Freedom and its Digital Discontents

As I make my final statement, I must say I am heartened by
the reactions I am getting to my stance on risk management regulation, both
positive and negative.

Too often, when writing and speaking about entrepreneurship
and risk-taking and specific policy issues like Sarbanes-Oxley, I feel as if
much of my public’s collective eyes are glazing over. Compared with topics like
the environment and the Iraq war, financial regulation does not always seem
like a sexy subject.

Yet, as we realise when there is a crisis, the complexities
of the financial world affect

us all. Our standard of living and the opportunity to fulfil
our dreams and goals are dependent on the degree to which politics allows
individuals and businesses to both take risks and manage risks. This is
precisely why we cannot let the crisis of the day guide our policy on risk.

These are trying times, to say the least. But I sense in the
comments, both pro and con, a deeper and legitimate concern about equity in the
world of risk. Do the poor and those outside the system really benefit from
innovation? There is also an antipathy which I share towards corporate
welfare—what is often referred to as the privatization of profits and the
socialization of losses—which we witnessed last week in the bail-out of Bear
Stearns’ creditors in the US (and which I opposed1).

But the benefits of new financial products flow to the
masses in the same way all innovation does, and government-imposed restrictions
on this innovation risks limiting opportunities for precisely those it is
trying to protect. And one does not have to be a political conservative or
free-marketeer to see that this is the case. Writing recently on the housing
boom and bust, the former senator George McGovern, forever a hero to the
American political left for his spirited challenge to Richard Nixon in the 1972
presidential election, had this to say about what he calls the worrisome new
trend of “economic paternalism”:

“With liberalized credit rules, many people with limited
income could access a mortgage and choose, for the first time, if they wanted
to own a home. And most of those who chose to do so are hanging on to their
mortgages … If the tub is more baby than bathwater, we should think twice about
dumping everything out.”2

One can believe, as Mr McGovern does, in progressive
taxation policy and government spending on antipoverty programmes, and yet
still be skeptical about governmental micromanagement of business transactions.
I am pleased to see that even Mr Moore says he favours “a set of regulatory
policies which allow for the taking of risk, innovation and flexibility”. But
when in the next sentence of his rebuttal he calls for “constant and active
governmental regulation and intervention”, I am afraid he is the one who is
acting naively. It was the mortgage innovations spurred by the partial
deregulation of banking in the US and the UK that led both countries to have
record homeownership levels in many demographic sectors. This was a quintessentially
progressive outcome that previous “progressive” governments had never achieved.

Indeed, when looked at in terms of distribution, the housing
boom’s benefits may have been even more widely dispersed than those of the tech
boom. Nearly 70% of US families and close to one-half of American black and
Latino families now own the homes in which they live.3 And the vast majority of
borrowers in all demographic categories do not face foreclosure. There have
indeed been “record numbers” of foreclosures, but these correspond with a
“record number” of homeowners. The overall rate of US mortgages in foreclosure,
according to the latest National Delinquency Survey that tracks the last
quarter of 2007, is 2.04%.4

Cycles of innovation spur many inventions and technologies
that will survive a boom and a bust and better everyone’s lives. Yet these
cycles also undoubtedly cause pain that is often spread unevenly. While there
will always be some dislocation in a dynamic economy, volatility can be much
reduced through the introduction of what we should call a second stage of
deregulation. Let us deregulate private risk management, as we have
risk-taking, for ordinary investors as well as hedge-fund fat cats.

Take short-selling, for instance. In 2007, many hedge funds
weathered the subprime storm and even prospered because they had shorted
mortgage-backed securities and the banks that held them. Yet decades-old
regulations in the US and European countries limited the ability of mutual
funds or pension plans to engage in these same strategies on behalf of ordinary

Had retail investment vehicles the same ability to use
short-selling or other investment strategies as hedge funds, there likely would
have been two results that would have made the mortgage crisis less severe.
First would have been the immediate gains to the portfolios of ordinary folks
that would have mirrored those which hedge-fund investors are realising now.

The second, and almost more important benefit, would have
been that a larger number of short positions would likely have sent the market
a stronger signal that something in the mortgage industry was wrong. As a New
Yorker correspondent, James Surowiecki, observes in his brilliant book, The
Wisdom of Crowds, if the price of a security “represents a weighted average of
investors’ judgments, it’s more likely to be accurate if those investors aren’t
all cut from the same cloth”. He adds that limiting short-selling increases
vastly the chances that if a price “gets out of whack, it will really get out of

Here, I am pleased to report that the new European Union
UCITS 3 (Undertaking for Collective Investments in Transferable Securities)
directive greatly liberalises the ability of retail portfolio managers to
utilise shorting strategies with financial products such as derivatives. The US
should follow suit.

There is plenty of other deregulation that could bring the
benefits of competitive risk management to ordinary homeowners, investors and
savers. Lifting these barriers to risk hedging, rather than reinstating failed
old regulations, would maintain the US and the UK’s prosperity while reducing
volatility significantly.


1. John Berlau, “Stop
the Bear Stearns Boondoggle,” OpenMarket, March 21st 2008, available at

2. George McGovern, “Freedom Means Responsibility”, Wall
Street Journal, March 7th 2008, available at

3. US Census Bureau, “Housing Vacancies and Home Ownership:
Annual Statistics: 2006”, available at

4. “Delinquencies and Foreclosure Increase in Latest MBA
National Delinquency Survey”, press release, March 6th 2008, available at

5. James Surowiecki (2005), The Wisdom of Crowds, Anchor
Books, pp. 227-8.