Mervyn King

Given that Mr. Kerviel was able to exceed trading limits and evade detection for so long, as well as Société Générale’s handling of Eurex’s November warnings, “we can easily infer that the internal controls were either inadequately designed or have not been operating effectively and efficiently,” said Francis Hounnongandji, a corporate governance expert who is also president of the French chapter of the Association of Certified Fraud Examiners.

That conclusion is being echoed at the highest levels of the French government. On Monday, Finance Minister Christine Lagarde said, “Very clearly, certain mechanisms of internal controls of Société Générale did not function, and those that functioned were not always followed by appropriate modifications.”

In meetings with investors in recent days, Société Générale’s chief executive, Daniel Bouton, has admitted his bank’s internal systems did not keep up with the pace of growth in the derivatives business. “He told them while our derivatives business was going 130 miles an hour, risk control was only going 80,” according to one analyst who covers Société Générale but insisted on anonymity. -- Nelson D. Schwartz, "A Trader's Secrets, a Bank's Missteps", New York Times, 2.05.2008

When victimized, people always look for someone to blame. But, blame is often bittersweet and always besides the point. Due to either ignorance, inability or unwillingness or, in the case of Société Générale, all three, internal control and self-restraint are illusory. It does not really matter whether Kerviel committed fraud, or his superiors tacitly agreed to it, or that the risk-control department at the bank was overwhelmed. Internal controls failed, causing a massive loss of investor value and a breach of trust. A failure which may not have been foreseeable but recurs enough in human organizations to be predictable nonetheless. Internal controls are bound to fail by hook or by crook, at some place and at some point in time and to great effect. The bigger the organization, the tighter the centralization, the larger the assets, the greater the devastation will be. And, this inevitable failure means that systems that rely upon them are bound to collapse as well.

One is wise not to put much stock in self-restraint, for when it is not violated by criminality and when it is not overwhelmed by irrational exuberance, it is the unintended consequences of complexity which finally renders it ineffective. If one must rely upon some type of control, then those restraints which are external and structural in nature are much less likely to disappoint than even the best risk management departments. But, ultimately, inventive people will always find a way around them. Which leads to one giant perplexing question in the end:

How did anyone, much less a JUNIOR trader, have access to so much liquidity that he could incur a $9b loss in a 1 month period? That this is even possible, even for good and in earnest, should be disturbing. Do you realize how much social value that represents? $73.5 billion, more than the market value of the bank itself! All at the whim of one person! Criminality is not the problem, that we have a system that makes it even possible for one person to play with more money than most national GDPs is the problem. And perhaps the greatest trouble of our time.

A trouble, that despite (or perhaps precisely because of) the Great Recession is not going to go away any time soon. One only need look at the resistance encountered by Mervyn King, governor of the Bank of England, and Paul A. Volcker, former chairman of the Federal Reserve, by the U.S. administration at the proposal that deposit and investment banks be separated once again and the record setting campaign contributions registered by financial companies in the first half of 2009 to see just how unlikely this trouble will be solved. It cannot. Because we have become scared of competition from central planning in China and oil rich sovereign wealth funds in Russia and the Middle East and dependent upon the globalization of commercial society for our prosperity, the age of grotesquely big is here to stay. The wealth of the whole world is now at the command of the captains of industry.

The real question is whether our global (but politically divided) society still has the capacity to adapt to it with effective management.

A Free People

The Supreme Court on Monday appeared reluctant to allow judges to take on a major role in policing the compensation of mutual fund investment advisers. But some justices nonetheless suggested that pay arrangements could be so outsized that the courts may have to step in. -- Adam Liptak, "Justices Scrutinize Advisers Pay", New York Times, 11.2.2009.

There is a danger in telling a free people (or a grouping of them such as 'the marketplace') what they should do. Not because you are depriving them of their liberty, and not because they will find a way to circumvent it, but because no centralized body, panel, consortium, or assemblage of directors, experts or leaders is able to understand the complexity of social behavior sufficiently well to do any better. Top down directives, mandates and benchmark goals are fraught with unintended consequences in any environment where behavior emerges as a consequence of innumerable interactions between individuals.

Complex environments are unpredictable, non-linear and often counter-intuitive, making efforts to direct them oftentimes no better off than a lack of direction and many times, worse off. Amongst a free people, information in its multivariate forms ripples across the population in strange, peculiar and unpredictable ways, but frequently more efficiently and more responsibly than by directed efforts to distribute it. As a result, a free people are more supple, adaptable, responsive and self-regulating than almost all arrangements that have hitherto fore been devised by man.

However, that is not to mean that a free people must be left alone. What must be done for a free people to maintain their capacity to outperform directed behavior is to maintain their freedom against those evolutionary forces which would extinguish it. Unfortunately in the battle against nature, the conditions under which a free people can remain free to decide their fate as they see fit are easily confused for conditions that do precisely the opposite. Granting license to anyone to do anything they are capable of doing, regardless of the cost or who bears it, has been long recognized by learned people to lead to neither freedom nor justice.

A state without mutual coercion mutually agreed upon is a state that is rather nasty brutish and short wherever interests between people do not coincide. Which, from an evolutionary standpoint arises constantly. So, as Rousseau has quite paradoxically put it: we must be forced to be free. Social force must be exerted on the individual to preserve the conditions of free choice. Or, in other worse, we lose the freedom to do whatever we want (which will quickly descend into anarchy) in order to be able to determine our lives within the equal confines of what we all can do without facing punishment.

But, also as Rousseau has so deftly observed, the forces of human nature desire constantly to make exceptions, to obfuscate processes and to disperse costs for personal advantage. He calls it particular interest and short of a totalitarian laconic state, is impossible to eradicate; as if a Spartan renaissance would be desirable anyhow. So, the only other alternative is to manage it. And, free peoples have proven fairly successful through out history at evolving effective management to the constant struggle for particular interest. However, when the capacity to pursue particular interest by exceptions, obfuscation and externalization is confused for freedom, either democratic or economic, the system will start to evolve more and more license instead, until freedom is only freedom but a name.

Subsidies

With this much money at stake, critics and some analysts say, the sugar subsidy system is like a cookie jar waiting to be pilfered. Europe’s antifraud division, called OLAF, reported that from 2005 to 2008, 67 million euros worth of sugar subsidies were tainted by irregularities and fraud. Many countries have been penalized millions more over the last few years for lackluster sugar inspections. In 2008, OLAF pursued 34 cases of sugar fraud involving 4.4 million euros, a figure they describe as the icing on the cake because so many of the schemes go undetected. -- Doreen Carvajal, "Fraud Plagues Sugar Subsidy System in Europe", New York Times, 10.26.2009

Subsidies for long-standing industries is misguided as much for the perverse regulatory structure it establishes as it is for the 'market distortions' which result. Once subsidies are put in place, the onus (and cost) of monitoring the efficiency, fraud and effectiveness of an industry is taken away from those involved in it and placed on the shoulders of the government whose officials have no personal incentive to make sure that the system functions properly. Without shouldering this burden themselves - a burden which naturally arises from competition amongst each other in a free marketplace - producers are slowly turned into a den of thieves. Instead of innovating the means of production and distribution, each producer maximizes its profits by how well it can exploit the subsidy system.

When the loop-holes and fraud are finally detected, it becomes an additional burden to bear by the government to prosecute the law-breakers and close the loop-holes. Unfortunately, as the industry will have already become fat and dependent upon the subsidies by this time, it will scream bloody-murder, withhold campaign contributions and threaten lay-offs, if corrective legislation endangers the provision of the subsidies themselves. The type of legislation which is finally enacted thus becomes little more than a patch. With stricter penalties and greater administration and documentation, it hopes to prevent the most egregious cases of abuse, without ever addressing the systemic reason for them in the first place: the subsidies.

Loop Holes

“Over a period of eight years, State Street bankers committed unconscionable fraud by misappropriating millions of dollars that rightfully belonged to California’s public pension funds,” California’s attorney general, Jerry Brown, said in a statement. “This is just the latest example of how clever financial traders violate laws and rip off the public trust.”
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Mr. Brown contended that although the bank was contractually obligated to charge the interbank rate to the pension funds at the precise time of the trade, State Street consistently charged at or near the highest rate of the day, even if the interbank rate was lower at the time of trade.
Mr. Brown asserted that State Street tried to conceal the fraud by deliberately failing to include time stamp data in its reports to Calpers, as the California Public Employees’ Retirement System is known and Calstrs, the California State Teachers’ Retirement System. -- "California Sues State Street for $200 Million", New York Times, 10.20.2009


As transactions amongst members of society become more complicated, there are more points that can be exploited by clever intermediaries. These 'exploits' can be corrected through legislation or procedural amendment after they are detected, but at the cost of two things:

1. Damage that has already been done, oftentimes without effective recourse
2. Increasing the regulatory codes associated with transactions in society.

The positive expectation value associated with exploitation only serves to encourage more of it - the 'savvy' placed at an advantage and the 'law-abiding' at a disadvantage as a result of the exploitation. Meanwhile the increased complexity of regulatory codes encourages further growth of sub-specialization in society, establishing a multiplicity of distinctions throughout society between 'initiated' and 'uninitiated'.

This arcanization of society increases the reliance of the members upon each other while simultaneously undermining the means with which they can monitor each other. Eventually, the level of regulatory complexity reaches a point where the conflicts of interest, contradictory imperatives and adversarial prerogatives among overlapping regulators can itself be exploited. Examples of this include, how attorney-client privilege and a defendant's right to due process pit the legal system against the regulatory need for information-sensitive, time-sensitive, penalties for undesirable behavior.

But what are the benefits?

1. Exploitation is the by-product of innovation. In order to have the freedom to innovate, people will always have the latitude to exploit. The benefits from increased innovation cannot be achieved without making society susceptible to exploitation - a trade-off that is oftentimes lopsided in favor of freedom.

2. Relentless attempts to exploit the law leads to more comprehensive statutory law, reducing the room for executive discretion. Those who enforce the law are subject to far greater protocols, procedural rules, training and monitoring as a consequence of efforts to tie up loop-holes in regulatory law. This increases the security of all the members of the community, especially those who would have otherwise been exploited by prejudicial acts of executive discretion.

What Genie?

The E.P.A. has come under scrutiny recently for not punishing tens of thousands of polluters over the last decade, and many of the lawmakers at the hearing on Thursday are longtime critics of the agency’s vigilance. In September, a New York Times investigation found that companies and other workplaces had violated the Clean Water Act more than 500,000 times in the last five years, but fewer than 3 percent of polluters had ever been fined or otherwise punished.
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Other lawmakers, primarily Republicans, were critical of recent E.P.A. actions that have delayed so-called mountaintop removal mining permits. The agency has argued that such mines pose a risk to local waterways. -- Charles Duhigg, "E.P.A. Vows Better Effort on Water", New York Times, 10.15.2009


Republican ideology and actions exemplified by the Bush Administration over the past decade reflect a deep misunderstanding about the nature of society, and especially the highly interdependent one that has emerged over the past century.

Extensive subdivision of labor has increased the complexity of a society beyond the scope for any one person or group to effectively monitor, evaluate or even understand what's going on and has thus created extreme moral hazards. In an advanced commercial society, members rely upon the actions of people far-beyond their ability to hold accountable, and individuals and groups have the capacity to adversely effect innumerable others through not only negligence and deceit, but also the unintended consequences of their actions. In an extensively interconnected society, the unanticipated by-products of even legally sanctioned behavior have a way of manifesting well outside the scope of compensatory jurisdiction or time frames for people who have been adversely effected by it to find recourse. As a result, behavior has a way of becoming predatory and exploitative over time, allocating a disproportionate cost upon others.

This problem of complexity is only compounded by the increase of population density and the capacity to exploit resources well beyond replenishment rates. Under these conditions, we have a collectively capacity to destroy ourselves very quickly by unsustainable behavior. Of course, the subdivision of labor, large populations and advanced resource extraction techniques also have the capacity to create unprecedented levels of prosperity for society which are often worth these risks. However, in order for the prosperity to not only be fair but also avoid ultimate self-destruction, society must be managed in proportion to its complexity and density.

Although governmental regulation is often a blunt instrument, guided by self-serving interests that have their own problems of unintended consequences, and policy-makers have a tendency to create ineffective remedies even when adhering to the advice of experts and interested parties, the marketplace cannot effect this kind of management on its own. Carefully aligned incentives that structure self-interested actors can produce an environment where the marketplace will take care of most of the details of execution, but the marketplace alone is incapable of creating or maintaining these incentive structures. Government is an adaptation of the human mind in its efforts at better self-organization that addresses what a marketplace of selfish individuals cannot: self-regulation.

Where government is lacking, all marketplaces quickly breakdown. A free market is ultimately a non-existent market. And, a society without governance is not a society for very long. These are not my words, but the conclusions of Adam Smith in his Theory of Moral Sentiments and other work on political economy.

For the majority of human existence, low levels of complexity and density have enabled people to get by with the rudimentary forms of governance fondly referred to as the 'minimalist state' - property rights, criminal prosecutions, national defense, you know, the mantras of the republic ideology. When early economists wrote in defense of a free market, the marketplace actually needed liberating from a form of government intervention that served the interests of officials and guilds at the expense of the population and consumer. The genius behind the American Constitution established a regime that made it hard to pass legislation because legislation was assumed by all parties at the time to always be preferential. The post-revolutionaries realized that it was not only the mob that risked overturning the effective governance of society but also the organized interest of those holding office or capable of influencing those who do.

With much less certainty associated with how the world worked, a great deal of space as a buffer between people and a depth of laborious subdivision that hardly extended beyond the home, a minimalist state was the best government for the world of 1787. It relegated most of the functions of governance onto the levels of society which were far better at understanding the complexities of social interaction and adapting practices accordingly: the individual and the local community. But that world no longer exists and few would put the genie back in the bottle even if they could. What more, the few that would recork the genie of commerce grossly underestimate the danger that would result if they did. The subdivision of labor in society is an evolutionary adaptation that has not only resulted in great prosperity but also increased security, both internal and external.

Insofar as the republican ideology functions in an adversarial system to create better regulations by ceaselessly seeking to minimize them, it serves a critical role in evolving effective incentive structures in society. But, the by-product of its interaction with other ideologies should not be taken as a vindication of its wisdom. When it alone attains the force of law, it causes numerous breakdowns in the complex form of society we live in. In the short-run, deregulation, laissez-faire and/or executive negligence will greatly benefit the interests of those who clamor for its application - those who stand to gain from the removal of governance on account of their knowledge of the system and capacity to exploit it - and much prosperity will trickle down to the overall population. But, shortly thereafter, even those who will have gained from a lack of governance will begin to suffer from the very processes they set in motion along with the vast multitudes that bear the costs of their 'freedom'. As trust in society breaks down, along with the rule of law, corrective feedback through elections and maintenance of public resources, credit will contract, commerce will come to a halt and the population as a whole will become dissatisfied. In this sense, republican ideology is self-defeating. The more it succeeds at grabbing a hold of the minds of the population, the more it reveals its problematic understanding of society.

But it is a perfect ideology for the elite, who are few in number and thus a minority in a democratic body. As long as they remain as such, it can even provide some benefit to society. But, fundamentally, it is an ideology friendly to democracy only as long as it is also an ideology of Social Darwinism. Taken to its logical conclusion, republic ideology is a stable democratic philosophy only insofar as its long-term solution is Malthusian. It counts on mortality through war, pestilence and starvation to cull the ranks of the non-believers and a police state to effect that mortality. Otherwise, policy will eventually be supplanted by the electoral victory of those multitudes that 'must suffer for a few to succeed', with potentially devastating results on individual incentives, property rights and the rule of law.

In practice, it rarely comes to this though. Since republican ideology is forced to moderate its policies in order to court a population large enough to obtain legislative control, there is never comprehensive republican reform or violent backlash. Even in moderation though, the policies produce a similar series of effects - ones that, once so moderated, can actually prove to be beneficial to society as autumn is to the tree. By periodically shedding itself of its extraneous members, the competition of the free market can be allowed to evolve techniques which magnify the power, standard of living and productivity of the core members that remain. And by exploiting resources ruthlessly, previously unimaginable technologies can often be found to support a population and its activities at levels which far surpass those previous believed to be sustainable.

To mark its success, republic ideology lauds these very instances of innovation and a free market's capacity for 'self-correction', for which there is much evidence. Given the complexity of society, there are many instances where government intervention would only make the situation worse. Instead of trying to understand these perverse incentive structures and develop adaptations to regulation which properly align actors to act on their own though, it sticks to a single principle of non-intervention. Where governance has a place, republic ideology focuses the population's attention on personal failings as the cause of social malaise and individual accountability as the cure.

Crime, greed and immorality are the culprits. So, let us prosecute lawyers, accountants and executives for fraud! Let us cap executive compensation! Let us teach better ethics in school! Symbolic sumptuary laws abound to 'fix' the problems confronting society. But these solutions obscure the systemic nature of the problem.

In this sense, republican ideology is antiquated. Like all similar conservative philosophies expressed in the midst of the collapse of a democratic regime, it can neither understand nor effectively address the forces driving political society to that collapse. Worse yet, when it does influence remedial action, it is more likely to accelerate the collapse instead because it advocates punishment of the (least savvy) actors for their indiscretions rather than address the dynamic which brought about their behavior. By misapprehending the nature of governance in complex societies, it seeks remedies that hasten the problems associated with complex societies. It gives even more discretion to those charged with enforcing the law and strips away many of the policies which moderated behavior informally and counter-intuitively among the population. By reducing the complex structures of non-market feedback to only those which can be effectively dictated by well positioned individuals, it clears the way for the emergence of those who will dictate.

Lesson: Just because the government often can't regulate effectively, doesn't mean regulation isn't necessary.

Social Selection

Evolution explains what does exist and what will exist, not what is optimal or what is fair. Those who succeed today make it through to tomorrow. Those who don't, die off along with whatever heritable traits they carry. Strictly speaking though, only genes can succeed in evolution. Individuals are merely carriers for a complex composite of genes which are engaged in a competition with each other for self-replication. Insofar as they manifest together in a functioning entity able to procreate, a subset of those genes succeeds and survives into the future.

Success is entirely context dependent. With traits tailored to the niches, the same heritable trait can die off in one place and thrive in another. Neither place being static, each environment can be seen to itself evolve, as it is constituted by the number and nature of living (and non-living) species that inhabit it. This form of dynamic complexity makes predictions of existence into the future extremely difficult to the point of meaninglessness.

The success or failure of any individual is convoluted with an innumerable number of unforeseen, unanticipated, interactions, rendering any determination of the future opaque with counter-intuitive outcomes. As a result, an evolutionary evaluation is rarely scientific except in retrospect. Insofar as it can be prospectively estimated, the genetic uniqueness of the individual is rendered irrelevant next to the common traits of the species it is a member of. The best individual analysis that is possible arises from simulation which can be no more accurate than its parameters.

If social selection is the process by which social behavior is selected for its fitness amongst a temporally static species, then what are the genes? How do they replicate? What is their method of transmission and propagation? Who or what are the entities that carry them? How are they 'expressed' in observable behavior? How does the process of co-expression operate?

Food & Finance

The subdivision of labor eventually creates a supply chain that is so extensive that it becomes impossible for consumers to independently assess the quality of the products sold to them or for producers to be held accountable for injuries that result from their particular negligent contribution to the defect. At this point, it is tempting in order to avoid litigation, curb hucksters and preserve confidence for both consumer and producer to endorse, or create, a governing body to establish guidelines and employ agents to regulate the production process. However, once so established, the regulatory entity has a propensity over time to become co-opted, when not outright corrupted, by those (well-organized and/or wealthy) producers that it regulates through overlapping personnel, preferential legislation and conflicts of interest, to the exclusion of new entrants, the detriment of the consumer and the liability of the citizen taxpayer.

Where demand is elastic, this has a tendency to create successive crises of consumer confidence to the detriment of the regulated industry. Where demand is not elastic, the breakdown of the regulatory agency will instead result in occasional crises in political confidence. These crises will be handled by selective resignations and strategic appointments in order to insulate representatives from electoral ramifications whenever possible. However, these measures will rarely address the underlying systemic problem. While it remains unresolved as such, insofar as it appeals to the frustrations of the electorate, the (in)effectiveness of regulation becomes a political football, with both parties able to claim to possess the correct solution.

Localized Costs, Dispersed Benefits

Senator John McCain had President Obama on his side in calling for a halt in production of the cargo plane, the C-17, to save money for other military priorities. But thousands of jobs were also at stake. The giant aerospace company’s efforts — it has 23 lobbyists — paid off. This week, the Senate voted to keep the program alive, and a House-Senate conference will make the final call soon on how many more of the planes to buy.
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Before the C-17 vote, Boeing’s lobbyists emphasized that up to 30,000 jobs were on the line, counting workers at its plant in California and among its suppliers in 44 states. -- Christopher Drew, "Flying Into Headwinds", New York Times, 10.08.2009

A government's concern for the level of employment is prone to direct social resources into areas of marginal productivity and social superfluity. On the other hand, project extensions, due-process, government contracts, unionization, tenure and unemployment insurance stabilize oscillations in the labor market and allow for smoother transitions as the economy changes.

The dragon of the free market is unforgiving, voracious and nearly indestructible. Its steady and indifferent appetite consumes the efforts of the entire population without any promise of the long-term security upon which most citizens must rely when planning such life-impacting decisions as child-rearing, home-ownership and migration. The social and counter-party risk that accrues on account of a super-viscous labor pool thus undermines not only the psychological well-being of individuals who have a natural tendency towards complacency, but also the fabric of social and economic life when it is left completely unmediated.

In a highly commercialized society, the constant redeployment of labor towards productive endeavors greatly enhances the prosperity of all those individuals who are able to engage in commerce. But, lacking re-employable skills, scuttled members of the population risk falling out of the commercial sphere altogether and can fail to realize their share of that prosperity. For scores of citizens each year, economic transition represents marginal or negative improvement on account of their inability to find a new job of comparable value. To them, the 'system' is unable to fulfill the promise of betterment and seems blatantly unfair.

Whatever general and dispersed benefits to society that extend beyond the specific and concentrated windfalls which are realized by the owners and management responsible for employment decisions come at the potentially devastating expense of those who are dismissed. For a democratic people accustom to equal political rights, such misery juxtaposed to decadence risks a heavy-handed backlash that threatens to undermine the whole evolutionary advantage of the free market. Preemptive efforts to rectify these injustices of the free market by softening the blow to the unemployed and providing resources for their economic rehabilitation help moderate this dangerous political disaffection, but at the risk of slowly paralyzing the economy as more and more people find employment inside the government or menial service sector positions.

Note: None of this behavior is intended by its participants, but emerges as a consequence of innumerable interactions between self-interested individuals in a complex political system. Representatives seeking to get re-elected are concerned with jobs in their home state, managers concerned about competition look for ways to retain their existing revenue streams, while executive officials have to cut costs to conform with a budget that already makes taxpayers and bondholders grumble.