October 7, 2008

Surveillance-based regulation puts its subjects in a Panopticon, Jeremy Bentham's model prison. For the left, this is a fate fit for reckless financiers, for the right, this is reason enough to free markets of all regulations. Consider high level sports though. The more difficult to trace drug abuse, the more athletes are watched all year round by responsible authorities. This offers, if not a ready made solution, at least a methodology.

As the current financial crisis continues to unfold its reality show, dumping subprime loans on prime time, let us indeed deepen our inquiry on information. Information theory it is not, in the technical sense developed by Claude Shannon and Léon Brillouin. Rather it belongs to social information theory, a field to be structured around concepts such as those proclaimed by our motto, Identity, Privacy, Responsibility.

As described by Chrystia Freeland (*), trust in the elite is in so short a supply today that elected representatives are paralyzed, afraid to follow their leaders lest they be accused of betraying their electors. Recalling the Great Depression, David Leonhardt shows how banks transform trust as well as money (**). To convey money from depositors to borrowers, a bank repackages its trust in its debtors back into its creditors' trust in itself.

Seen in this light, the financial crisis is a study in Responsibility. Eschew responsibility long enough and, inevitably, trust comes to bust.

Comic effects should be savored. As illustrated by Peter Thal Larsen and Francesco Guerrera (***), self-regulation has been exposed as an oxymoron by the "past excesses" of investment banks. The same lesson, wolves cannot be entrusted with the sheep, ought to apply to private data aggregators, who are but data banks. Speaking of confidentiality, we have described a flight from responsibility, we have predicted it will go from trust to bust. Yet watch the FTC slumber as Google plans future excesses. Can truth, like privacy, depends on the industry?

As a whole it is a tragedy. As Stefan Stern rightly points out (****), we live in "the misinformation age", "a short seller's paradise" where vicious rumors thrive. Whether they claim human lives, as Choe Sang-Hun relates from Korea (*****), or corporate ones, as Louise Story accounts from Wall Street (******), rumors always start as opinions. Whether true or false, well intended or malicious, these opinions need to pass a certain volume threshold to claim their victims. Overwhelming rumors are the microeconomic equivalent of market bubbles.

To forbid all short-selling in principle is a blunt measure urgency might well justify. But, as most bubbles start as reasonable opinions, many short-sales are legitimate bets against reckless targets. Why not design a mechanism to freeze equity related transactions on a case per case basis before the avalanche threshold is crossed? It would be to equity what bankruptcy protection is to debt. Let whistle blowers be rewarded for their acumen but stop the herd from mindless stampedes. This gives truth time to emerge and discourages those whose business model is to create stampedes.

It all comes back to regulation. Its details may depend on the industry concerned. Its enforcement however is not and enforcement is what arouses ideological fears. To reintroduce objectivity, recognize and distinguish the three commands of rule enforcement: Prevent, Watch and Audit.

To prevent is the privilege of the operator, who alone determines what can happen and hence what may not happen. Whether the operator offers a computing platform, credit or recommendations, whether it controls a media, a market or a service, government regulation can take over this power. As Jonathan Zittrain pointed out, today's disappearance of enforcement latency makes this type of regulation so efficient that it must be reserved to vital, time sensitive matters, as when an avalanche threshold is about to be crossed or facts are knowingly misrepresented to begin with.

To audit is to let one exercise one's responsibility. While audit-based regulation respects the freedom of actors and their rights to confidentiality, it requires in exchange that all actions be traceable and all actors accountable. With cause or at random, relevant actions can be examined and actors found in violation of the rules punished. Traceability has a cost for actors, who must maintain accurate logs, and regulators, who must staff appropriately to audit them and ought to compensate victims of negative audits. Consider these costs to be the price of fairness.

The real issue comes from regulation by watching. Governments are naturally keen on universal, permanent surveillance. Last Halloween, we have mocked this temptation but reality is never far away. John Markoff tells us for instance how "Skype Text is monitored in China" (*******). Lest we conclude democratic governments are more principled, remember the Airport Syndrome, the need to adopt the studied blandness of the spy, is fed by US government practices, pursued in the name of security despite some ludicrous results.

There exist two spheres, one private, the other public. Since it is normal to subject public activities to surveillance by the state, it is crucial to set the border between public and private spheres so as to protect the private one. When it comes to complex securities, we suggest that a mechanism which prevents actors from fooling traceability and reports the aggregates necessary to keep a watch on avalanche thresholds is optimal. Why not for instance set up global, yet decentralized markets whose operators are not privy by design to each and every negotiation? It can be done.

Exposés of how society deals with sickness and madness in its midst made Michel Foucault famous. Financial bubbles await a disciple of his.

Philippe Coueignoux

• (*) ............. The hoi polloi vents its discontent on an untrusted elite, by Chrystia Freeland (Financial Times) - October 1, 2008
• (**) ........... Lesson From a Credit Crisis: When Trust Vanishes, Worry, by David Leonhardt (New-York Times) - October 1, 2008
• (***) ......... Never glad confident morning again?, by Peter Thal Larsen and Francesco Guerrera (Financial Times) - September 27, 2008
• (****) ....... There is nowhere to hide in the misinformation age, by Stefan Stern (Financial Times) - September 23, 2008
• (*****) ..... Web Rumors Tied to Korean Actress's Suicide, by Choe Sang-Hun (New-York Times) - October 3, 2008
• (******) ... Banks Fear Next Move By Shorts, by Louise Story (New-York Times) - September 15, 2008
• (*******) . Skype Text Is Monitored In China, by John Markoff (New-York Times) - October 2, 2008