moyers' July 9, 2004 interview with Thomas Frank,
http://www.pbs.org/moyers/journal/video_popups/pop_vid_frank.html
and I was reminded of one extremely important reform, that, while not directly having to do with financial markets, is perhaps the most important we could undertake to begin to raise working class and middle class incomes again. That is: remove all the Reagan-era obstacles to labor organizing, and let labor unions go on an organizing tear. Near the end (about 90 seconds from the end to be exact), Franks talks about labor lawyers he knows that have repeatedly described how someone trying to organize their workplace is fired - a direct violation of federal law - but the companies and managers involved are never really brought to justice because the penalties are negligible.

In fact, there was a rescued diary on DailyKos last night, aptly named "You Haven't Even Been Paying Attention" about the Machinists' strike at Boeing.
http://www.dailykos.com/storyonly/2008/10/16/73224/164

It included this insightful paragraph from a recent Businessweek article:

Underlying the current standoff are the poor relations Boeing has long had with the IAM. That became clear in last-minute talks between Calhoun and Blondin just before the strike began. The two were deadlocked over yet another relatively minor issue, involving worker training. Blondin recalls asking: "I just don't understand why you always fight us." Blondin says Calhoun replied: "You just don't get it. We represent Corporate America. You represent labor. We are always going to be adversaries." Boeing says Blondin's account was taken out of context.

Calhoun's Corporate America needs to be slapped down, hard, on this issue. As someone noted on an Amazon politics forum discussion yesterday, "In the field of development economics there's a huge number of cross-country studies that find a negative relationship between income inequality and economic growth, i.e., more income inequality is associated with less economic growth."

President Eisenhower warned about the rising threat of a military-industrial-governmental complex, and John Kenneth Galbraith wrote of The New Industrial State. Added to those trends, the past five years has seen the growth of the new financial state. All of these influences are undermining the basis of liberal democracy based on free market capitalism and are leading to the rise of plutocratic oligarchy and the neofascism of corporate statism. There are several problems that are associated with this tendency:

1. Problem: Interest rates do not properly reflect risk.
Solution: Eliminate intervention in setting interest rates to manage the economy and leave it to the market to appraise risk.

2. Problem: Opacity increases uncertainty and conceals weaknesses, distorting price discovery and risk appraisal that free markets arrive at through unbiased market operations.
Solution: Require transparency and eliminate accounting subterfuge. (Accounting practices that intentionally disguise business practices are fraudulent.)

3. Problem: Market price does not necessarily reflect true cost resulting in negative externalities that are socialized.
Solution: Government need to determine true cost and adjust market price to true cost either by taxing to pay for socialization of negative externalties or requiring producers to eliminate negative externalities associated with their products.

4. Problem: Systemic risk cannot be fully eliminated through legislation and regulation.
Solution: Tax to compensate for socialization of systemic risk, in addition to reducing it to a minimum through legislation, regulation and oversight.

5. Problem: Disequilibrium of essential economic factors leads to both economic and social instability.
Solution: Economies remain in dynamic equilibrium through distributive justice, through which all factors are given their due, necessary to maintain a balance among them through market forces. Policy, especially fiscal policy, legislation, regulation and oversight should be aimed at achieving and maintaining dynamic equilibrium of essential factors.

6. Neoliberalism is not working, threatening the reputation of free markets to solve economic problems.
Solution: Free market capitalism only works properly on a level playing field, suitable rules, impartial referees, and equal opportunity among competitors.

7. A system that encourages centralization, operates on chiefly on economies of scale, and consolidates wealth and power at the top is unstable and ultimately incompatible with the principles of liberal democracy.
Solution: Incentivize decentralization and disincentivize consolidation economically, e.g., by taxing for the costs of socializing dislocations, and where that is not possible, use political means in the form of legislation and regulation to limit centralization and prevent consolidation.

Many of these factors are not accidental, but rather they are integral to the rise of the corporate statism that underlies economic neoliberalism and the political neo-imperialism and neocolonialism with which it is bound up. The result is the rise of the military-corporatist-governmental revolving door that is threatening the rise of neofascism in the rush toward globalization. This can be seen as part of the desire of the West, especially the dominant US, to model globalization on this basis, giving those who are in control at this time, permanent control over global development.

The overall solution requires recognizing the threat and taking action to prevent it from developing in this unwholesome direction.

Very very logical ideas. My only caveat would be the Tobin tax. I see two issues - neither show-stoppers per se - that would need to be considered. One is that taxing cross-border currency flows only makes sense as part of a larger approach to dealing with global trade. Global trade is here to stay and the trend will only continue. A Tobin tax may very well not work unilaterally. I tend to think he issue is far more complicated that a simple tax.

The second issue is how the tax is spent. I'm not arguing that our current foreign aid in any way resembles what it should. But it is very difficult to ensure that it is spent effectively. Building essential infrastructure for countries less well off than ourselves has long been used by our government as a way to tie those nations to us in ways that are not beneficial to said nations. And it is been used by a number of large U.S. multinationals as a way to make heaps of money. Just read "Confessions of an Economic Hitman" by John Perkins to hear from someone who was involved in it first hand.

Great post! I only take issue with you on one point:

As much as I dislike Milton Friedman, markets are efficient, but they are prone to excesses when improperly regulated

I never believed this was true... and until I read a book on complexity economic theory, I never quite knew how to explain it.

Take, for example, the drug companies. They are capitalistic machines, but are they efficient? Hell no!

It makes no sense for ten drug companies to all spend time, energy, and money, just to create drugs that are already created. Whether it be ne anti-depressants, or Viagra clones. It is horribly inefficient for them to be engaged in the same business. It would make more sense for the government to mandate on company make anti-depressants, another to cure malaria, another to cure cancer, etc. All that competition is wasteful, so get rid of it.

That would be efficient, but not effective.

The problem is that without wasteful competition, there isn't a push to innovation. The market works well to create bigger and better products, because otherwise, the inherent wastefulness of the system could never sustain itself.

We will, slowly but surely, create new innovations because of the market... but that doesn't mean it's "efficient."

--
http://bexhuff.com
Of COURSE you can trust the US Government! Just ask the Indians.

I would like to address the reforms advocated by Sean. My background is a B.Sc. in Math together with an MBA in Quantitative Analysis. I also have extensive consulting experience including the documentation of internal controls in Risk Management Shops, where they used Mark-to-Market modelling to uncover pricing anomalies.

I disagree with your first point of eliminating M-to-M as it applies to the electricity market. There are simply too many possible contracts and parameters (Week-Ends, Holidays, Off Hours, Peak Hours, DST on and DST off) and too few counter-parties to avoid the use of mathematical models to evaluate contracts.

I agree with the second point of requiring disclosure and absolute transparency when it comes to any kind of credit derivatives.

Your third point of mandatory licensing and requisite on-the-job training for the sale of financial and investment instruments by anyone is already operational in Canada -- and we don't even have a federal regulator -- and I am surprised that it is not the case in the US.

I would couple that with Know Your Customer as part of the licensing procedure. If you are dealing with someone who has inherited a large sum of money with just a high-school education, you would not offer the same investment advice or the same range of products as a person with a background in investments. That should address the third point of fiduciary responsibility.

As for your fourth point, executive compensation and claw-back provisions, that should be addressed through corporate, business and individual income taxes. Simply limit the deduction of executive compensation and fringe benefits for a business or corporation and tax the recipient of fringe benefits (including favourable options) on a more progressive basis (i.e., at a steeper rate) than ordinary income as they do in New Zealand.

I agree with your fifth point: "enforce anti-trust laws. If it is too big to fail, it is too big to exist." I would further say that the US and other governments should cease lobbying other governments whenever a home corporation is accused elsewhere of monopoly practices (e.g., the US government lobbying on behalf of Microsoft in Europe).

I agree again with the sixth point: "regulate hedge funds, although keeping said regulation at a minimum." This should include documentation and evidence of effective internal controls over operations. I also agree that surprise audits by regulators should be undertaken. (Aren't they being done now?)

I can't comment on the seventh point as the municipal market in Canada is not the same. Municipalities are considered to be creations of the province. Interest on these bonds is not tax-free to the recipient unless they are an exempt entity (e.g., a pension fund). The municipal market is regulated as any other securities market. (BTW, we have also eliminated almost all tax deductions from income -- these, for the most part, have been converted into non-refundable tax credits (take the lowest tax rate and multiply by the would-be deduction to get the credit against taxes payable)).

Insurance industry reform, your eighth point, should include capital requirements and regulation of permissible investments. When taking the equivalent of deposits, acting in competition with banks, they should be regulated for that portion as a bank and the deposits should be insured in a manner equivalent to bank deposits.

Be careful in your ninth point: "enact a Tobin tax on all cross-border financial trades"… There will always be a way for sophisticated investors to avoid paying any kind of tax.

I agree with your last point of "everyone in the investment business, (*instead of having to take obligatory exams on new bullshit PATRIOT (it is an acronym, believe or not) Act money laundering laws*)--which actually made it harder for new business to start up, not to mention the fact that anyone with half-a-brain and a sound understanding of fiduciary responsibility knows who's laundering and who's not--should take mandatory classes on financial prudence, what systemic risk is, what causes it, etc."

The whole purpose of that act (and equivalent acts elsewhere) was to make it look as if governments were doing something. (All transactions over $10K in Canada get electronically reported to FINTRAC -- even the corner stores). So they end up with looking for a needle in a haystack.

As for your other point of money creation, you should realize that it's only the US (and Zimbabwe) that have unlimited money creation. What will probably happen is that some government will go on the gold standard (or an equivalent) and that will be end of the US dollar as the reserve currency. Not Iran, BTW, but maybe Russia if they are able to surmount their current financial difficulties.

As for markets being efficient, they are not efficient -- they are not even wise -- otherwise Microsoft Windows would have gone down the tubes long ago - but they are effective as commented by tjfx.

Albert

The whole executive compensation thing is a populist . Executives before the crash did exactly what they were paid to do. Lehman doing the bonuses after the BK, yeah, that was wrong.

But what is not noticed is dividends. Do these companies, nationalized or subsidized in other ways, still pay dividends? They're borrowing at the extra-special drive-up Fed window and they're still paying dividends?

“The Playboy reader invites a female acquaintance in for a quiet discussion of Picasso, Nietzsche, jazz, sex.” - Hugh Hefner