Thursday, April 03, 2008

An Occasional Crisis is the Cost of Innovation: The Case Against New Regulation of Financial Markets

THE ECONOMIST--Bold re-regulation could damage the very economies it is designed to protect. At times like this, the temptation is for tighter controls to rein in risk-takers, so that those regular, painful crashes could be avoided. It is an honourable aim, but a mistaken one.

A sophisticated and innovative financial system is susceptible to destructive booms; but a simple, tightly regulated one will condemn an economy to grow slowly.

The tempting answer is to try to wriggle free from the dilemma with a compromise that would permit innovation but exert just enough control to squeeze out financial failure. It is a nice idea; but it is a fantasy. The experience of the past year is an object lesson in the limited power of regulators.

The notion that the world can just regulate its way out of crises is thus an illusion. Rather, crisis is the price of innovation, so governments face a choice. They can embrace new financial ideas by keeping markets open. Regulation will be light, but there will be busts. The state will sometimes have to clear up and regulation must be about cure as well as prevention. Or governments can aim for safety and opt for dumbed-down financial systems that hobble their economies and deprive their people of the benefits of faster growth. And even then a crisis may strike.

Comment: As tempting as more regulation of the financial markets seems right now, we should not underestimate the market's resiliency and ability to self-correct. As economist Arnold Kling reminds us, "Markets fail, let's use markets."


At 4/03/2008 10:30 PM, Blogger Jack McHugh said...

Government failure is the rule; market failure the exception. Government failures are rationalized and reinforced; market failures are self correcting and are eliminated. Use markets.

At 4/03/2008 10:38 PM, Anonymous Anonymous said...

Markets fail, use taxpayer money to bail out markets. Lets not forget the corporate welfare. Capitalism is nothing more than privatizing the profits and socializing the losses.

At 4/04/2008 11:20 AM, Anonymous Anonymous said...

Anon. 10:38

Not sure if your reference about "corporate welfare" referred to the recent sale of Bear Sterns.

Just to clarify, Bear Sterns was not a bail out - investors lost their shirts. When a company with assets valued at $80.00 per share sells for $10.00 per share, we generally call this a capital loss. Just what do they call it on your planet?

What often doesn't get discussed is the extent to which the present crisis has been exacerbated by the following governmental actions:

1. Loose monetary policy resulting in interest rates at 50 year lows
2. Changes to international banking rules (Basel II) increasing capital requirements for conventional loans but excluding mortgages held in the form of securities thereby creating an incentive for firms to securitize mortgages
3. Mandating that banks make loans to borrowers with poor credit ratings without pricing in the risk with the social goal of increasing home ownership
4. Failing to privatize Freddie Mac & Fannie Mae. Fred & Fan have not been necessary for years and providing greater mortgage options if anything has helped to fan the flames of the housing bubble
5. Making mortgage payments tax deductible has further encouraged taxpayers to mortgage their assets rather than pay down their debts. The U.S. savings rate has declined over the last 20 years to -1% in 2004 (ie. people spending more than they earn) (source: Predictably Irrational by Dan Ariely)

Government does have an important, necessary role and it is very difficult to gage the full effects of public policy. It is very easy to get it wrong thinking that we will prevent the next crisis particularly when emotions are running high (read desire for blood and blaming).

Brush fire management does not generally produce the best policy. The kinds of financial instruments and even the structure of the finance industry has become increasingly complex over the last 20 years.

Ben Bernanke and Henry Paulson have tried to stabilize the financial system in the present crisis and I believe that they have done a credible job given the present constraints. Any regulation will need to be very carefully considered on this question.

I agree that public money should not be simply thrown at a problem or used to protect companies or individuals from the consequences of bad decisions.

I must confess to some grave reservations regarding the present proposals to "fix" the mortgage market coming out of Washington. The idea of bankrupcy judges being able to change the terms of a signed contract is of particular concern. Some of these ideas could easily keep the market from correcting itself or drag out the problem for an extended period of time.

The devil is in the details.

At 4/04/2008 3:31 PM, Anonymous The Masked Millionaire said...

Would you trust the government to manage your business? I would not.

They can't run the government for goodness sakes. How naive would a person have to be to let them run a business, a sector, or your life?

At 4/04/2008 10:03 PM, Anonymous Anonymous said...

The scariest part of this crisis is that Washington is returning to the idea of "managing the economy". We are getting back to the tom foolery of Keynesian interventionism. The fed maintaining liquidity and easing lending rates in the present crisis is one thing, a full scale Washington style "solution" to the housing crisis is another. Feel a snafu in the making especially with Obama's idea of allowing bankrupcy judges to alter the terms of legal contracts.

Henry Paulson's idea of temporarily increasing oversight on investment banks seems like a good one. It will likely not win the day. As Ronald Reagan once said "there is never a sunset clause on a government program".


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