A Man against the Machine

We do not yet know what combination of black-box computer programs and electronic trading algorithms, interacting across more than 50 market centers, caused this catastrophe. But our lack of knowledge itself confirms how far our regulatory and surveillance capabilities have fallen behind financial innovation.
Kaufman’s approach – with speeches on the Senate floor as a central feature – seemed irrelevant or even quaint to critics even a few weeks ago. No significant Wall Street voices acknowledged his concerns – preferring instead to praise the equity markets as a shining example of well-functioning technology.

Now people get it. As Senator Mark Warner graciously acknowledged, The Senator from Delaware sounded an early warning signal that the massive amounts of investments that had been made by certain firms to try to get what appears to be a fractional millisecond advantage in the trading process might come back and haunt us all... I’ve been proud to follow his lead.

The SEC was once a great and powerful independent agency. It fell on hard times in recent decades and is only beginning to get its act together under new leadership. Yet it still does not routinely collect the data that it needs – trades by time and customer – to understand the actions and impact of large traders. Kaufman has consistently pressed them to do more – and do it much faster; to be sure, they and many others are now listening.

On a third issue, the results so far are mixed. Kaufman championed the case for making America’s biggest banks smaller, as part of comprehensive financial-reform efforts. His advocacy helped build support and forced a Senate floor vote on an amendment, co-sponsored with Senator Sherrod Brown, that would have imposed a hard cap on banks’ size and leverage (debt relative to assets).

The amendment was moderate and entirely reasonable, yet it went down to defeat, 33-61, also on May 6. It might have gained more support just a few days later – after senators witnessed the bailout of the giant eurozone banks. Still, it has strengthened backing for another amendment, sponsored by Senators Jeff Merkley and Carl Levin, which would restrict proprietary trading by megabanks for their own account – coincidentally a practice that is presumed to be a large and dark part of high-speed trading.

The deeper and overriding point of Kaufman’s critique of our system is the need for tough laws. We cannot merely rely on regulators to do the right thing. In particular, regulators have no chance to look over the horizon and act preventively when markets are opaque, and when powerful Wall Street interests (and their Capitol Hill allies) can circle the wagons and claim that there is no problem.

Unfortunately, despite his newfound prominence on the national stage, Kaufman will be out of office at the end of this year – he was appointed to fill Vice President Joe Biden’s seat at the end of 2008 and committed at that time not to run for re-election.

When he goes, dangerous elements on Wall Street will no doubt breathe a sigh of relief. Let’s hope that by then he will have helped move the consensus permanently among his colleagues – preparing the ground for further congressional action aimed at a serious tightening of safeguards over the financial sector.

Kaufman’s lasting legacy will be a simple and powerful idea that reasonable people increasingly find to be self-evident: relying on deregulation and self-interest in today’s complex, opaque markets will manifestly fail to produce a reasonable allocation of capital or support entrepreneurship and growth. We must write and enforce laws that restore credibility to our financial markets.

Simon Johnson, a former chief economist of the IMF, is co-founder of a leading economics blog, , a professor at MIT Sloan, and a senior fellow at the Peterson Institute for International Economics.

Copyright: Project Syndicate, 2010.www.project-syndicate.org

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