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December 02, 2008

Lesson for Next Time: Small is Beautiful

Antitrust law needs to be updated to include "too big to fail" as a criterion for dismemberment. The alternative is pervasive regulation and/or government ownership of institutions which control huge swathes of the economy.

Financial regulation as we've seen is, a chimera: whether or not you blame Fannie Mae and Freddie Mac for being a partial cause of the current collapse, there's no question that they WERE regulated – as is Citibank – and that they collapsed. All public companies in the US are regulated to some extent by the SEC and have draconian external audit requirements. Neither the regulation nor the auditing warmed stockholders of the potential collapse of AIG, Lehman Brothers, and now GM. Why? It's not that all the auditors and regulators are corrupt or even incompetent even though some are surely both. The problem is black swans as Nassim Taleb elegantly pointed out in his book of the same name: you are in more danger from the unknowable than the knowable risk; the past is an extremely misleading guide to the future. Put less elegantly, shit happens and all the regulation in the world can't prevent or predict it. The appearance of regulation is dangerous because it gives us a false sense of confidence – we even start believing financial statements.

Government ownership of finance and manufacturing is even worse. Witness the late not-lamented Soviet empire or China or India before they shook off their socialist ways. You do need some regulation – especially safety, environmental, and fraud regulation to govern the terms of competition; government should perform that function in an adversarial role to the private sector. Government is at its worst in regulating itself. Chernobyl was a government reactor.

A century ago the continued success of capitalism required harnessing the "trusts" – especially Standard Oil, business which got so large that they could throttle all competition and swallow adjacent parts of the value chain. Railroads had to pay Standard Oil a fee for each barrel of competitors' oil they dared to ship. Antitrust law largely accomplished what it set out to do.

Today's problem – and tomorrow's if we don't address it – is businesses which are "too big to fail". They are certainly unfair competition to their smaller competitors who can't count on bailouts. They can make up for their size-induced lethargy and opulent life styles (for executives) by taking risks secure in the knowledge that it's heads we win and tails you lose. When the mortgage securitization risks paid off, AIG and Citi could reap the rewards; when they failed, we paid.

It was hard to write and establish the law which defined dominant market position and has been used (and misused) in the last century of antitrust enforcement. It'll be hard to write the law which define "too big to fail" and it'll be subject to endless court interpretation. It shouldn't be a crime to create an entity which is too big; however, the government should have the power to require the dismembering of such an institution just as it can dismember a company whose market position is too strong to allow the market to function.

If no company is too big to fail, than market discipline will be a much more potent regulator than it is today.

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