Is Bureaucracy the Right Prescription?

This afternoon on Bloomberg Radio, Charlie Stein talked with Laurence Kotlikoff, professor at Boston University and President of Economic Security Planning Inc. The discussion was primarily framed around an article that Dr. Kotlikoff penned for Bloomberg yesterday, where he introduces his recommendation for a medium-term solution to ensuring “safe” assets make it to the markets, rather than the toxic ones that have gotten us where we are today.

The proposal involves the creation of what Dr. Kotlikoff calls the Federal Financial Authority (FFA), which would be a government agency responsible for certifying assets to be traded in the capital markets. This agency, which would function similarily to the FDA would essentially regulate which assets should be traded versus those that are ‘unhealthy’ assets prone to a higher level of systemic and short-term risk.
Dr. Kotlikoff also stated that the FFA would serve as a government-sponsored credit rating agency, so that this organization would be certifying assets and issuing credit ratings, rather than Moody’s or Standard & Poors.

Finally, the FFA would serve as an auditing function for the top 500 corporations based in the U.S., as a means to prevent another Enron-level accounting and financial scandal, and eliminating the reliance on the Big Four accounting firms, where there are many perceived (and perhaps real) conflicts of interest between their audit and accounting and consulting functions.

This is quite a proposal that Dr. Kotlikoff is presenting and I wouldn’t say that these issues don’t need to be addressed, but I am afraid that I disagree with the manner in which the professor is proposing this initiative take place. Here’s why …

First, the idea of increasing regulatory protocols through the establishment of yet another bureaucratic agency is not what the economy or the country needs at this point. I am not one of those people that see de-regulation is the only way to go, but I can assure you that bombarding the markets with new bureaucracies that only increase the markets’ murkiness is not the best solution for resolving the crisis that we’re facing.

I believe there are going to have to be changes to the regulatory landscape, particularly within the financial markets and banking sector, which will likely include an increase in regulations on firms operating within these sectors. Simply put, we will not emerge from this crisis without the regulatory environment on Wall Street increasing. It just won’t happen, whether we agree with increasing regulation or not. However, I think there is a prudent way to expand regulatory authority for the government, and of course, there are measures that will ultimately only make the challenges we’re facing much larger and last longer. Following Dr. Kotlikoff’s recommendations, in my opinion and as I see things today, would fall under the latter.

Second, there is an inherent assumption under Dr. Kotlikoff’s proposal, which I believe is extremely dangerous and perhaps careless. To think a government agency could perform all of these functions is somewhat naive. Moreover, to think a government agency could perform these functions more efficiently that the private sector (in all it’s “evil-ness”) is downright laughable, or perhaps scary.

The comparison to the FDA is a good example of this. The FDA serves to approve or disapprove drugs and devices used by physicians in the application of medical treatment or healthcare services. For those of us that work within the healthcare industry and encounter the FDA through the approval process, we know that this process can be horribly inefficeint. Many firms have generated a great deal of wealth helping other companies – biotech, medtech and pharma – navigate the temultuous channels and challenges that the FDA process presents. But, what do we expect from a government agency.

Another challenge that many firms face when dealing with the FDA is that the people there often do not fully understand the products they are considering. Based on the amount of time they spend considering these products and the limited scope of expertise they have (in comparison to the broad range of products they see), they cannot adequately measure the effectiveness of a product with 100% certainty. This is why many good products do not receive FDA approval, as well as why there are numerous recalls of drugs and devices each year (much more than the general public typically sees or hears about).

Overall, the comparison of the FFA to the FDA does not strike a great deal of confidence for the proposal of this agency as presented by Dr. Kotlikoff. You will not see me defending the credit rating agencies much, but I am not sure how the government would obtain the resouces to conduct higher quality credit rating protocols than the private sector firms that lead this business today. The majority of investors would not feel confident in an asset just because a government employee with little training and experience, making $35,000 a year certified it as good or bad.

Finally, what would the costs of a FFA-type agency be? If you just look at the credit rating function, you would have to get people that have advanced training in credit analysis, most of whom would need prior experience on Wall Street at another rating firm. Further, the FFA would need a large number of these professionals, based on the large number of assets and firms out there, which I presume the agency would have to cover all of them. Moody’s and S&P are large organizations with hundreds of millions of dollars in resources behind them, not to mention some of the most highly trained analysts; yet, they still aren’t able to cover every asset in the marketplace. I cannot imagine the operation a government agency would need just to perform this function. The building to house these government employees alone would probably be bigger than the CIA headquarters at Langley, so I can’t imagine what the costs would be, not to mention the government salaries and benefits to go along with that.

All of this doesn’t even address the other functions that Dr. Kotlikoff is recommending, including the audit responsibility, which in and of itself would have to be an entity larger than all of the Big Four accounting giants combined. I have a number of friends that came from the world of public accounting and I have worked with at least one of these firms (or a product of a public accounting firm) on multiple occasions and I can tell you the resources and effort that goes into auditing a Fortune 500, publicly-traded company is not small, as I am sure you can imagine. Again, to think this function could be efficiently performed by a government agency is borderline ridiculous, not to mention the lack of confidence that most people would have in the idea of government employees performing job functions that were once done by highly trained and well-paid private sector employees. The only positive reaction that I can imagine coming out of this is if the corporations themselves would be relieved of the high audit costs that they currently have to bear each year, although, something tells me the government wouldn’t be providing this as a complimentary service, nor would they be “company friendly” in the process.

Ultimately, I can see the direction of where Dr. Kotlikoff wants to go with his recommendation, but I can tell you that a plan, such as the FFA would not only be inefficient, it would be a catastrophic failure, resulting in significant harm to the capital markets, which of course we can’t handle at this time. Moreover, I think this is another example of a theoretical recommendation made in a vaccume, without consideration of the realistic cost, time, and logistical variables involved.

Note: This post was originally pupblished on my blog at www.marktomarket.typepad.com.