Baseline Scenario -- Two Important Topics

The Baseline Scenario
At the Beach
Has Anyone Taken Responsibility For Anything? (Weekend Comment Competition)
Management Consulting for Humanities Ph.D.s
An Inside Perspective on Regulatory Capture
At the Beach
Posted: 15 Aug 2009 07:00 AM PDT
I will be at the beach with my family for a week. I’m not certain about this, but there is a strong possibility that I will not be using a computer, let alone checking email or blogging. (Computers are useful when traveling, especially since I don’t have an iPhone or a Blackberry, but if you have one then there is the temptation to check your email, and then you are on a slippery slope to hell.)
Luckily for you, Mike Konczal, aka Mike Rorty, of Rortybomb and The Atlantic, has agreed to be my stand-in for the week and will be guest-blogging here. Mike is a bona fide financial engineer with the good sense to live in the San Francisco area, and is a natural with economics, finance, public policy, and the English language.
Enjoy.
(Simon will probably still be blogging, although he will also be on vacation; in fact, he has been on vacation for the past week.)
By James Kwak

Has Anyone Taken Responsibility For Anything? (Weekend Comment Competition)
Posted: 15 Aug 2009 03:14 AM PDT
With the anniversary of the Lehman-AIG-rest of the world debacle fast approaching, it seems fair to ask: Who accepts any blame for creating our excessively crisis-prone system?
Friends and contacts who work in the financial sector freely discuss their participation in activities they now regret. But where is the mea culpa, of any kind, from a public figure – our “leadership”?
I suggest we divide the competition into three classes.
Policymakers who now admit that any of their actions or inactions contributed to the Great Credit Bubble. Blaming China gets a person negative points; this may hurt Fed officials.
Private sector executives who concede they made mistakes or misjudged the situation so as to lose a lot of Other People’s Money. Blaming Hank Paulson also earns negative points (too obvious).
Anyone charged with safeguarding consumers, in either public or private sector capacity, who now says that they or their organization did a completely miserable job. My guess is that you will find precisely no one in this category.
You can award points for style, timing, and extent of the apology or near-apology.
Feel free to suggest other categories or to propose additional scoring rules.
By Simon Johnson

Management Consulting for Humanities Ph.D.s
Posted: 14 Aug 2009 08:00 PM PDT
Ezra Klein referred me to a 2006 article, “The Management Myth,” by Matthew Stewart, which has just led to a new book by the same name. Stewart has a Ph.D. in nineteenth-century German philosophy and was a founding partner of a management consulting firm; I have a Ph.D. in twentieth-century intellectual history and spent three years as a management consultant (at McKinsey) before co-founding a software company, so I thought I might find a kindred soul. Also, I’ve been thinking for years that I should write a book about my strange journey through the business world, but will probably never get around to it, so I was wondering what that book might have looked like.
Well, we’re not so kindred after all, although my criticisms of the management consulting industry certainly overlap with his. One difference: I have never, ever found myself thinking, “I’d rather be reading Heidegger!,” although (or perhaps because) I read my share of Heidegger back in the day – Being and Time was on my orals list. (That said, I have also never read books about management, which is what Stewart was doing when he was wishing for Heidegger.)
Stewart is full of scorn for the “management literature” – meaning books with big fonts, bullet points, and truisms disguised as buzzwords – and I’m sure that scorn is well-deserved. But he blurs that scorn into scorn for the management consulting industry itself. And while the latter may deserve scorn for its own reasons, I think the two – the books and the consulting firms – are quite different.
As a management consultant, on an actual project, I can’t recall anyone ever discussing, let alone taking seriously, anything he or she had read in a business book or learned in a corporate strategy class. Our main job was digging up information, doing analysis that was trivially lightweight by academic standards but more than most companies do on their own, and packaging the whole thing into a coherent storyline that made a point. What McKinsey brought to the exercise was smart people who were willing to work extremely hard and obsess about trivial details until late at night – for example, after photocopying presentations for a client, someone had to flip through them to make sure that none of the pages got rotated or pushed off-center by the copier – along with some core skills in turning relatively little data into a convincing-sounding story.
As for getting an MBA, I would say that 90% of the consultants I knew already acknowledged what Stewart argues – it’s not what you learn at business school that matters, it’s the screening function. Top business schools screen for the attributes that certain types of companies, including consulting firms and investment banks, value – above-average intelligence, ambition, presentability, ability to get along with others, willingness to follow orders, and a strong streak of conformism. McKinsey recruits people with Ph.D.s (and certain other advanced degrees) as well because the Ph.D. is an indicator of intelligence and (to some extent) ambition, but it is considerably harder to get a consulting job as a Ph.D. from a top school than as an MBA from a top school because of the other things that an MBA signals. But the point is that everyone knows this already, and many people still choose to go to business school, because it’s the rational choice given the job market.
I think the biggest problem with management consulting is that most of the work on a project is done by junior people who know absolutely nothing about the industry they are serving, and don’t even realize how little they know. (And generally the partners don’t know that much, either, since many of them have never worked anywhere except in consulting or maybe banking.) Having worked as a consultant to the software industry and then as an employee of the software industry, I have seen this from both sides, and I’m embarrassed for the naive consultant I used to be. But it’s also true that many of our clients could not have assembled teams of people to do the kind of work that we were doing – not because they didn’t have the right people, but because those people are invariably too important to be freed up from their day jobs.
I hear that in the legal industry more and more clients are refusing to let law firms bill them for first-year associates. I think that the consulting industry will probably move that way. But even so I think there is some place for management consulting firms.
By James Kwak

An Inside Perspective on Regulatory Capture
Posted: 14 Aug 2009 05:43 PM PDT
We received the following email from Jim Coffey in response to Bond Girl’s recent guest post, “Filling the Financial Regulatory Void.” Coffey agreed to let us publish the email. As he says below, he spent 27 years in the enforcement division of the SEC.
Bond Girl’s “Filling the Financial Regulatory Void” provided insight into human deficiencies in the current financial regulatory system. But it overplays the human failings of regulators and concludes with a proposed solution that, in all likelihood, would turn out worse than the current situation. But first, in the interest of full disclosure, I should tell you that I retired two years ago from a management position in the enforcement division at the SEC after 27 years. So I was (and in my heart, I suppose I still am) a financial regulator. That background probably should be taken into account by anyone who reads this response.
There is no doubt that “regulatory capture” exists and is a meaningful factor in the recent failures of our regulatory system. Many of us in the enforcement division dealt with the problem regularly when we sought input from those in the agency who were responsible for regulating aspects of the securities markets. Over time, regulatory policies and practices had emerged that seemed to contradict the purpose if not the letter of the law. In other cases, over-arching issues (e.g., increases in fees charged by investment companies despite growth that should have resulted in economies of scale and decreasing fees) simply were not addressed in any meaningful way.
But the majority of regulators I worked with were critics of the problem of “capture,” not victims. Much of the problem arose from decades of deregulation dating back to the beginning of the Reagan administration. Elected deregulators appointed their own kind to head regulatory agencies and they, in turn, removed career regulators from management positions and replaced them with appointees who had worked in or represented the regulated industries. These new managers and, in many cases,the people they recruited and promoted, advanced or adhered to a regulatory scheme that, at least with respect to the most important issues, advanced the interests of regulated.
Bond Girl is right, the industry “captured” the regulators and the regulatory system. But not in the passive sense that true regulators over time came to identify too closely with the interests of the regulated. This is not a case of financial regulators falling victim to the Stockholm syndrome. The vast majority of capture resulted from intentional efforts by the finance industry to advance their narrow interests at all costs and defeat meaningful regulation. Unfortunately, we live in a country that can be bought from the top down and the finance industry exploited the situation very successfully. But do not blame the regulators. Career regulators are as much the victims of these events as the public’s economic welfare.
The creation of paid social entrepreneurs to perform regulatory functions will not enhance regulation nor reduce “capture”. I’ve sued too many CPA’s over the years for bad audits to believe the answer lies in creating a new class of auditors. Audit clients often “capture” their auditors. The result is bad audits resulting in uncorrected and undisclosed financial fraud. The victims are always the shareholders and the market. Besides, using money to “incentivize” a new, private class of regulators plays directly into the hands of the finance industry. No matter what the regulatory fee structure may be, government will never be in a position to compete with the financial industry when it comes to “incentivizing” regulators-for-hire.
We need to look elsewhere for solutions to the problems that hamper our financial regulatory system.
First, we need to look at the structure of the finance industry. Commercial banks got into trouble in large part because they warehoused (often off the books) toxic securities underwritten by their investment banking counterparts within the holding company structure. Similar abuses in the past resulted in separating investment banking from commercial banking. We should try it again. Insurance should be split off as well.
Second, no institution should be allowed to become too big to fail. Those that have already achieved that status should be broken up.
Third, we must put in place an effective financial consumer protection agency which can counteract the worst consumer practices of a too powerful industry.
Fourth, investment banks should be made to eat what they kill. Public ownership of investment banks coincided with the industry’s decline into extremely reckless risk taking. Investment bankers should be required to own a significant percentage of the equity in the institutions in which they work (something approaching 50%, to pick a number). Having a significant portion of their net worth tied up in such stock would provide an incentive to carefully identify and measure risk. It should also reduce outsized compensation for investment bankers.
Fifth, there should be greater limits placed on the ability of political appointees to oust career regulators. Make capture more difficult.
Sixth, more financial products and firms should be subject to government registration and reporting.
Seventh, regulators should not be forced to wear conflicting hats. One cannot promote an industry while protecting the public from it. Don’t ask regulators to be industry cheerleaders. Limits can be placed on regulators to ensure that they not act without consideration of the impact of their actions. But over-regulation is not what got us in this position. Cheerleaders purporting to be regulators did.
Finally, the government should adopt a bonus plan for regulators, run by regulators (who would rotate off after short, fixed terms, to prevent back-scratching among board members) to provide incentives for regulators to excel at the job of regulation. Recognized, protected and incentivized regulators will resist capture.
By Jim Coffey
Update: Bond Girl responds.