Will the Europeans Take the Lead on Reforming Derivatives Regulation?

On Leave It to Beaver, when Beav did something to dig himself deep into a hole, his brother Wally would say, "You've really done it now." The big banks on Wall Street may have really done it now in the derivatives market.

News media today report that Goldman Sachs and other Wall Street firms have been buying credit default swaps that would rise in value if Greece were to default on its sovereign debt. This follows other recent reports that Goldman Sachs helped Greece disguise the level of its indebtedness by offering derivatives transactions that wouldn't appear to be debt. Thus, Goldman helped Greece appear more fiscally sober than it was. Moreover, other European nations seem to have drunk of this same derivatives cup to sweep national debts under the carpet.

It would be difficult for an EU member to scold Greece for profligacy if it had indulged in similar extravagance. The Wall Street firms involved in these deals have the EU nations exactly where they want them--financially bound to the Street while mutually lacking the moral standing to police each other.

But then, it seems that Goldman (and other firms) may have also bet on a Greek default, after having aided its fiscal excess. If so, they would have gained perhaps hundreds of millions in fees for their derivatives products and then who knows how much profit if Greece collapses under a heavy debt burden that Wall Street facilitated. To make things worse, credit default swaps are sometimes thought to affect the market for the primary debt to which they relate, with increased credit default swap trading activity and rising prices fostering greater doubt about the debtor's chances. Thus, buyers in the credit default market might exacerbate the debtor's problems and thereby increase the profit potential of their credit default swaps.

If it's true that Goldman and other major Wall Street firms have been on both sides of the table with Greece (for them and then against them), they would have been too clever by half. Continental Europeans almost reflexively mistrust "Anglo-Saxon capitalism." They have limited faith in market forces, and are quite willing to accept the stability of government control over market volatility. Business people are not as highly regarded in the EU as they are in the U.S., and don't have the political pull in Berlin and Paris that they do in Washington. Per capita income in Western Europe was, some 40 years ago, close to per capita income in America. Today, it's about thirty percent lower. The Europeans have been willing to pay the economic price for slower growth in exchange for greater stability. After the American-spawned mortgage crisis and credit crunch of 2007-08, they've lost a lot of faith in market forces. The sovereign debt mess would only reinforce these feelings.

There's a good chance that Europe will take the lead in reforming the regulation of derivatives. The EU already leads the U.S. on antitrust enforcement and electronic privacy. Big American companies like Microsoft and Intel have had to knuckle under to EU regulatory imperatives that reached beyond the requirements of U.S. law. Goldman Sachs, J.P. Morgan Chase and other denizens of Wall Street are not worshiped across the pond. Even worse, they've made various European governments appear to be easy marks. No one likes to be seen as a gullible dupe, especially not high ranking government officials who are the likely dupes. Regulatory fervor is undoubtedly rising east of the English Channel.

By all indications, neither Congress nor the Obama administration are focused on reforming the regulation of derivatives. Heavy duty lobbying by Wall Street is probably the most important reason for their inaction. But that will leave an open field for the Europeans to do as they please. Ninety percent of life is just showing up, as Woody Allen once said. American participation would help shape the future regulatory structure, and make it more closely resemble something we'd prefer. It's fallacious to think that the regulation of the derivatives markets won't change just because of somnolence on the Potomac. The world today is much bigger than the United States, and will move on with or without the United States.