The Deregulation Ideology among Economists

I have to come clean on regulation. Contrary to assertions about "left-wing economists," I am generally anti-regulation. When markets approach competitive conditions, they work best when they are left alone. Sometimes regulation and market intervention are needed to force markets into the competitive mold, at least approximately, but only when we are sure that the costs of market failure are sufficiently high to justify intervention. The threshold for intervention is fairly high.

I think Greenspan is getting a bad rap when he is criticized for being anti-regulation with respect to financial markets. Most of us were. Well, maybe I should speak for myself - I was. When you looked at the data and saw, for example, except for the S&L crisis, no or very few bank failures you wondered if there was enough competitive pressure in the industry. In a few years there were literally no bank failures in all of the U.S. At the time, it seemed like regulations such as those that prevented banks from paying interest on deposits above a set amount inhibited flexibility and helped contribute to disintermediation problems, and there were other regulations that also seemed to do more harm than good. If someone had asked me at the time if I thought we needed more or less regulation in financial markets I would have said less, except for a qualification about capital requirements for bank owners so they are not playing with other people's money with no stake of their own in the bet. That's a prescription for moral hazard and excessive risk taking. But there was a general belief among economists that modern financial markets could handle more competition, and a movement toward deregulation.

Maybe other economists saw things differently, I'll let them speak for themselves, but I have a hard time being critical of Greenspan as an individual on this particular point (and, in general, he gets too much credit/blame as an individual anyway). He was part of a deregulation wave, but he didn't start it. There is the Gramlich episode (Greenspan's response), but Greenspan didn't ride roughshod over others who thought we ought to intervene with new regulation, or who thought we should step up enforcement of existing regulation. Sure, he was a bit on the outer fringe in terms of the degree to which he believed in these ideas, not all of us were completely anti-regulation, but for he most part the general attitude was that we needed to deregulate whenever and wherever we could, and it's my impression that most economists supported this view, even those who are known to be "left-leaning."

My biggest complaint in the past was that we were failing to rein in market power, that's where I thought the regulators were falling down, by allowing too much monopoly power in certain sectors (I still think that). I believe regulators should intervene with new regulations or lift old regulations as needed to approximate competitive conditions - the goal of regulation is to make markets work better - but I can't say that I was worried about deregulation somehow leading to a market meltdown of the type we have seen recently (with respect to the present crisis, the problem was more the failure to enforce existing regulations or to impose new ones rather than deregulation). Monopoly power was my main worry.

Most markets don't collapse like this - they are self-regulating and can be left alone (and if they do collapse, the entire economy is not threatened) - but financial markets are different and that's something I won't forget again. I'm still not sure exactly how to prevent the build-up of common risk to the point where the entire financial sector and greater economy are vulnerable to a bad outcome, capital requirements, transparency, and better ratings agencies are a start, as is reducing the concentration of market power, but using regulation to prevent the possibility of systemic breakdown in the financial sector is something that demands more attention, and something I hope I - or we - don't overlook again. There are good ideas out there, and hopefully we can find a way to reduce our vulnerability to the problems associated with widespread failure in financial markets.

Comments

[david]

Put another way, most economists, even if they are to their colleagues' left, are not really all that left-leaning. And, not precisely the same thing, they tend to believe that competitive markets are the default norm. Lots of us are left leaners (some of us have tipped all the way over) that don't; we just tend not to be economists.

I don't think the the goal of regulations is to make markets work better; I think it's to make society function better, and worrying too much about the magic market seems to get in the way more than it helps. I suspect I've been wrong more often about the world than you, though, which is why I'm especially happy to get to read the blog, and I hope this comment doesn't read as complacently as it might.

The weird thing for me is the uneasy balance of the empirical claim that competitive markets are the norm and the ideological claim that regulation is something to be constantly warned against. Looks like a closed circle too often, where all the evidence is assumed to support the ideology, and the ideology determines what counts as evidence.

[save_the_rustbelt]

Perhaps I am in a sour mood, but my view on regulations has been modified by what I see as a significant deterioration in business ethics over the past 30 years.

There have always been problems and scandals, but I get the feeling (backed up by experience) that the baby boomers plowed a wide path through former ethics expectations.

Having said that many government regulators are ham-fisted and have no relationship to common sense, and some regulations have no relationship to common sense.

Somewhere there is a balance.

Am I right? Wrong?

[Dickeylee]

Good God, Mark is an Ayn Rander?!?

[jfb2252]

rein in markets, not "reign" in markets

[Oops - thanks - fixed - MT]

[JeffF]

"I don't think the the goal of regulations is to make markets work better; I think it's to make society function better..."

This is exactly what I was going to say.

"When you looked at the data and saw, for example, except for the S&L crisis, no or very few bank failures you wondered if there was enough competitive pressure in the industry."

It would appear that you ought to have wondered at the effectiveness of banking regulation.

Were there really very few bank failures, or were there merely few banking failures in the banking sectors which had been carefully regulated since 1930's?

I think most libertarian ideology wilts under a less provincial perspective.

[Dave]

So the problem isn't Greenspan but freemarket economists all across the spectrum? How many economists were predicting this mess a year ago? Not many, not Krugman or this blog. I thought something like this was coming but I'm just a simple old fashioned Marxist. One positive result that I hope to see out of all this is that the economics profession loses some clout and prestige. They richly deserve it. I think that would be an appropriate market response.

[David in NY]

When you looked at the data and saw, for example, except for the S&L crisis, no or very few bank failures you wondered if there was enough competitive pressure in the industry. In a few years there were literally no bank failures in all of the U.S.

Mark, to a non-economist criminal lawyer, this sounds absolutely nuts. I prefer a system in which, "no bank failures for years" is the norm. It's a feature, for heaven's sake, not a bug. "[C]ompetitive pressure," remember (I know the leave this out of Econ classes, but bear with me), includes pressure to do irrational or illegal things, and to do it with other people's money. Regulation for years was a brake on that, mostly, with a rather bigger exception in the S&L situation than your rosy view allows.

I guess I'd like to know what the deregulation has done for the economy as a whole, viewing as I do its concentration of enormous wealth in the hands of a relatively few investment bankers and their ilk as more a downside than an upside. Who, besides Wall Street, has gained from it? Damned if I know. And if I'm right in my suspicion that any "gains" have been limited to a very few prosaic type of financial transactions, can we throw out the filthy bathwater that is the rest, and just keep the baby?

[hari]

After the Great Depression...this financial meltdown will be more than just a matter of tinkering with regulatory regime and whatnot. This is one-of-kind of historical watershed in which global capitalism, as we have known it during last three decades - under deregulation - will be a distinct past phenomenon. It has very little chance of getting a second life.

The framework of financial regulatory oversite will be discussed in great detailed behind closed doors by G-7 finance ministers over the weekend. They have a brief in front of them and I suspect Paulson will encourage them to facilitate its implementation. [FT has dealt with some of it last week or so.]

Mark is, of course, not a political economist with historical perspective; otherwise he would not be so categorically against market regulation. My sense is that a lot of derivatives under hedge funds and others will become defunct or,like Revlin said, part of historical dustbin.
Highly leveraged financial instruments in which the issuer has no own risk is NOT any more viable - and will certainly be opposed by EU and others.

Personally, I wish we could get back to the organized financial market in which transparency - not greed - was the *option* of modern-day banking management. You bet they will not regulate themselves - where money making is concerned. They will need to be regulated and if necessary controlled by Agencies - even if it means slowing down the 7/24h hi fi market a bit. That's the result of Globalization.

[David in NY]

Mark, I like to hear a discussion between you and say, Michael Greenberger of the U. Maryland Law School, on the merits of deregulation.

[robertdfeinman]

Language police (again).
What is "regulation"?

1. Prohibit or inhibit certain actions
2. Set requirements for health, safety, fraud protection etc.
3. Insure that adequate information is provided

Now let's look at the current situation.
1. Excessive leverage occurred because of inadequate reserve requirements. This is bad, so regulation would have been useful. Excessive market power also is bad, but the normal goal of all capitalists, so this should be controlled (but isn't anymore).

2. Excessive fraud has occurred both in the housing sector as well in many other areas of commerce (Enron, et. al). The Justice Dept has revealed that they aren't even prosecuting wrongdoers - they're "deferring" prosecution. When firms are found guilty there is hardly ever any criminal liability, instead they pay a fine (which comes out of the stockholder's earnings, not management's) and promise to be good in the future.

3. Sarbanes-Oxley is now made out to be the villain, but who created the opaque financial instruments that are now impossible to price? Markets need both parties to have adequate information, the lack is a form of market manipulation and needs to be regulated.

That modern economists are generally in favor of a market-based system is unsurprising, it is the only type of structure being taught any more. How many courses are given about Henry George, or the Ephrata commune, or the new type of South American socialism?

As I keep saying it isn't who owns the means of production that is important, it is the governance structure. Right now we have public ownership of firms, but not public governance. In Germany they have a mixed model where labor has some input. There are other combinations, but they aren't considered by US academics.

So what type of "regulation" is excessive or unneeded? I'd like some specifics.

[hari]

The bottomline is that American capital market is the foundation of international finance. Therefore, under no circumstances, can it be allowed to be fraudulently manouvered by (SIVs, CDOs, etc) under unregulated investment bank and hedge fund instruments.

[hari]

rdf -

You will get it after the G-7 meeting over the weekend.
I hope you have patience for them to deliberate and decide how to go forward - after this dismal period of credit crunch.

[dissent]

It seems to me that economists have had great influence on policy over the last 30 years and the results are in: good for finance & the wealtht, bad for the American people. On trade, regulation, taxes, and more.

Perhaps this is because the influential economists have been conservatives, and their ideology was simply wrong.

But in that case, this deregulatory bias Prof Thoma describes fits most comfortably into the conservative framework, and thus it appears to have a quality of guilt by association.

[spencer]

I'm not so sure we need so much more new regulation as a more professional, less biased application of the existing regulations. To me the biggest source of problems was off-balance sheet accounting. Why the accountants and regulators let that practice spread the way it did is a major problem. Except for a few extremely limited exceptions there is only one reason for off-balance sheet transactions -- to hide the truth from investors and regulators. It should never have been allowed to be used to avoid capital requirements.
But we do not need new regulations to achieve that goal.

To the lawyer who questioned the point about no bank failures.
To an economist if there are no bank failures it implies that bankers are being too cautious and are not funding some good investments that should be funded. Banks can err on both sides of caution.

[anne]

http://www.nytimes.com/2008/04/11/business/11soros.html?ref=business

April 11, 2008

The Face of a Prophet
By LOUISE STORY

George Soros will not go quietly.

At the age of 77, Mr. Soros, one the world's most successful investors and richest men, leapt out of retirement last summer to safeguard his fortune and legacy. Alarmed by the unfolding crisis in the financial markets, he once again began trading for his giant hedge fund — and won big while so many others lost.

Mr. Soros has always been a controversial figure. But he is becoming more so with a new, dire forecast for the world economy. Last week he rushed out a book, his 10th, warning that the financial pain has only just begun.

"I consider this the biggest financial crisis of my lifetime," Mr. Soros said during an interview Monday in his office overlooking Central Park. A "superbubble" that has been swelling for a quarter of a century is finally bursting, he said.

Mr. Soros, whose daring, controversial trades came to symbolize global capitalism in the 1990s, is now busy promoting his book, "The New Paradigm for Financial Markets," which goes on sale next month. An electronic version is already available online.

And yet this is not the first time that Mr. Soros has prophesied doom. In 1998, he published a book predicting a global economic collapse that never came.

Mr. Soros thinks that this time he is right. Now in his eighth decade, he yearns to be remembered not only as a great trader but also as a great thinker. The market theory he has promoted for two decades and espoused most of his life — something he calls "reflexivity" — is still dismissed by many economists. The idea is that people's biases and actions can affect the direction of the underlying economy, undermining the conventional theory that markets tend toward some sort of equilibrium.

Mr. Soros said all aspects of his life — finance, philanthropy, even politics — are driven by reflexivity, which has to do with the feedback loop between people's understanding of reality and their own actions. Society as a whole could learn from his theory, he said. "To make a contribution to our understanding of reality would be my greatest accomplishment," he said.

Mr. Soros has been worrying about the fragile state of the markets for years. But last summer, at a luncheon at his home in Southampton with 20 prominent financiers, he struck an unusually bearish note.

"The mood of the group was generally gloomy, but George said we were going into a serious recession," said Byron Wien, the chief investment strategist of Pequot Capital, a hedge fund.

Mr. Soros was one of only two people there who predicted the American economy was headed for a recession, he said.

Shortly after that luncheon Mr. Soros began meeting with hedge fund managers like John Paulson, who was early to predict a crisis in the housing market. He interrogated his portfolio managers and external hedge funds that manage his fund's money, and he took on new positions to hedge where they might have gone wrong. His last-minute strategies contributed to a 32 percent return — or roughly $4 billion for the year.

The more Mr. Soros learned about the crisis, the more certain he became that he should rebroadcast his theories. In the book, Mr. Soros, a fierce critic of the Bush administration, faults regulators for allowing the buildup of the housing and mortgage bubbles. He envisions a time, not so distant, when the dollar is no longer the world's main currency and people will have a harder time borrowing money.

Mr. Soros hopes his theories will finally win the respect he craves. But, ever the trader, he hedges his bets. "I may well be proven wrong," he said. "I would say that I'm the boy who cried wolf three times."

Many of the people Mr. Soros wants to influence may view him with skepticism, in part because of how he made his fortune. In 1992, his fund famously bet against the British pound and helped force the British government to devalue the currency. Five years later, he bet — correctly — that Thailand would be forced to devalue its currency, the baht. The resulting bitterness toward him among Thais was such that Mr. Soros canceled a trip to the country in 2001, fearing for his safety.

Asked if it bothers him that people accuse him of causing economic pain, his blue eyes dart around the room. "Yes, it does, actually yes," he said.

Asked if those people are right to blame him, he says, "Well no, not entirely."

No single investor can move a currency, he said. "Markets move currencies, so what happened with the British pound would have happened whether I was born or not, so therefore I take no responsibility." ...

[spencer]

Save-the-rustbelt -- what you are bring up is the generational issue. I'm old enough that when I first went to work in financial markets the senior executives had started working in the 1930s and had first hand experience of the 1930s. They taught me those experiences and lessons. But the next generation was taught by people who did not experience the 1930s. So they looked at the restriction created as a result of the 1930s experience as something to get around, not as something to prevent problems.

In economic history they use to teach the long wave concept that depended on this generational experience fading away.
But even in economics the old school that taught the long wave theories have been displaced and no is exposed to that in school anymore.

[Dave]

Yep, it's looking an awful lot like the trough of a big K.

[anne]

Paul Krugman has been angry with Alan Greenspan for years, angry enough to have been privately and publicly critized by Greenspan rather bitterly. The problem for Krugman has not been monetary operations or broad Federal Reserve regulation, but an unwillingness to attend to obviously distorted pricings of credit that had to be a problem in some parts of financial markets through the years and especially in mortgage markets.

I think the issue was never more regulation of financial markets, but simply be willing to caution from time to time when pricings were obviously distorted. Save for the questioning of irrational exhuberance, which helped, there was no such caution through Greenspan's career at the Federal Reserve.

[robertdfeinman]

Hari:
I'll bet you a virtual Euro that the results of the G7 meeting will be what one of my colleagues called "political pablum".

As a case in point I offer you the recently launched blog by EU Energy Commissioner Andris Piebalgs. So far he has filled it with nothing but platitudes. See for yourself:

http://blogs.ec.europa.eu/piebalgs/

Any changes in current policy, whether over finance, or banking, or energy, or trade that are to be effective will have to require sacrifice by those who have the most resources. Everyone is offering pain-free solutions.

When the riots move from Haiti and the Philippines to the US or Europe then maybe we'll see some serious attention being brought to the issues.

[kthomas]

Is this Mea Cupla Week for economists?

Deregulation sure worked for the airline industry? And how about energy (Enron anyone)? And what wonders has deregulation wrought upon us in the financial services industry? No bubbles here, just a little froth.

"Save for the questioning of irrational exhuberance, which helped, there was no such caution through Greenspan's career at the Federal Reserve." - I could not agree more. It's not saying much, but at least anne has some courage, for an economist.

[anne]

Mark Thoma:

"I have to come clean on regulation. Contrary to assertions about 'left-wing economists,' I am generally anti-regulation. When markets approach competitive conditions, they work best when they are left alone. Sometimes regulation and market intervention are needed to force markets into the competitive mold, at least approximately, but only when we are sure that the costs of market failure are sufficiently high to justify intervention. The threshold for intervention is fairly high."

Agreed completely; but we have passed through a period when what market oversight and regulation has been exercised has seemingly been increasingly slanted to business management and away from employees or consumers and even ignoring a slant to management and away from general shareholders. I would argue we have slanted regulation away from management while claiming to be de-regulating.

[MrMan]

Savers do not own thier savings (there is no apparent risk to savings due to deposit insurance) and thus there is no management.

Instead the state is meant to regulate lending to prevent boy bankers abuses with enforced lending, deposit ratios on housing to income etc...

Its not credible that all these eminent economists (Greenspan et al) have not studied a scrap of history - the Jackson bank Crisis in 1837, The 1907 bank crisis, the innumerable crisis since then which led to the formation of the central bank itself. All caused by unregulated lending and the fractional reserve system.

Oh and can anyone explain why houseprices are out of the inflation measure?

[esb]

The entire set of issues which swirl around banking and investemnt-banking regulation (or lack thereof) constitutes a red herring intended to divert attention from the fundamental core problem which underlies the insoluble mess in whose hands we all find ourselves.

Central banking in the USA evolved following 1970 as a set of processes whose primary practical purpose was and is to generate inflation to finance wars and to incentivize activities that produce employment.

Now, this construct, which has come to absolutely require endless asset bubble formation, has imploded, leaving in its wake this morass of intellectual, policy and political confusion.

Bernanke, in his infinite faux wisdom, seems to be throwing a "maybe commodities inflation can save us" hail Mary,

but the ECB, possessing actual wisdom, wants no part of this one.

[ndd]

Prof. Thoma's confession reminds me of something I learned in another field entirely a few years ago that seems applicable here.
Most of you have probably heard of Dutch Elm Disease. 100 years ago there were over 50 million American elms lining the streets of most American cities and towns. During WW1 some diseased asian elm wood was imported, and in the 1920s people started noticing that American elms were dying in what seemed like a plague. With the Great Depression, municipalities had little money to spare, so dead elm trees harbored the insects that infected living trees nearby, and like the great black plague, the vast majority of those elms lining the streets died.

Except that a few cities (Washington DC is still one) engaged in aggressive sanitation projects. As soon as a tree was known to be dying of dutch elm disease, it was immediately removed. Result: with no dead elm wood in which to spawn, few insects were propagated, and the infection rate in living trees was almost stopped in its tracks.

After a few years, when local politicians were looking for budgets to cut, in many of these cities, the elm sanitation program was among the easiest to end. After all, it wasn't like many trees were being infected. The remaining elms seemed just fine. And so the sanitation programs ended.

And sure enough, with the sanitation programs ended, dutch elm disease shortly returned and ravaged the remaining elms.

You see, the result of sanitation wasn't visible. The trees looked the same, year after year. Sanitation stabilized the situation rather than changing it. The price was the ravaging of the population of trees when the stabilization ended: that was what became visible.

Like elm sanitation, economic regulation seems inefficient. You pay for bureacrats and programs and enforcement and what do you get? You can't see any progress year after year, it seems such a waste. And for a few years after you do away with the regulation, everything still seems fine. It is only when the disease of human greed and stupidity return to ravage the economy that you see the price. And you see the reason for the regulation in the first place, only after the damage has been done.

[anne]

Excellent story; the point being the ability to be protective when necessary so that transparency and oversight are always in order, regulation should be infrequently necessary.

[billy]

http://www.nakedcapitalism.com/2008/04/ban-no-one-could-have-foreseen-crisis.html
Quote.......
Consider the contrast. In 1987, after the stock market crash, the so-called Brady Commission (formally, the Presidential Task Force on Market Mechanisms) was established a bit more than two weeks after the crisis. Admittedly, the stock market meltdown was a discrete event, while our credit crisis has been an slow-moving train wreck. Nevertheless, the Brady Commission working oars were not part of the regulatory apparatus; its executive director was a Harvard Business School finance professor, Robert Glauber; the staffers came heavily from the private sector. This gave them the freedom to look at deficient practices without incurring the ill will of people in their field.

By contrast, consider Bernanke's in a speech yesterday, "Addressing Weaknesses in the Global Financial Markets," of the measures taken to understand the roots of our current financial mess:

In the United States, policymakers' efforts to identify the sources of the financial turmoil and the appropriate public- and private-sector responses have been coordinated through the President's Working Group on Financial Markets (PWG), chaired by the Secretary of the Treasury. The group's other principals include the heads of the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission, and the Board of Governors of the Federal Reserve System. With the support of the staff of the respective agencies, the PWG began to address these issues last fall, as the severity of the financial turmoil became increasingly apparent; in mid-March, we issued a brief statement outlining our tentative conclusions and policy recommendations.1 At the international level, the Financial Stability Forum (FSF), whose membership consists of central bankers, regulators, and finance ministers from many countries, including the United States, will also soon release a report on the causes of and potential responses to the turmoil.

There has been no independent investigation by people who had access to the key actors and relevant documents. No matter how well intended the regulators and government officials looking into the credit crunch might be, it simply isn't human nature to point fingers at oneself.
.....
Similarly, I don't place much stock in Norris' "I didn't think it would get this bad, therefore no one should be held accountable for missing it." With all due respect, Norris may be well connected, but that is not the same as being an insider (see Daniel Ellsberg's book Secrets for long-form treatment of this topic). And there were few Cassandras with far less access than Norris who did see this coming. We shouldn't shy away from understanding why those who should have known better chose instead the convenient path of wishful thinking and willful denial
...endquote

There seems to be a concerted effort at no-one-could-foresee-this hand-wringing to cover the ass of the Fed and economic establishment. This is managed by placing articles in the media and other PR efforts, and by sycophantic economists.

BS was bailed out - because Bears books becoming public would have blown the top off this con job.

Tell me - how does Greenspan, the Fed, and economists gets a pass, without not even an independent investigation?

Yup - all this was unexpected - like Katrina. And the FEMA-like economist establishment is now mounting a CYA PR effort.

[Eric Dewey, Portland OR]

Mark, thanks for opening up on your position on regulations.

I'm a regulatory compliance officer in the financial services industry who despised Econ in college and went to law school thinking I'd get away from it. Chalk it up to irrational youthful exuberance.

Having spent the better part of the last 10 years reforming my inner educational sinner (both in my work and my leisure reading) it's becoming increasingly clear to me that there are some pretty fundamental flaws in the dismal science - and chief among them is a fatally naive view of human behavior, a view that masks itself by presenting a mathematical face. (See Eric Beinhocker's exploration of complexity economics in "The Origin of Wealth").

From my personal experience (including two stints with top ten banks), the point of the current mess is that human beings usually make mistakes - something that economists generally fail to adequately consider.

Sometimes those mistakes are honest - and I tend to believe Greenspan's were. Honest mistakes that are acknowledged can be addressed and form the basis for learning.

More often, however, either the mistakes are dishonest or they are hidden out of fear or shame, and in both those cases the mistakes cannot be acknowledged and thus can't form the basis for learning.

Thus, the problem is human. There are some very good and smart people working as regulatory examiners and as compliance staff in our banks. There's no doubt that A LOT of these people had some sense that things were not right, and many of us raised flags about the things we saw - for us, Gramlich and Sherron Watkins are patron saints.

What incentives are there for those whose job it is to point out problems? Absolutely none. On the contrary, for compliance staff the incentives run entirely the other way.

Management on the other hand has perfect incentives to blame the "risk managers".

Good economics should teach us to make critical judgments about questions of the allocation of scarce resources - in other words, value judgments. Value judgments are in their very essence political decisions. Political decisions generally depend on whose ox is getting gored.

It takes moral courage for leaders to listen to unpopular messages and to take action on them, because it will hurt (just not as much as failing to act). And economics hasn't had any incentives to teach moral courage.

And, sadly, regulations won't give us moral courage, either.

Perhaps it really is time for the economically disadvantaged but morally courageous people of Eastern Europe, Asia, Africa, and the rest of the developing world to take the lead - for some reason, the USA seems to be fresh out of stock.

[kthomas]

Certain industries must be fully regulated.

Transportaion, energy, and water are foremost.

All this talk of regulation in the financial world is moot, and our buddy Winslow R. made it clear: so long as corporations (and therefore, corporate executives) are not held accountable, the way we individual citizens are held accountable for our actions, then there will be no reforms, just band-aides and heaps of propaganda.

My ideology is simple: if you come preaching the wonders of deregulation, then you're a crook or a facilitator of crooks.

[2slugbaits]

I'm a little confused here. One day I here people beating up on the Fed for mismanaging things and allowing this bubble or that bubble. Then the next day I see the very same posters complain that govt and the Fed didn't get in and try to regulate things. Well, I'm sorry, but you can't have it both ways. If you don't have confidence in the Fed to manage the money supply, then why would you want the Fed to get deeply involved in regulating complex financial instruments? Or again, they blame Greenspan and the Fed for not regulating these investment houses better, and then those same critics accuse Greenspan and the Fed of trying to make a power grab by expanding their control.

I'm with Mark here. Allowing markets to sort things out is the preferred choice. Sometimes the markets get stuck and need some regulation to be set right. Sometimes regulators make a bad situation worse.

Brad DeLong once said something to the effect that all liberals (such as himself) who were inclined towards more government regulation should first spend a little time working in government. True words.

As to those who seem to think zero bank failures is a good thing, let me ask you if you would be suspicious if a baseball player went all season batting a thousand, or if college basketball scores always exactly matched the spread. That's a sign of too much manipulation. If you don't trust markets, then why would you assume that private bankers NEVER make bad decisions, because that's what zero bank failures means. If you think there's not enough regulation but yet you believe that zero bank failures is a good thing, then apparently you must think that markets are working perfectly. Markets generally work well, but they never work perfectly. There should be at least a few failures in a well running market...unless you live in Lake Woebegone where everyone (bankers included) are above average.

[Jim Harrison]

I work in the electric power industry. In my world, economists don't argue for the superiority of deregulation and privatization. They postulate the superiority, and then spend much of their time explaining why the apparent failures of deregulation and privatization are the result of not deregulating and privatizing enough. I don't think I've seen a single industry document that seriously entertained the possibility that the a priori approach favored by economists might be contradicted by mere experience, even in the face of disasters like the California power crisis.

I've got no general brief for regulations--god knows I've seen plenty of incredibly stupid ones--and I expect that privatizing public assets can be a good idea in particular cases. Absent sufficient regulation, however, the market will teach managers to be irresponsible; and absent the possiblity of competition from publicly owned utilities, privately owned utilities will inevitably abuse the public.

Neoliberal economists remind me of the leftist ideologues I met in my youth. The lefties assumed that people were alienated and unhappy because they decided that it was just awful to have to spend all your time putting the same nut on the same bolt, even if you got well paid and got great benefits. The Neoliberals assume that people are willing to trade security and predictability for the some notional future benefit postulated by theory because, apparently, they assume that everybody ought to approach life like an endless game of hold 'em. Phooey.

[2slugbaits]

Jim Harrison,

Hmmmmm....the electric power industry is one industry in which there has always been a lot of agreement among economists on the need for some regulation. Left to their own devises utility companies would like to practice some kind of price discrimination. And typically the optimal amount of power generation is greater than what an unregulated natural monopoly would want to provide.

[Spectator]

I think Mark Thoma is exactly right about regulation. Less is more.

Markets are far from perfect, and you often get distortions and people get hurt. There is no system to avoid some measure of problems. But the big disasters are caused by government interference and implied guarantees. In the case of this financial crisis, the Fed directly caused the problem as described so well in the financial times.

The coddling of the financial industry (it's not like they are needy!) is the core problem. If left completely alone, they would be be smaller, self-correcting, and less of a threat to the broader economy. Once you gift money and bailouts to these fatcats, regulation is a necessary evil to avoid the worst excesses.

[donna]

OK< Mark, but either you have free markets, or you don't.

I can't print my own money. I don't have any say in what the Fed does or doesn't do.

I just want them to protect the taxpayers, not the friggin' bank. If we're gonna have no regulation, then let 'em fail already.

Otherwise, I want my money's worth out of this. I want some hides, dammit. Regulate the hell out of them til all the idiots are out of the business.

[anne]

Eric Dewey:

"Having spent the better part of the last 10 years reforming my inner educational sinner (both in my work and my leisure reading) it's becoming increasingly clear to me that there are some pretty fundamental flaws in the dismal science - and chief among them is a fatally naive view of human behavior, a view that masks itself by presenting a mathematical face."

Thought-filled response; please do continue when this is time. A useful discussion all through, no matter any seeming contradictions.

says...

Donna,

"I want some hides, dammit."

Unfortunately, that's exactly the problem. Too many posters here are more interested in exacting revenge against fatcats than they are genuinely concerned about innocent folks who are apt to lose their homes if there isn't some kind of bailout. Is it just? No. Is it fair? No. Does it make you want to vomit? Yep. Get over it. The rich and well heeled will always be with us and they will always get away with stuff that you and I would hang for; but at the same time it's important to recognize the difference between economic policy and morality plays.

[notsneaky]

"How many economists were predicting this mess a year ago? Not many, not Krugman or this blog. I thought something like this was coming but I'm just a simple old fashioned Marxist."

Yes, but Marxists are ALWAYS predicting something like this. Not sure they should get much credit.

[blam]

``The bright new financial system, with all its talented participants, with all its rich rewards, has failed the test of the marketplace,'' Volcker said.

To quote Mr. Volcker again, “For financial regulation in general, competition in regulatory laxity cannot be a tolerable approach.”....

Mark, I love ya man but get a grip.

[zinc]

"something he calls "reflexivity" — is still dismissed by many economists. The idea is that people's biases and actions can affect the direction of the underlying economy, undermining the conventional theory that markets tend toward some sort of equilibrium."

I believe this is a misrepresentation of the Soros theory. It is not that an equilibrium doesn't exist, it is that market pricing gyrates between overshooting and undershooting the equilibrium value. Not a foreign concept to process control engineers dealing with discrete step changes.

[eightnine2718281828mu5]

---
Unfortunately, that's exactly the problem.
---

Really? That's exactly the problem?

So you think if these folks would should just shut up and accept the fact that their betters are always playing a better hand, everything would just be peachy?

I thought it was a little more complicated than that.

[gordon]

It would appear that Prof. Thoma is on the point of discovering the work of an obscure economist called John Kenneth Galbraith, whose works actually achieved some notoriety in the 1950s and 1960s, though they were afterwards forgotten. I would recommend his books The Affluent Society and The New Industrial State. A few copies of these rarities may still be knocking around the used book stores, awaiting the persistent researcher. It was Galbraith who said somewhere that "The trouble with competition is that in the end somebody wins", a trenchant comment on the evolution of competitive free markets which Prof. Thoma could easily recycle - nobody but me remembers it, and I won't say anything.

And there is the website Oligopoly Watch, too. It might be useful.

[Jack]

So, less bank failures is a bad thing because it means there isn't enough competition in finance?
And how is not enforcing existing regulations, much less not creating new regulations where they might be needed, not a form of deregulation?
And how is the financial market different from the rest of the market? What makes it so special?
I am very perplexed this blog entry.

[Andrew]

Anti-regulation sentiment in economics stems from the fact that neo-classical thought strives to be scientific, but has the method of scientific inquiry exactly backwards.

In the same way that we know certain methods of agriculture, surgery, astronomy, or chemistry are better than others, "it does not follow that the better methods are ideally perfect. Nor are they regulative or normative because of conformity to some absolute form (Dewey)."

Economic epistemology doesn't follow from real life, as it should if it were a genuine form of scientific inquiry, but follows from some abstract theory to which reality is expected to conform. When the complexities of society fail to conform, it is the society which is at fault, not the theory. That is absurd.

This is what people are complaining about when economics is decried for over-mathematization. Economists (stereotypically) look down their nose at sociologists and political scientists, to whom they left the messy work of dealing with the impossibly complicated way in which people actually behave, in order to focus on the 'truth' they have found in these perfect little models. In the same arrogant sweep into the abstracts of econometrics and game theory they have left behind the intellectual underpinnings of Galbraith and Smith, who understood and addressed that economics must explore how society actually functions, not simply how it ought to function.

I believe this is the neo-classical attraction to monetary theory. Economists can simply work in a world of numbers and theories without worrying about human behavior and political capital, and then bury the bodies under the dry sand of econospeak.

Furthermore, aversion to regulation (along with a number of other economic theories) makes a huge assumption: That 'economic efficiency' is the sole purpose of our economic institutions. It is not. We have numerous rights in this country; a 'free market' is not one of them.

[Bruce Wilder]

ndd: "economic regulation seems inefficient. You pay for bureacrats and programs and enforcement and what do you get? You can't see any progress year after year, it seems such a waste. And for a few years after you do away with the regulation, everything still seems fine. It is only when the disease of human greed and stupidity return to ravage the economy that you see the price. And you see the reason for the regulation in the first place, only after the damage has been done."

Very good. The economics of prevention and safety produces few heroes.

[don]

It would be really hard to regulate away market bubbles. The current crisis is happening mainly because housing is such a big part of the nation's wealth, so a big bubble there has big effects on the overall economy. We had serious bubbles in other assets before, but real property has not had one for a long time. Hence the notion that housing can never go down.
The new financial instruments are true innovations. They allow risk to be diversified and marketed over a wider spectrum of buyers. True, they exacerbated the housing bubble, but they will improve economic efficiency when properly used.
Part of the problem may also have arisen from executive compensation, which encouraged CEO's to take risks. The idea of tying the CEO's pay to stock performance seems to align incentives of management and shareholders, but the system of rewards is not symmetrical. If the company's stock gains, the CEO makes huge profits, but he or she stands to lose little if things go badly awry. To my mind, executive compensation is insane. The effects can be expecially disastrous where leverage is great, as in financial services.

[eightnine2718281828mu5]

---
They allow risk to be diversified and marketed over a wider spectrum of buyers.
---

It also allows risk to be hidden from the buyers.

says...

Beautifully said Andrew.

[Lafayette]

Playing with fire

MT: ... except for a qualification about capital requirements for bank owners so they are not playing with other people's money with no stake of their own in the bet.

It is easy to agree that less regulation is better. But, it is better to add the caveat "most often, but not always".

Banking is part of the larger Financial Services sector of our economy, and as a result of loosening regulatory supervision, these services have got highly imaginative. Yes, subprime lending did allow a lot more of the poor to access home ownership, which is ostensibly goodness, despite the higher level of foreclosures in that credit category.

But, and its a Big But, it is not the practice that needs regulating. It's the practitioners.

We are trending towards an economy where close to 40% of the GDP depends upon Golden Boys before computer screens taking bets on who wins and who loses in markets. And, arbitragers do this with borrowed money.

We must ask ourselves, "Is this the best sort of value added to the economy? Does it render the economy useful added-value ? Or, is it just making some financial banks richer, along with a select few arbitragers?". We could ask the same question down at the race track, but at the race track it is considered Entertainment (or a diversion) – not Finance.

The real difference is that the arbitragers (our practitioners) are not making bets with their own money, but the investment banks that they work for. And, that simple fact changes everything.

They are not putting their money where their minds are. They are putting stockholder money (often on credit) up for a bet. And, sometimes they lose very badly. Some believe the breadth and depth of derivative markets, which are intuitively a gamble, can and will lead to a major economic world crisis - incomparable with that which has passed recently. This is not yet proven. Neither has it been disproved.

Gambling casinos are very heavily regulated businesses. For good reasons, we have found over time. And, still, such casinos have flourished -- from Las Vegas to the Indian Nations.

I suggest we are finding some very good reasons for tighter regulatory practices in the present learning process. How would you like to say otherwise, and risk being wrong? With the detritus of destroyed economies around the world lying at our feet?

Such a calamity is unexplainable to an investigating Senate Panel. Who should care, the damage having been done? With the world trying to climb out of the deepest economic recession ever known by mankind?

We may be playing with fire, my friends. We deserve to get burnt.

says...

"The new financial instruments are true innovations. They allow risk to be diversified and marketed over a wider spectrum of buyers. True, they exacerbated the housing bubble, but they will improve economic efficiency when properly used."

I remember in college a Camaroonian dormmate would argue that Communism was a fine system. The fact that the Berlin Wall had just collapsed didn't matter. "No one had 'tried' to do it properly."

[James Killus]

Does it occur to no one here that corporate law, contract law, property law, and criminal law are forms of regulation?

So is vendetta, for that matter.

The first part of the conceptual shell game is to convince people that, somehow, corporations are "natural" entitites, that exist independent of "government" and "regulation." Or that there can be an impartial "referee" in the form of a legislative and judicial system that respects all players equally.

Does anyone believe that such a situation has ever existed?

Or how about inherited wealth? People "naturally" want to leave everything to their blood heirs, don't they? Or do they? Watch those blood relatives use the law to break a will that does not conform to such preconceived notions, sometime. Very enlightening. The law does not behave impartially on that one.

Yes, economics may be too mathematical, but I really think the problem is one of categorization and definition. The very term "free market" is propagandistic, implying liberties that most people do not possess, and denying powers that only a few enjoy.

[Lafayette]

s-t-r: Perhaps I am in a sour mood, but my view on regulations has been modified by what I see as a significant deterioration in business ethics over the past 30 years

Agreed. I can remember talking to brokers decades ago who patiently explained to me the Prudent Man Rule. This rule, explained in WP, comes from a 19th century court ruling [Harvard College v. Armory, 9 Pick. (26 Mass.) 446, 461 (1830)] in the matter of trustees at Harvard exercising their management judgment.

An excerpt from that ruling urged the trustees:"... to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested"

One hundred an eighty years later, I suggest that the rule has not aged one bit. What has changed is the increased disregard for ethical behaviour in our lives.

To a point where one may wonder if some have not lost entirely the notion of right versus wrong ... in Lotus Land.

[Winslow R.]

"Like elm sanitation, economic regulation seems inefficient. You pay for bureacrats and programs and enforcement and what do you get? You can't see any progress year after year, it seems such a waste. And for a few years after you do away with the regulation, everything still seems fine. It is only when the disease of human greed and stupidity return to ravage the economy that you see the price. And you see the reason for the regulation in the first place, only after the damage has been done."

What's silly about this story? it is the sentimental attachment to elms (banks) that drove regulation not that they were superior to other trees.

We've learned a variety of shade bearing, oxygen producing entities can do a better job than just elms (banks).

Economists just can't let go of something that is bound to attract disease and death again and again. Rather than designing a better system (who decided to plant all elms anyway?) they stick to their guns convinced it will work this time.

If there was an elm lobby handing out bundles of cash to economists for speaking engagements and studies proving how great and necessary elms were, the analogy would work perfectly.

[dale]

"The very term "free market" is propagandistic, implying liberties that most people do not possess, and denying powers that only a few enjoy."

There was a German guy living in England back in the 1800s that wrote some books about that.

[Bruce Wilder]

I've worked in government, and studied in detail various industries/markets. I've never seen one, which was reliably self-regulating, without non-firm institutions. Never. N-E-V-E-R.

The perfectly competitive market of profit-maximizing firms is a valuable exercise, necessary to develop and understand various concepts. It is also too simple, and has no immediate application. None. Taking perfect competition as a general, and generally practical, ideal is misguided, at best. Perfect competition and the profit-maximizing firm under complete information is a scheme, which completely eliminates the aspect of economic functioning, which "is" regulation and calls for regulation -- the control of error in a stochastic process in a world of limited knowledge and unlimited accident.

My baseline model, for heuristic purposes in my studies, was of a rent-seeking firm, controlling a stochastic production process, and operating in the market under conditions of monopolistic competition. One of the first questions I would seek an answer to was whether the market in question had any kind of market price-equilibrium. My experience is that some kind of qualified market price equilibrium (not necessarily a competitive equilibrium arrived at by independent seller and buyer bidding) is common, but far from universal, and where such exists, it often exists alongside, and only as a consequence of, considerable market power. Administered prices are the general rule in the economy; administered prices often exist in circumstances in which no competitive price-equilibrium can exist.

I regard libertarianism, and its presumption that zero regulation is possible, to be pernicious ignorance.

I think economics neglects the study of control, and that's unfortunate, because technical and managerial control of production and distribution processes are a pervasive economic activity, and accounts for most of the dynamic efficiency gains of the industrial revolution(s).

Every firm is engaged in rule-driven control of economic processes; elaborate hierarchical control and control extending to markets and cooperating firms is common. When we talk of "regulation" we are generally talking about extending and monitoring such control schemes. Regulation is rarely, primarily about allocative efficiency. It is more akin to technical quality control than linear programming.

In banking, banks, which are often very large bureaucracies, have to control the behavior of loan officers and others with rule-driven systems. Regulation of banking is typically about various ways in which someone outside the bank is controlling the systems of control -- controlling the controllers.

A full model of control does not begin or end with incentives. Principal-agent models, popular in economics for the study of incentives are derived from a classic model of control, but they are usually specified as a subset of that complete model of control, omitting elements considered irrelevant to the incentive problem under assymmetric information. And, to the best of my limited knowledge, no one has proposed a generally workable model of hierarchical control.

But, the general idea of regulation as control of error should not be too much to grasp, and the insight that an effective regulator has to be able to break the incentive bound to ensure compliance should not require explication.

The relation of regulation, qua control of error, to allocative efficiency is more problematic.

Maybe, we should not press ahead with a scheme for airline regulation, that anticipates and strives for zero crashes of commercial passenger planes. Maybe the rarity of plane crashes is evidence of a serious misallocation of resources. I, personally, doubt it very much. But, ymmv.

I doubt that a system of banking regulation, in which no banks failed, is either practical or desirable, but I think the question ought to be asked somewhat more intelligently than it has been in comments here. The New Deal system of depository institution regulation centered on the FDIC does not contemplate a "no failures" standard. The FDIC scheme, in fact, centers, instead on a model of audit, which permits the FDIC to declare failure on a timely basis. Regulation identifies what bank failure is, and when a bank meets the standard, the bank is declared a failure, and taken into receivership. It does not prevent risk-taking, per se; it prevents fraudulent representation of failure as success, and provides a straightforward process for dissolving a failed bank.

Alan Greenspan is arguing that fraudsters should be free to ply their fraud, until the market, without the benefit of audit, is able to discern the fraud, and make a run on the bank. And, the bank run should be chaotic, noisy and without predictable result. The man is an idiot for mistaking Ayn Rand's hackery for philosophy, and should never have been ask for his opinion on regulation.

[HispanicPundit]

Great post! Kudos for speaking up!

[JimPortlandOR]

Between episodes of outright panic about the financial mess we have allowed to develop - whether too much deregulation or to little new regulation of new institution types, I've been thinking a lot about the phrase "too big to let fail" (and the off-mentioned moral hazard this presents when the Fed or Treasury bails them out after massive market failure).

I've concluded:

- moral hazard is spin thinking - this is financial risk carried to the point of financial danger. Morals are not enforceable without laws and regulation.

- we should dust off the anti-trust laws that largely haven't had any effect on financial conglomeration, and do some serious trust busting.

The objective should be that no institution should be allowed to grow to the point where they are 'too big to let fail". If they are already in that class, then break them up. We should coordinate this approach with counterpart governments that have institutions that fit into this class, so the problem doesn't just move offshore.

That will still leave some relatively small financial actors that have way too much influence to be allowed to be essentially unregulated: the debt insurrers/re-insurers, and the debt/bond ratings agencies. And finally, the hedge funds and private capital groups must be brought into the regulatory scheme.

Overall, market forces should prevail, but we need far far more control over the rogue actors with the potential to bring the financial house to collapse.

[Lafayette]

The mice will play

BW: When we talk of "regulation" we are generally talking about extending and monitoring such control schemes. Regulation is rarely, primarily about allocative efficiency. It is more akin to technical quality control than linear programming.

There are two houses of thought regarding regulatory practices. Ours, in the US, is rules based. Meaning that where there are clear rule transgressions, they are prosecuted. The other, British (and more European) is principles based. Principles or guidelines are established in a general fashion and behaviour (key word) is expected to correspond with the principles expounded. This too can result in criminal/civil procedures, but usually ends up with the transgressor being expelled.

The first is obviously administered by courts and lawyers, the latter by self-administered ethical principles. Which is better?

That question is hard to answer. Particularly when tort lawsuits result in such large remunerations to lawyers. Remember, in many instances of regulatory lawsuits, lawyers don't get paid unless they go to court. Then, they get paid handsomely.

OTOH, you are right to comment that "self-regulation" is mythical in the US. It is a cop-out to vested interests.

Grounding regulatory principles in guidelines however has the advantage of making them far more influential in terms of individual behaviour, which is why they affect the practitioners more than the practice (of any given profession). Being expelled from practice also has the onus of public shame, a powerful restraining force.

In the profession of medicine, its overreaching principle is called the Hippocratic Oath. Of course, when no such principle is in practice and when no instruction has ever been given in ethics based values ... then the cat's away.

And the mice will play.

[Hank Jestor]

I would hate to bring up a very simple point that was taught to me when I was younger. "Locks are for honest people". We have regulation to re-enforce the underlying good in people.
We expect for our government to walk a very fine line between market freedom and public good. They have failed us.
Karl Marx may look like a profit by the time this is all over with.
Common good as been sold down the river. Good luck to all of you because this discussion is academic. They have leveraged the entire financial system and its not going to be pretty.
I find it curious that the key point attempts to leave out the S&L meltdown. That is like the murderer saying I'm a good Christian if you don't include those 30 people I killed and ate.

[Paul G. Brown]

Why is the market for money different than the market for bread, or beer, or diapers?

Because money is a monopoly product; it is produced only by the state. Financial markets - markets for money - require special regulation because they are dealing in a product where supply is ultimately determined by the state.

In practical terms. If you charge an interest rate (of ANY kind) then you are first required to send a proportion of the principal to the state.

[yamada]

Why not make clear in which case regulation is needed on market?
Market is not always perfect and it does fail, as Bruce Wilder says...
"I've worked in government, and studied in detail various industries/markets. I've never seen one, which was reliably self-regulating, without non-firm institutions. Never. N-E-V-E-R."
And as don says...
"It would be really hard to regulate away market bubbles. The current crisis is happening mainly because housing is such a big part of the nation's wealth, so a big bubble there has big effects on the overall economy. We had serious bubbles in other assets before, but real property has not had one for a long time. Hence the notion that housing can never go down."
Yes...when the price of a certain asset overshoots the rational level that reflects economic fundamentals, the portion of the "overshoot" is bubble, and is doomed to bust. Considerable "overshoot" makes the market to fail.
Therefore the rule after the bust must be provided as a regulation, with remaining market function as much as possible, as on the blog below.
http://reversewealtheffect.blogspot.com/

[Patricia Shannon]

Some airlines are failing. Big airlines failed in the past, but we survived.

[Lafayette]

Just words

Don: It would be really hard to regulate away market bubbles

There are several interesting ideas on the table for "regulating" asset price bubbles.

One of them is in tightening the capital requirements for credit, in those circumstances. A lending institution would then have to set aside a higher level of its capital to finance the loans made to purchase property buyers.

In theory, this practice makes them a lot more choosy since their total "capital leverage" (own capital versus borrowed capital) is reduced.

The same can be done for equity bubbles as well.

The flip side of this coin is to loosen capital requirements when the asset market in question is gloomy.

It is easy to say and hard to implement. Just when is a market too hot or too cold? The Fed would have to develop that expertise. For the moment, they are simply watching inflation -- which is part of their original charter.

Unfortunately, real estate and stock market price movements somehow are not on their radar. Funny that, dontcha think?

But, they seem to have a good idea for this sentiment called "exaggerated exuberance", which is Fed-speak for "hey guys, cool it!" But, those are just words and they don't go nearly as far as increasing capital requirements would.

Let's not forget, we are coming out of a particular historical circumstance -- a VERY LONG period of low interest rates. This factor, abetted by human greed, is the culprit for the asset bubbles of both the dot.com boom and the subprime bust.

[Lafayette]

Then there is taxation as a regulatory tool.

If a speculator was "flipping condos" at two a month, then maybe capital gains taxes on real estate held for less than, say, five years would bring about tax bill of 50% of the total capital gain -- relaxed ten percent for every year the property was actually owned.

In the first year, all capital gains on a property transaction would automatically be taxed at the first 50%; then 40% in the second year, then 30% in the third, etc., etc.

Or something like that.

[hari]

Finally we're all getting closer to the real truth about the principles of governing the socalled money market or banking system. Mark will surely have to reconsider his academic point of view and come down to the threshold of practical moral hazard - normally a product of free market regulating itself.

In medicine, for example, there is what's called *preventive medicine*. What is that? I was with my *mundhyginist* for preventive dental care (for aging gums). If preventive medicine is normative and conceptually right for an individual, why is it so difficult to accept regulatory oversite/regime when it comes to hi fi markets?

Libertarians must come out of their woodworks and reveal their moral principles of societal behaviour....Greed is normality with the human species; we know it; accept it even in a family circle. However when you are managing the wealth of a nation(s) the moral principles - not only economic efficiency - must become a part of that money-making ethos. Otherwise, after this financial turmoil, few will trust in the ideology of free market capitalism.

[ndd]

Winslow R:
I don't mean to hijack this thread but in re your response
What's silly about this story? it is the sentimental attachment to elms (banks) that drove regulation not that they were superior to other trees.

We've learned a variety of shade bearing, oxygen producing entities can do a better job than just elms (banks).

As to the first paragraph: Well, no. As to the second paragraph, Yes.

The story of Dutch elm disease does have some further parallels for economics.
It wasn't sentiment that led to the planting of so many American elms: if you were to pick a single shade tree to plant on urban streets, the American elm was it -- fast growing, tolerant of drought, flood, salt, and abuse in general, and a vase shaped canopy that wasn't just beautiful, it was functional (the limbs gradually spead out above building height).
The problem was, as your second paragraph says, it was planted as a monoculture. So when disease struck, it was an urban disaster.
Rather like a monoculture of "the internet/growth stocks/gold/real estate will make you rich!!!" the story argues for diversification.

But whether or not American elms were planted as a monoculture, once disease struck, sanitation was cheaper than no sanitation. But because you couldn't "see" the result of sanitation (because it made no "difference"), it was undervalued.

So it seems with economics. Sanitation is undervalued because you can't "see" the result.

P.S. One further note of interest: American elms are also a case study for natural selection. The average American elm out in the woods now is much more resistant to dutch elm disease than was the average elm 75 years ago.

[save_the_rustbelt]

There have been some benefits of deregulation in some industries.

When I started my career trucking was regulated, and securing a route to drive loads of widgets from Toledo to Monroe Michigan (20 miles) might take a year of paperwork, specialized lawyers and considerable toadying to bureaucrats. It was insane.

And I think there have been some benefits to financial deregulation, in our personal lives we have a much better menu of services, but there are also some really ugly downsides that must be addresses.

Balance is everything.

[2slugbaits]

Some folks need to reread Mark's post. Contrary to what many seem to believe, he is not arguing against the need to regulate industries from time to time. And he is not arguing against the need to impose more regulations on the financial markets. The lesson of the last couple of years is by now pretty clear that we do need more regulation. The point is that there should always be a predisposition against regulation. The prima facie case ought to be that markets should be left unregulated until there is strong evidence to the contrary. Economists are well aware that unregulated markets don't always work as they do when drawn up on the blackboard. This is not news. But what might come as news to some folks here is that regulated markets don't always work as Congress intended. Regulations carry very high opportunity costs. In the case of the elm tree we read about how govt involvement in an elm sanitation program could have saved it. What you didn't read was that in many communities it was local ordinances mandating elm trees along parkways that created the very monoculture that doomed elm trees. When I was a kid the village came along and ripped out every tree in the neighborhood and planted locust trees. And even today the city will only allow a small variety of trees to be planted...and over the years they've had a strong preference for ash trees. We'll see how well that works out.

There have been a lot of deregulation success stories. The airline industry is one such case. I travel a lot and I hate these crowded cattlecars that airlines use today, but competition has made air travel more affordable and that's a good thing. If anything the problem today is creeping govt reregulation that is giving airlines back some monopoly power that they didn't have 15 years ago. And govt regulation in foreign trade usually ends up badly. Another example is in petroleum refining. Back in the bad old days the govt subsidized old and inefficient refineries, which created some very expensive excess capacity. Today refineries are operating at very high capacity rates. Sometimes that creates seasonal price spikes, but over the long run deregulation has been a good thing for consumers. And no one here should have to think too hard to come up with examples of local zoning boards who use their regulatory power to create all kinds of havoc and economic waste.

Bruce Wilder mentioned the problem of monopoly rents, and it's true that in cases of natural monopolies the govt should impose regulations. But most monopoly rents today are a consequence of govt regulation and not the other way around. This is the Dick Cheney model of govt. Government is put at the service of granting monopoly powers to political allies. Since Bruce worked for the government he should know full well that whenever the govt begins to regulate industries the Halliburtons of the world end up being the norm rather than the exception.

[bakho]

Regulations are nothing more than attempts to limit the scope of external costs of activities or prevent cheats from gaming the system. One alternative to deregulation is more lawsuits as injured parties try to recover imposed costs.

Regulations can be complicated (as in the US tax code) or they can be simple. Complex regulations most often evolve from additions to simple regulations. A review process to continually simplify regulations would seem to be in order, but that process does not exist. Arguments for and against deregulation are often asymmetric with well funded special interests dominating the discussion against the diffuse interests of the public bearing the external costs. The willingness of politicians to accept money from special interests in return for special exemptions drives the complexity of the regulations.

[hari]

What you are asserting on deregulation is or was true until now - when fraudulent derivatives practices implicitly provided for its own*creative destruction*....

The moral of the story is more relevant than the exception where deregulation has worked efficiently. In global money matters deregulation will not work efficiently, in my long professional experience, without creating moral hazard of one kind or another. Therefore, acknowledging the need to provide for efficient markets to perform based on its own rules, oversite must be conducted by a permanent professional staff. Not political hacks!

G-7 have now agreed to allow global banking sector 100 days to fix their backlog of asset depletion due to one sort of bookeeping tricks or another. The Basel Forum has no legal capacity to demand compliance - it can recommend and banks are required to accept. We will see how they manage this tricky phase of making banks more transparent and willy-nilly risk free - knowing there is no such thing as *risk free* banking system.

[ndd]

2slugbaits:
Agree with you re mandating a monoculture or anything close to it.

But there are also reasons for zoning boards to regulate what can be planted as street trees. You don't want varieties with thorns (for obvious reasons to passersby), or roots that will push up everything nearby (silver maples) or aren't resistant to salt (re winter plowing in the north) for example.

If the municipality is going to have to pay to repair its sidewalk, sewer systems, or just the replanting, there are reasons to have a list of trees that are acceptable. There are also reasons to be sure that a monoculture or something close to it isn't the result.

I don't see why "no regulation" should be the default. I regard that preference as highly suspect. Moderate regulation, with preference for diversification, transparency, oversight and sanitation are what I see as most successful.

[2slugbaits]

ndd,

Things like roots uplifting sidewalks and damaging sewer systems are examples of externalities, and in that case there is a case for govt regulation. In the presence of externalities it is guaranteed that an unregulated market will be inefficient because some of the costs are shifted to someone else. But there's a difference between regulations that say "thou shalt not" (e.g., planting silver maples) and regulations that say "thou shall" (e.g., plant elm trees). Govt bodies do a better job of telling us what we shouldn't do than they do telling us what we should do. In the case of regulating some of the investment houses, creating reserve and capital requirements would have been a idea. I'm not a lawyer, so I don't know whether the Fed had that legal authority or not. I've heard it both ways. If they didn't have that authority, then it's hard to blame them for not exercising it.

The reason "no regulation" should be the default position for markets that are inherently competitive is that I haven't met the govt bureaucrat (myself included) who is smart enough to determine prices and output quantities in ways that clear markets. Free markets don't always do that, but they generally do it better than regulated markets. And free markets allow folks to fail, something that govt agencies don't allow. As an aside, the rule that govt projects are never allowed to fail is especially true of the military. And you saw that on display this week with GEN Petraeus' testimony. His commitment is to continue to try to do the impossible because failure is not an option. Brave talk, but not the kind of thing that an economist would understand. Sometimes projects need to fail. And sometimes businesses need to be allowed to go belly up.

The irony on this board is that the same folks that are PO'd because Bear Stearns isn't being punished enough are the same folks that want more govt regulation across the economy and apparently don't realize that the first effect of regulation is to insulate businesses from competition.

[skeptonomist]

"...financial markets are different and that's something I won't forget again."

Yes you will.

Financial markets collapse regularly, and when they do those who facilitated them go through a period of hand-wringing and promises that they have learned and it won't happen again. But when things are going well again all this is forgotten and the herd applauds the benefits of free markets.

In general, regulations only come about because of some obvious abuse - they are made by legislatures, and the special interests are usually successful in preventing regulation unless the entire population is made aware of the problem through a major crisis. After a period when crises are absent, perhaps because of the regulation, the special interests prevail again.

It is foolish to try to organize a complicated world on some simple ideological principle such as "markets are self-regulating".

[hari]

Your conclusion is what G-7 agreed upon in principle - ie. until further notice!

(I noted you're at DoD) Here, in Holland, all public tree planting and management is, in fact, a monopoly of the local state authority - to preserve the diversity and genetic origin. The workers are all civil servants and wear a special uniform, so society can recognize them and their vans. There must a good rason why Dutch State is taking over this responsibility?

[hari]

Your conclusion is what G-7 agreed upon in principle - ie. until further notice!

(I noted you're at DoD) Here, in Holland, all public tree planting and management is, in fact, a monopoly of the local state authority - to preserve the diversity and genetic origin. The workers are all civil servants and wear a special uniform, so society can recognize them and their vans. There must a good reason why Dutch State is taking over this responsibility?

[ndd]

2 slugbaits:

With the qualification that:

The reason "no regulation" should be the default position for markets that are inherently competitive

I think we are in violent agreement.

[2slugbaits]

hari,

Here in the US public tree planting is sometimes done because the brother-in-law of some local city council member owns a nursery and wants a sweetheart deal.

The case you are describing in Holland does not sound like an example of government regulation as we understand it here in the US. Government regulation usually means that the government tries to guide the private sector towards some outcome. But what you're describing sounds like a flat out government program that replaces the private sector. That's really a different kettle of fish.

[jamzo]

i suspect the most important phrase in the "free" market and "free" trade debates is "When markets approach competitive conditions"

what does it mean? how would we agree that a market is approaching competitive conditions?

how often do markets approach competitive conditons?

what markets can be said to be "approaching competitive conditions"

what is gained by "approacing" versus "in competitive conditions"?

[2slugbaits]

ndd,

That is also what Mark Thoma said. The second sentence in his post says: "When markets approach competitive conditions, they work best when they are left alone." So clearly he has in mind markets that are inherently competitive and need to be regulated due to some defect in the marketplace.

[Winslow R.]

ndd wrote:"It wasn't sentiment that led to the planting of so many American elms: if you were to pick a single shade tree to plant on urban streets, the American elm was it"

Yes, the planting of elms may have been based on 'sound' analysis, but now that the analysis was shown to be flawed, sentiment limits change. Nostalgia/inertia plays a part in why a system evolves so slowly and perhaps not at all.

But we have another problem limiting evolution besides sentiment as sentiment eventually dies off all by itself....

Sound analysis, based on the disastrous results of a monoculture, has been overshadowed by loads of cash distributed to economists by those with economic interests tied to the existing system.

How much 'sound' analysis has the fingerprints of the Fed, World Bank, IMF, and the financial community?

This is why people question Mark's motives when he says he wants to save the financial system first and then figure out how to fix the problem later.

Leaving the current financial system intact, insures a strong, perhaps insurmountable advocate for the status quo.

[Bruce Wilder]

2slugbaits: "Contrary to what many seem to believe, he is not arguing against the need to regulate industries from time to time."

Just to be clear, my view is that regulation is necessary for every industry, every time. There is no instance, ever, of an unregulated industry surviving in the long-run. Does not happen. Can not happen.

Regulation of production and distribution processes is an inherent economic function, and the development of an industry is the development of hierarchies of regulatory control. The firm, itself, performs control functions. An ecology of firms forms performing complementary control functions. And, government power is used to enhance and police the control functions. This is the core of the complex development of economic institutions, which manage every economic activity. Every functioning market is the product of such careful and detailed management.

It is a delusion to imagine that a level of economic development can be reached with more or fewer rules. A level of economic development literally "is" a level of control, and therefore a level of complexity and sophistication of rules.

I am not arguing that the quality of rules do not matter. On the contrary, I am arguing that that is all that does matter. Regulatory reform is absolutely necessary for further development; innovation in regulation literally "is" economic innovation.

I am saying that the argument that the quantity of rules matters is a foolish distraction and illusion. As any economy reaches a level of sophistication and complexity, there will be rules. As soon as there were two automobiles, there had to be a rule about which side of the street to drive on, rules about rights-of-way, etc. The rules, in number, are inescapable; the choices are simply about quality, compliance, technical efficiency, and openness to further innovation.

You cannot sensibly simply take away the rules, without creating costly chaos and regression. We rolled back the rules on financial regulation, and re-created the conditions for financial panic, which we had seemingly escaped 65 years ago. Hello!?

2slugbaits: "The reason 'no regulation' should be the default position for markets that are inherently competitive is that I haven't met the govt bureaucrat (myself included) who is smart enough to determine prices and output quantities in ways that clear markets."

Echoing ndd, I think we are in violent disagreement. In my view, "competition" does not cover the case. Regulation is about an economic function that does not even exist in the model of perfect competition under complete information, and is not, ordinarily or properly primarily about allocative efficiency. It is about technical, managerial, organizational efficiency in the control of error.

[Bernard Yomtov]

Most markets don't collapse like this - they are self-regulating and can be left alone (and if they do collapse, the entire economy is not threatened) - but financial markets are different and that's something I won't forget again.

Isn't this the key point. It's not clear to me how financial markets into a sort of standard efficient competitive market model, at least in its basic form.

I suppose I would say something like the main input used by financial institutions is risk and that optimally they satisfy some sort of efficient frontier return/risk standard. But if the cost of the risk input is significantly borne by others then there are strong grounds for arguing that regulation is justified. Not sure all that's exactly right, but maybe.

[Bruce Wilder]

2slugbaits: "most monopoly rents today are a consequence of govt regulation and not the other way around."

Utter nonsense.

Rents (and I include quasi-rents) are a pervasive feature of the structure of a developed modern economy. Every persistent firm owns or controls resources, which earn rents or quasi-rents. There is a sufficiently large difference between the firm's use of the resource and the next best use, that the firm is practically never under effective pressure to yield the resource to reallocation by market exchange -- that's what creates a persistent industrial structure; it is those asset-resources, which allow the firm to attenuate risk without falling apart with the vicissitudes of the marketplace -- they are the "real" correspondent to owner's equity in the financial structure. Firms are universally "rent-seeking" rather than profit-maximizing, because their chief economic function is administrative control of a production process, and they orient their control to direct residual returns to the rent-earning resources they own. A railroad manages its operations to earn a return on its sunk cost investment in its railway. A one-man law firm manages his career to earn a return on his sunk cost investment in education and relationships in the community.

The rational profit-maximizing firm in perfect competition under complete information would ignore sunk cost investments in its decision-making. But, that's not how a world of risk and uncertainty works -- it is just the opposite, and firms are oriented to earning returns on resources that they own, the income to which, are composed largely of rents. Those rent-earning asset-resources are the source of insurance that makes the persistent existence of the firm and the contractual incentives the firm offers for cooperative use of other resources (e.g. hiring workers) possible. Elements of monopoly and market power enter into things, more commonly than not, and monopolistic competition is the rule, not the exception, because it is often necessary to ensure that firm can manage recovery of sunk cost investments through such common devices as price discrimination and such common circumstances as market structures without the possibility of market-clearing equilibrium prices (e.g. scheduled airlines, movie theatres).

It is strictly true that we would not need regulation in the case of perfect competition under complete information, but the correct conclusion to draw from that observation is that the shape of perfect competition under complete information tells us absolutely nothing about the need for regulation.

We live in a world of incomplete information, risk and uncertainty, in which firms are organized to control economic processes, and in which all economic actors behave strategically, in the presence of incomplete information.

Any industry/market where firms are behaving strategically is one, which departs from the assumption of perfect competition, and which will require regulation. This is pretty much all markets/industries, by the way.

All that financial "innovation" in banking was strategic behavior. Hello!? Strategic behavior. Not competition. Shall we check the textbooks. What's perfect competition? The absence of strategic behavior. Strategic behavior. Absence of competition. Let's get real, people. This is economics, not rocket science.

Changing the rules of the game is a common object of strategic behavior. I would not suggest that creative changes in the rules of the game is not sometimes desirable. But, most experiments end badly. And, the object of regulation is to keep such strategic experimentation within reasonable bounds, and the resulting costly errors limited in their consequences.

I fail to see how perfect competition under complete information, where no rules are necessary and no strategic behavior exists, is a useful guide.

[hari]

Bruce Wilder -

You have more than convinced me on *perfect competition* and *strategic behaviour*.

In the absence of perfect competition, all sorts of things happen to maximize leverage and outcomes.

For a moment - forget about perfect competition - try to deal in more detail what constitutes *strategic behaviour* and how it is leveraged/applied in market place (using some of your simple examples).

I think we all need to digest this conceptual nuance and benefit from an analysis of its intrinsic value.

[2slugbaits]

Bruce,

I think you're going way beyond what was the original scope. No one is pretending that there is perfect competition. Imperfect competition is not the same as no competition. That said, even imperfect competition will still push firms to respond to price signals from the market.

The problem with your argument is that it is fundamentally at odds with itself. On the one hand you argue passionately for the need to regulate markets; but most of the examples you cite are really examples of the consequences of government regulation gone wrong. And all too frequently it does go wrong. I don't know about you, but I trust market forces a hell of a lot more than I do Dick Cheney's sense of civic virtue. Businesses that can compete will compete. Businesses that cannot compete will bribe politicians to set up complex regulatory schemes to keep out competition. Look at George Bush's career as the owner of a baseball team. Could you find a better example of a regulated business than the Texas Rangers? Or any sports team for that matter. They typically use govt regulations to carve out protected markets and then use govt funds to pay for it all. What about state legislatures that are in bed with casino operators because of the gaming revenues, and then that same state legislature passes a smoking ban that only applies to bars and restaurants other than casinoes? Is that the state acting to promote public welfare, or is it a case of the state carving out monopoly rents for itself (Note: that just happened yesterday in one state). If regulators are so good at understanding markets, then why have so many states managed to lose money with state operated liquor monopolies? If you can't make money with a liquor monopoly, then you better give up the idea that you can effectively regulate markets.

Your argument takes the form of pointing out that there is no such thing as perfect competition, therefore regulation is required. Aside from the fact that the first part of you statement could be true without the second part necessarily following from it, my bigger concern is that you don't apply the same test to regulations. In other words, you are comparing imperfect markets with wise, benevolent and well designed regulations. Most regulators are not wise, hardly benevolent, and "well designed" isn't the term that usually comes to mind when I think about my experiences.

There are times when regulation is required. And when it is required it's important that the govt get it right. As a matter of allocating regulatory resources that means we should not try to fix every market failure out there. There are very real transaction costs involved with regulating industries. Finally, liberals run the risk of losing credibility on this issue of regulating businesses. There is a (well justified) perception that liberals have a knee jerk reaction to want to regulate every aspect of the economy. That doesn't sell well poltically. Us liberals would have a lot more credibility if we concentrated on regulating things that matter. We would help ourselves even more if we occasionally turned the tables on rentseeking Republicans and argued for free markets (e.g., abolish farm subsidies).

[Bruce Wilder]

2slugbaits: "Your argument takes the form of pointing out that there is no such thing as perfect competition, therefore regulation is required."

I think you are projecting. My critique of the argument that markets in competition are optimally self-regulating and self-stabilizing is that models of perfect competition under complete information completely leave aside regulation. You can not put forth this model as one of self-regulating stability, because the model does not include regulation, per se, in any form.

My argument, as I see it, comes down to pointing out that there is production process control, and regulation is, typically, an extension of the control hierarchy and function.

Market-place competition may be an important aspect of the environment, within which the particular organizational scheme for controlling the production process exists, but it is an environment, in which strategic behavior is of paramount importance.

If you have a model, which admits process control as an inherent function, and strategic behavior, then we can talk about what kind of regulatory scheme is appropriate, and why. But, a model of perfect competition under complete information does not admit control or regulation as an economic function -- arguing from such an ideal is contentless and meaningless.

I am saying there is a critical and vitally important economic function -- control of production process error -- which is distinct from the allocative efficiency highlighted in a model of market price competition, and that "regulation" ought to be understood as primarily an extension of that function, a function that is always being carried out primarily by private firms or other private institutions.

To give a concrete example (torn from the headlines!), the government regulates air safety, and FAA supervision of aircraft maintenance is part of that regulatory scheme. I see this primarily in terms of a system of control, aimed at reducing error. The FAA operates as an extension of the airlines' and aircraft makers' own bureaucratic hierarchies, and acts to see that those bureaucracies do their jobs. The allocative efficiency implications are only, at most, tangential consequences.

The model of allocative efficiency leads to very weak thinking. People talk about "more regulation" or "less regulation" as if regulation were an allocative efficiency decision. It is certainly sensible to talk about "more or less" in an allocative efficiency context, because that's what allocative efficiency is: the allocation of resources in optimal proportion. But, that's not what technical control of process error is. The pattern of resource allocation associated with control regimes is one of progress through sunk cost investment -- so there's path dependence and not infrequently, increasing returns. Talking about statically optimal "more or less" regulation just does not make much sense.

To return to the example of airline safety, I trust it would be obvious that having no airplance crashes is not necessarily evidence of fundamental misallocation of resources, or that the Federal regulatory scheme has failed, or, in the Friedmanite view, is an illusory redundancy vis a vis the magic of market forces.

I'm sure some bright fellow could figure out what "market failure" category accounts for the need for the FAA, but such categorization, to my mind, misses the main point, which is that the regulatory scheme strengthens the control function and reduces costly errors. Since there is no control function in the model of market competition, it is really difficult to talk sensibly (from non-existent insights gained from that model) about what the necessary relationship is, among competition, market price equilibrium and control.

I would suggest that recovering the sunk cost investment made in control schemes is generally problematic, and market power may be convenient to sustainable business models that rely on elaborate control schemes. That implies some impairment of allocative efficiency, in order to achieve the technical efficiency gains of enhanced control. Lots of people are inclined, in their thinking, to elide the distinction between price competition in a market approaching price equilibrium, and the rivalrous competition that we often associate with technical or organizational innovation. But, the latter rivalrous competition, in which innovation is strategic, is characteristic of markets/industries where monopoly rents and strategic behavior are critical factors -- there's no justification that I can see for applying a model of perfect competition to those markets. I would certainly include banking and finance among the markets/industries in which strategic behavior and innovation have been sufficiently prominent that talk of perfect competition strikes me as intellectually inadequate.

[run75441]

You can be with Mark all of you want to be. The fact of the matter is, Greenepsin led the charge in 1987 while just a member of the Fed to rewrite Section 20 of the Glass-Steagall Act.

"The vote comes after the Fed Board hears proposals from Citicorp, J.P. Morgan and Bankers Trust advocating the loosening of Glass-Steagall restrictions to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, then vice chairman of Citicorp, argues that three "outside checks" on corporate misbehavior had emerged since 1933: "a very effective" SEC; knowledgeable investors, and "very sophisticated" rating agencies." www.freedom4um.com/cgi-bin/rea­dart.cgi?ArtNum=74200

Today's issues are a direct result of Greenspins actions from 1987 - 1999 when the Glass - Steagall act was repealed. The albatross of today's market problems should be worn by Greenspin. As if Citicorp did not have any issues to protect and promote with WorldCom. JP Morgan is also on the list of advocates for a rewrite of Section 20, a bank that Greenspin was on the board of directors previous to his appointment to the Fed and eventual promotion to Fed Chief in 1987. Voelker protested the rewrite of section 20 before his departure as the Fed Chief and express his fear that the Feds actions would lead to a lowering of standards in order to capture more lucrative securities offerings and in turn market bad loans to the public . . . securities risk versus deposit protection the same as 1929.

With the appointment of Greenspin as Fed Chief, the degeneration of the Glass-Steagall Act continued. 1990, JP Morgan received permission from the Greenspin led Fed to dabble in securities up to 10% of Revenue (up from 5% in 1987). In 1996, the Greenspin led Fed renders the balance of section 20 ineffective by allowing banks the ability to acquire securities firms (think Travelers, Salomon Brothers and Smith-Barney) with a limit of 25% of revenue derived from these operations. From 1984 onward, the Senate actively tries to kill Glass-Steagall.

Led by Sandy Weil, lobbying efforts to repeal Glass-Steagall with Greenspin and Congress plus an expenditure of $300 million; lead to its repeal in 1999 as signed by President Clinton in what is called the Financial Modernization Act. Weil merges Travelers with Citibank to become Citigroup Incorporated.

That is the history of what led to today’s demise as led by business. Here are some of my issues with the Treasury Secretary Paulson’s solution, a solution I consider little more than lipstick on a pig coming from a Treasury Secretary who was a former head of Goldman Sachs. The proposal does not fix the problem of banks speculating in lucrative and risky securities. The same as in 1929, we have banks speculating in risky securities rather than in the protection of bank deposits and investments. The Treasury Secretary proposes less regulation by giving over the reins of regulation to a financial industry that has “again” proven they are incapable of regulating themselves when it comes to protecting investments or deposits as opposed to risk adverse investments. Hello, this is a rerun of 1929; just maybe not as bad because of other stop-gap measure such as printing more money and funding the market with it at the taxpayer’s expense.

Replacing the rules of the SEC with the goals of a to-be-created industry based group to regulate is silly at best when the very industry that is to be regulated can not determine the adversity of the risk of a security as measured against their investor’s trust and money. Foxes guarding the chickens? Leave the SEC alone and force them into doing what they are supposed to do with the required funding. Force the Fed to use its power of requiring greater margins by banks and financial institutions regulated by them. Under Greenspin, the Fed has slept through one bursting bubble, and most of another, and has manipulated the outcomes of legislation that has seriously impeded our ability to control speculative investments. Place Bear Stearns, Lehman Brothers, and Goldman Sachs type businesses under the same Fed regulations as banks. Put together a legitimate committee to study the issues indepth that is not chaired by investment firms and is headed up by depositers and investors.

[Mark Thoma]

Nice story, but it doesn't explain today's problems, i.e. it does not does it explain subprime loan failure - those changes are not the cause of the problems we are having today (the problem is not that traditional banks were caught holding risky financial assets that declined in value and caused them to fail, this problem is largely outside the traditional banking sector).

And for the record, I've been calling for broader regulation - beyond traditional banks - for quite awhile.

[anne]

"And for the record, I've been calling for broader regulation - beyond traditional banks - for quite awhile."

This is a problem I do not understand, but will be speaking with an attorney who represents investment bankers. Are bank-like lenders subject to oversight-regulation as lenders, even beyond being corporate? I do not know. As corporations there is oversight, but how significantly so? I do not know, but had assumed there was SEC oversight and this may be misleading.

[acerimusdux]

To me, the conclusion that "with respect to the present crisis, the problem was more the failure to enforce existing regulations or to impose new ones rather than deregulation" is debatable.

It isn't that long ago that states were permitted to have interest rate caps, that ARMs, balloon mortgages, and interest only mortgages were not allowed, and that conflicts between investment banking and commercial banking were prevented. Those S&Ls, which so suspiciously seldom failed, paid a reasonable return to small depositors, in insured accounts, and were restricted in their lending to local housing meeting FHA standards. They insisted borrowers meet credit standards, as this allowed the loans also to be insured through FHA. They also needed to meet certain standards to be able to resell the loans, which could only be done through FNMA.

Was this the most efficient system imaginable? Likely not. But it was very secure for savers, borrowers, and S&Ls, and at no great cost to taxpayers. In short, it worked. The improved, less regulated, more efficient system favored by deregulators seems to me to still mostly only exist in theory--much like the good kind of communism, I suppose it has never been properly "tried". After all, what we have now surely isn't what they were after, is it?

And yet we've seen a string of high profile failures from those real world kinds of deregulation that have been tried, from S&Ls, to energy markets and utilities, to airlines, to telecom, to broad accounting scandals which have for years now have caused eroding faith in our equity markets. Even our biggest foreign policy failures have been largely failures of deregulatory zealotry, from the trend in former Soviet states away from democracy and back toward totalitarianism, to the complete failure in Iraq of the CPA--which wrecked havoc on that economy by eliminating all trade barriers and throwing a large chuck of its population into unemployment.

And yet we are supposed to see these as exceptions to the "good" kind of deregulation. We are supposed to accept that the default position ought to be in favor of deregulation. To accept that "for the most part the general attitude was that we needed to deregulate whenever and wherever we could".

To which I say, NO, NO, NO....

I suspect that anyone who has studied any economics is familiar with examples of well intentioned interference in market pricing mechanisms yielding unintended consequences; rent controls that ultimately lead to higher rents, for example. But very seldom do real world regulations involve such interference with market pricing mechanisms.

The vast majority of regulation that currently exists is there to aid in the creation of efficient market mechanisms. Inherently efficient open markets, after all, rarely exist in nature, outside of some commodities markets. If you have a commodity, a uniform good, available from a range of competitive independent suppliers, whose value is easily understood by both buyer and seller, then yes you have the conditions under which unregulated markets are efficient. The problem here is that under these conditions, profits also tend towards zero. Thus, capitalists in general, often aren't truly such big fans of competitive open markets after all. It might even be said that the corporation which profits most, competes least.

And so in the real world, the alternative is well-regulated markets. Regulation is required to compensate, in most markets, for the lack of perfect information. And so we have disclosure and labeling laws, and we have consumer protections, health and safety inspections, and reporting requirements. Regulation is required to account also for externalities, public costs that aren't otherwise reflected in market prices. So we have environmental regulations, and public health regulations. And regulation is required to insure against the more extreme outcomes and fluctuations of sometimes wildly irrational markets.

Thus, some of the best regulated markets of all have long been the financial markets. From the SEC, to the Federal Reserve and FDIC, participants in these markets have long depended on government protection and oversight.

For all the time academic economists spend studying or teaching about tulip markets in 15th century Holland, I wonder if enough time has been spent studying or teaching about the causes of American prosperity in the 20th century. It seems to me that the populist and progressive reform movements of the late 19th and early 20th centuries, followed by further depression era reforms, created much of the regulatory environment which allowed efficient markets to flourish in this country.

How much attention is paid to the importance of a non partisan civil service--those bureaucrats who are so frequently scapegoated by deregulatory zealots? Or to the importance of the SEC, and effective regulation of securities markets? Or of the Federal Reserve System? Of the FDA? Of the Fair Labor Standards Act? Or, even of the wealth of data collected and reported by the federal government, including all of those economic statistics kept by agencies like the BLS and BEA, data economists might not even have available to study were it not for regulation?

Perhaps if more attention were paid to these accomplishments, we would hear less talk about the "default" position being to favor deregulation--a position which assumes that whatever rules and institutions have been put in place by those who have come before us, whatever has seemingly worked for previous decades, or longer, must have been wrong, unnecessary, and without good reason.

The utopian "efficiency" of the imaginary unregulated market is much like the utopian efficiency of the ideal centrally planned communist economy; both only exist in theoretical models which fail to account for the all too human failings of market participants. In the real corruptible world, we need markets to be well regulated, even if that sometimes means they are less than optimally efficient.

[john c. halasz]

Sorry, Prof. Thoma, but I think you've gotten the facts there somewhat wrong. In the first place, this is not just a "subprime crisis", for all the media still uses that tag, but it's an across-the-board credit bubble crisis, of which the housing bubble and mortgages of all kinds form a considerable part, but not by any means the whole story. And the story concerns the exponentially increasing growth of the levered, but off-balance-sheet "shadow banking system" via securitization of loans transfering them from the regulated sector onto unregulated markets and firms. (You'd have to go back to the 1970's, with the troubles in fixed income investments with the stagflationary crises, the rise of expanded capital markets, and the sovereign loans crisis combining to impair the profitability of regulated banks, to fully trace the evolution of finance market to where we've got to today). At any rate, note the measures concerning section 20 mentioned, and that they directly concern the involvement of regulated banks in the ABCP market and the munis market and the private mortgage securities. In fact, SIVs, auction rate securities, and collateralized debt obligations were all invented precisely at that time, 1987, and these schemes are precisely prime culprits in recent blowups, though the issuance of such vehicles early on was miniscule compared to what was to happen in the course of the naughties. And note Volcker's concerns that they would "lead to a lowering of standards in order to capture more lucrative securities offerings and in turn market bad loans to the public", which sounds quite prescient, no? Part of the problem with the originate-loans-to-securitize model is not only does it function effectively to evade capital and reserve ratio requirements, but it further evades limits on credit creation, since for each loan at 90% of deposits and 92% capital the pool of loanable funds doesn't proportionally diminish, if loans are continuously sold off onto markets, thus renewing the supply of loanable funds. And, needless to say, there are other severe problems with information assymmetry/loss/opacity and misaligned, deficient, or confused incentives involved. But the upshot is that "efficiency" in providing cheap credit does not necessarily serve, beyond some point, any real economic or business purpose, and can well convert into its opposite, as the current credit implosion is revealing all too well. And these tendencies have been a long time in building though at an exponentially increasing rate.

I'm somewhat surprised that no one in the above comments has made the very elementary point that financial markets are a distinct sort of beast from product markets, and involve different considerations, though Bruce Wilder as usual has chewed the fat well from the other side of the case. Industrial oligopolies may well implicitly cooperate with one another in dividing up market share and thereby avoiding mutually deleterious competitive stresses, but otherwise they don't generally depend on each other and each would be advantaged by the failure of a competitor. And though they must manage heavy fixed-capital investment through a variety of macroeconomic and market conditions, the accounting of profits from sale of output is relatively straight-forward and market share and output capacity maintains the valorization of their capital by and large. (Their main problem concerns technical innovation). But fractional-reserve banking, as the main basis of finance, is at once intrinsically highly levered and constantly dependent of continuing cash flows and rather speculative and variable accounting. As a result, banks at once compete with and depend upon one another, which is distinct from other kinds of business, and that combination of high leverage and distinctive cross-dependency generates, as the history of financial panics demonstrates all too well, a need for careful regulation. Not only do bank failures threaten the liquidity, if not solvency of other banks, but it threatens spillover into the real economy, as banks functionally serve to intermediate between producers and consumers, firms and households, in the real productive economy through the allocation of credit. Ultimately the point of regulating the financial system that extends from fractional-reserve banking through capital and reserve ratios, disclosure requirements, accounting regulations, etc. is not just to prevent or dampen financial panics, but to prevent the excessive growth of the financial economy to the point where it begins to lose its functionality for the real productive economy and effectively disintermediates itself from it, minting profits out of profits through fictive asset inflation out of synch with the productive and income generating capacities of the real economy and distorting the latter, up to the point where such asset valuations "suddenly' are revealed to be misvaluations.

I might further add that the problem of regulation does not just concern the extent and appropriateness of regulations and their efficacy or obstructiveness, but the obverse side of the problem, which is regulatory capture by the regulated. Misregulation is often more a function of regulatory capture than it is of intrusion on the effective functionning of markets.

[wjd123]

Sometimes regulation and market intervention are needed to force markets into the competitive mold, at least approximately, but only when we are sure that the costs of market failure are sufficiently high to justify intervention. The threshold for intervention is fairly high.--Mark Thoma

Secretary of the Treasury Paulson could have written that. I take it that the difference is that Mark believes in transparency first, hedge funds included or any other new type fund the Fed wants to poke its nose into? That way, when the crisis nears the Fed will know which haystack to look under. Or will they, that is if contagion has spread from unregulated markets in the global economy. Or will they, that is if regulators are captured by the people they are regulating. Or will they,that is if regulators can't understand the financial scribblings of financial engineers.

I rather the Fed had information about the marketplace than merely look for signs in the marketplace. After all it couldn't seem to recognize the signs of the last two bubbles enough to do much about them.

This calls for some rules:

Rule 1. The "huh" rule. If financial engineers can't explain to a regulators what they are doing without the regulators going "huh," they can do it.

Rule 2. The no wooing rule. If you are caught offering a regulator anything--meals, employment, or paying for their services, you go to jail. You're entitled to have two meetings with regulators to make your case and then you're band from any further contact with them during the year.

Rule 3. The make them sweat rule. Once a year outside auditors with a list of standards at hand look over the books of commercial banks, investment banks, and hedge funds and any off the books financial dealings they may have. The CEO signs a statement that the information is truthful and complete. If it isn't the CEO goes to jail. (Do we already have that one, if so, it didn't help keep today's financial crisis away.)

Rule 4. The quarantine rule. If the product is coming from lightly regulated foreign markets you're limited to how much of the product you can buy. This also goes for poorly regulated markets like we have with our rating services.

Rule 5. The fly low rule. Leverage calls come sooner.

If the Fed is doing the regulating it has to follow these rules.

These rules are designed to make the market safer and not more efficient. Does efficiency require mystification, regulatory capture, off the books dealings, blind risk, and big risk?

[Mark Thoma]

Let me try an analogy. Suppose there's this new innovation - automobiles - and we put them into place. Unfortunately, some people drive their cars recklessly and endanger other people, cause massive pile-ups on freeways, and they undermine the whole road system. The problem gets bad and there is a call to do something about it.

One response would be to ban cars altogether. Cars are the problem, so get rid of them. But another answer is to allow cars and regulate driving behavior - set speed limits, licensing requirements, use speed bumps if necessary, there are a variety of ways to regulate driving behavior and reduce (though not totally eliminate) risks so as to keep the transportation system flowing (more) smoothly.

When it comes to our current problems, it wasn't the new financial vehicles so much as the way we allowed them to be driven. The windshields were cloudy (lack of transparency), the ratings agencies got it wrong (cars rated safe by expert mechanics - hired by the car dealers - had the wheels fall off when speeds got too high), there were no speed limits (we allowed too much systemic risk to accumulate), and so on. We need to regulate how cars are driven, not get rid of them.

Also, it wasn't that banks and other financial institutions were doing new things as a result of the repeal of regulation (particularly the Clinton changes), non-traditional banks had already started infringing on banks' territory (and failure to look into this is a regulatory failure), banks were under competitive pressure and in danger of failing due to the inability to compete (developments in the foreign sector also put pressure on regulators), so the relaxation of 20 was a means of allowing banks to remain competitive, or so regulators thought. Banks were allowed to drive cars like everyone else.

In the end, traditional banks were not the problem, the problems were outside the traditional banks and it was the way these new cars (financial instruments) were driven, not the fact that they existed (traditional banks turned out to be pretty good drivers). I think we need to regulate these markets so that big multi-car crashes that clog up the system can't occur, or are very unlikely to occur, but I don't think we need to roll things all the way back to a strict demarcation of activities (ban cars). That won't work in global financial markets, so we will have to learn how to temper the activity with regulation rather than trying to ban it altogether or keep functions strictly separate.

Glass-Steagall restrictions (or not) is not our only choice, we can allow financial markets to serve our needs - I certainly benefited from innovations in mortgage markets in buying the house I live in now - while still preventing excessive speed and other risky or reckless behavior. It wasn't the repeal that was the problem, it was our failure to regulate risky behavior when these new innovations were put to use.

[ndd]

Prof. Thoma, the automobile analogy is an interesting one, but there is a crucial point about the current crisis that I submit is lacking:

There were way more automobiles sold than the roads (or the police) could handle (And the police were ordered not to crack down on the unsafe driving anyway).

Furthermore, because of the cloudy windshields, wheels falling off and reckless driving, fatal accidents and disabled cars shut down all of the traffic lanes -- even for safe drivers with well-maintained safe vehicles.

In that respect, the cars ARE the problem. In order to free the expressways, you need to remove all of the disabled or unsafe cars from the roadway now, and keep them off the roadway in the future.

[wreck on the highway]

And when the automobiles crushed innocent pedestrians and bicyclists under their wheels, the Federal Reserve funneled cash to the drivers so that they could buy even larger automobiles (hummers) less likely to be damaged by the pedestrians and bicyclists but more likely to cause their smaller victims irreparable and lasting harm.

[Winslow R.]

mark wrote; "Suppose there's this new innovation - automobiles ..."

Automobiles represent financial instruments and the problem is how they are created not driven. The problem is 'excessive leverage'. How is leverage represented in your model?

How about BofA, Citigroup assisted the creation of millions of cars, through subsidiaries. They provided warranties on these cars and now, all of a sudden, those cars have quit functioning and now need to be sold for junk. BofA and Citigroup, start stripping parts from the cars they make at the main office to keep the subsidiary cars running.

Since the U.S. government guarantees cars produced by BofA's main office, they have started lending auto parts to BofA to lend to its subsidiaries.

Not sure how speed limits would stop that from happening.

mark wrote: "Also, it wasn't that banks and other financial institutions were doing new things as a result of the repeal of regulation....

In the end, traditional banks were not the problem, the problems were outside the traditional banks and it was the way these new cars (financial instruments) were driven"

1) Of course the problem appears first with the most highly leveraged (but this does not mean it started there!) and progress towards the least leveraged. Because banks have access to the 'lender of last resort' they will be the last to fail. Remember the TAF was one of the first facilities made available by the Fed. Also we must remember, everyone can be brought down.

2) Many of the most highly leveraged are 'off-balance' sheet entities created by less leveraged traditional banks.

I don't understand how you can continue to ignore traditional bank involvement in the current problem in good conscious just because they have 'subsidized access'.

[wjd123]

Also, it wasn't that banks and other financial institutions were doing new things as a result of the repeal of regulation (particularly the Clinton changes), non-traditional banks had already started infringing on banks' territory (and failure to look into this is a regulatory failure), banks were under competitive pressure and in danger of failing due to the inability to compete (developments in the foreign sector also put pressure on regulators), so the relaxation of 20 was a means of allowing banks to remain competitive, or so regulators thought. Banks were allowed to drive cars like everyone else.

But Professor Thoma aren't you already forgetting your warning to yourself "but financial markets are different and that's something I won't forget again."

If cars like everyone else means like investment banks, than to improve on your analogy, banks weren't driving cars but something "different": they were driving trucks. And commercial bankers who were driving highly regulated trucks were allowed to compete by creating a fleet of highly unregulated trucks on the side. As a result when these fleets took to the highways the highways became much less safe for us predestrians driving ordinary cars.

So for increasing the likeihood of really bad pileups on the highway, weakening the firewall between commercial and investment banks was a bigger deal than you make it out to be in your analogy in that the highways all the more quickly became filled with dangerous trucks.

[Bruce Wilder]

Mark Thoma: "When it comes to our current problems, it wasn't the new financial vehicles so much as the way we allowed them to be driven."

A pretty good analogy.

The question nagging at me, about all of this increasingly levered financial innovation is where is the economic gain coming from.

Back in business school days, I was taught that the art of the deal was the art of slicing cash flow and risk into attractive packages, but (and, this is the big but), it is really not possible to make the parts worth more than the whole. You can facilitate diversification, and reduce the tax on the value of the whole imposed by risk aversion, but that's it. The original cash flow, unchanged by the slicing and dicing, forms a ceiling on the value of the whole and the value of the parts.

The sums involved make me think that more was going on than just improving diversification a bit around the edges -- that there was, and is, a lot of . . . what? theft? extraction? skimming?

I keep coming back to the proliferation of payday lenders and 33% credit cards, alongside resetting Alt-A and subprime ARM, and I wonder where the cops were hiding. When I hear Alan Greenspan complain that "no one could have anticipated . . . " I am not inclined to forgive and forget. I tend to think grand jury.

[Eric Dewey, Portland OR]

Anne and Andrew, not sure you'll get this on a dying thread (but lived into Sunday??? wow!), but thanks for the support. (FYI to Anne: there are certainly regulations on the books that apply to non-bank lenders - however, the oversight authority belongs to the FTC and/or state governments, which are either overburdened, lax enforcers, or in a few cases actively in support of business for the tax revenues. Regulated deposity banks have dedicated examiners at the Fed, OCC, OTS, FDIC, and NCUA. The SEC has oversight authority over investment banks that is not as extensive as depository banks. Oh, what a tangled web we weave...)

Prof. Thoma, your car analogy is pretty good, but the current challenges involve an intersection of complex regulations, not simple ones - which often allows the regulated entity to play competing policy interests against one another.

A better analogy might involve corporate charters. In law school (1996 UO Law, by the way) I took Prof Mooney's course in legal historiography. His text was Morton Horwitz' "The Transformation of American Law, 1780-1860", which is a fascinating exploration of how the law of corporations developed over time.

A simpler but still complex analogy might be the gradual evolution of railroad crossings. In the early years of the railroads, lots and lots of people and livestock were killed or injured by trains. Over time, the railroads made some attempts to address the problems (i.e. cowcatchers on the front of the engines). Until autos came along, the question of who had the right of way when a road crossed the tracks wasn't squarely faced. When it was, a clear solution was needed - and railroad crossings signs were then required by law (an expense that the railroads objected to). It took decades for the simple markers of a crossing to evolve into the automatic gates we see today - at the cost of thousands of lives. How much time and how many economic failures will take place before we get CDO's right?

The point of my criticism of economics as being overly mathematical is simply this: ultimately economic questions are questions of human value. Mathematics can illuminate the range of choices to be made, but will never provide a single definitive answer - that requires a decision, and decisions are inherently and inescapably political. And we forget that every single time, to our peril.

Ultimately, each value question posed by economic theory comes down to whether the often unspoken moral consensus of a culture more highly values individual success or group success (Galbraith's point about ultimate winners). They're both vitally important, but when choices have to be made, they're made politically, not mathematically.

In the Star Trek version for non-economic lurkers such as myself, does the greed of a powerful few outweigh the of greed of the multitudes? History has an answer for us - see the food riots featured in the WSJ today (Monday).

Ultimately, to paraphrase a wiser man than I, the fault lies not in the regulations or lack thereof, but in ourselves and our propensity to undermine our own carefully constructed moral credos.

[SAV]

The concept of regulation is of paramount significance and I was very happy to stumble across this post. I agree whole heartedly that government regulation should be dramatically limited in certain markets while expanded in others, the financial sector most notably. A great example of government interference that does little to streamline efficiency is satellite radio. As I am sure you have heard, XM and SIRIUS have been laboring away to pass a merger that has been stalled, first by the government, and now by the FCC (due to monopoly of the market). You stated that "monopoly was your main worry." And I also am wary of companies that are in complete control of very important market sectors. However, I think the taboo of monopolies tends to hurt companies like XM and SIRIUS radio that are incapable of competing against each other due to high costs. Granted, I am not a forecaster, but I do not believe that a merger between these two entities would increase consumer dead-weight loss. First, by merging, the company should be capable of offering lower prices and expanding the consumer base. Second, if the company did raise prices, customers are capable of resigning from their service as it is easily substituted. Digressing slightly, static government regulation presents only a small part of current involvement in economic matters. Because your post did not mention it, I was interested in your opinion towards the government's and Federal Reserve's recent trend in economic first aid. Though not specifically regulation, it follows the discussion of separation between government control and economic developments. Considering the Federal Reserve's debt exchanges, the multiple interest rate cuts, and the direct involvement in helping a private institution from becoming bankrupt, how do you feel about the Federal Reserve's active roll in the economy lately? Do you think they have done more harm than good? As an extreme case, what would you think if the Federal Reserve temporarily suspended its monetary policy to allow for market correction?

[reason]

There is a fundamental problem with regulation in that is set up by law, but there is no living accountable process to enable it to evolve. It is a problem with all law, not just regulations. There is too much of it, it tends to be too prescriptive (the legislators who enacting having limited foresight) and it rapidly becomes dated. It have suggested (only slightly tongue in cheek) in the past that there ought to be an upper limit on the number of rules, if you need a new one, you have to repeal one.

And I'm a fan of regulation. I think it often reduces costs, because compared to the open ended and unforseeable costs of litigation it makes the de facto rules governing the market clear for all players and it enables externalities to be internalised.

But there is bad regulation and good regulation, and more attention should be paid to the difference. (In fact much more attention than is paid today to regulation or no regulation).

I would rather have efficient, well written regulation that is not needed, than suddenly in an emergency discover that something ad hoc needs to be set up from scratch.

[hari]

This is a good point at which to mention that today (16 Apr)is 6oth anniversary of OECC (OECD) established in Paris (1948). The OECD & Marshall Plan - after WWII - established the framework of economic stabalization policy for the West.

In this new age of Globalization of 7/24h hi fi markets we need to seek OECDs intervention to review not only how we got into the present credit crisis but also to identify the way forward in a globalized world.