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Thursday, March 27, 2008

Did Too Much Regulation Cause Our Economic Problems?

Ed Glaeser says John Kenneth Galbraith's "'The Affluent Society' seems relevant once more":

The Age of Abundance, by Edwatd Glaeser, Commentary, NY Sun: Fifty years ago, John Kenneth Galbraith's "The Affluent Society" soared to the top of the best-seller list. ... Much of "The Affluent Society" is rooted in the 1950s, but the book's central question remains central today: Should a rich society embrace free-market capitalism and private wealth, or should that society use its wealth for more public purposes like fighting poverty and improving infrastructure?

"The Affluent Society" reflects both the economy and the culture of 1958. The book's main observation was that America has become unbelievably prosperous. ... Galbraith beautifully captured that moment in the late 1950s when rising prosperity freed the median American from having real fears about basic necessities. ...

But while "The Affluent Society" reflects American society in the 1950s, it was quite detached from postwar trends in economics, which is why Galbraith has rarely been embraced by economists. In the 1940s, cutting-edge economists turned to mathematical models and statistics. Galbraith did not. ...

"The Affluent Society" is better seen as eloquent moral suasion rather than expert economic analysis. Galbraith sees two possible paths for an affluent America, and he strongly favors one of them. "The Affluent Society" argues that America can put its faith in free enterprise, which might create more and more stuff, or it can follow the more morally uplifting path of trying to reduce poverty and improve the quality of life with the help of a more robust public sector. .. Galbraith attacks the relentless pursuit of output, which, as he sees it, only satisfies unnecessary desires ginned up by clever advertisers.

Galbraith's advocacy of public spending aimed at reducing inequality and improving infrastructure helped usher in the 1960s. Lyndon Johnson's war on poverty was decidedly Galbraithian. While the New Deal social programs were born of economic desperation, Johnson's social spending reflected the confidence of prosperity, just as Galbraith had foreseen. But after 1969, the American public gradually turned against Galbraithian social policy. By 1980, Galbraith's arch-nemesis, Milton Friedman, had found an intellectual home in the White House. In the 1990s, even Democrats embraced private wealth over public spending. But in 2008, "The Affluent Society" seems relevant once more. As the political pendulum swings left, candidates once again call for a more vibrant state to right social wrongs. The excesses of the 1960s are forgotten and once again, the government is seen as society's savior. For people of all political stripes, it is worthwhile returning to "The Affluent Society," and pondering what Galbraith got right and what he got wrong.

While I am a staunch supporter of free markets, I agree with Galbraith that there is much the public sector needs to do. Private firms do not automatically provide safe streets, good roads, and clean water. Even more important, Galbraith was dead right in arguing that we need more effective schools. Human capital is our best tool against poverty and economic stagnation.

Galbraith's great failure was that he never really understood how much society is strengthened by a free and competitive private sector. "The Affluent Society" argues that a lack of regulation made American homes inferior to those in European social democracies. That view was wrong in 1958 and is completely untenable today. American housing is the best in the world, and the weaknesses of the housing market reflect too much, not too little, regulation, especially those rules that stymie construction and make housing unaffordable. While Galbraith was right that some social problems do need a stronger public sector, his analysis would read better today if he had also appreciated the tremendous vitality that comes with economic freedom.

Obviously, I disagree that the problems we are seeing in the housing market were caused by too much rather than too little regulation. Glaeser's not the only one making this claim:

Regulatory Overkill, by Allan Meltzer, Commentary, WSJ: The claim that deregulation went too far is coming from many sides. We need more regulation, the argument goes, and even a single regulator to bring stability. ...

Their diagnosis is wrong. Mistaken regulation contributed greatly to the current problems in financial markets. Take the 1970s Basel agreement between developed country governments, which followed bank failures in Germany and the U.S. The idea was to have equivalent risk standards in all the principal lending countries. The agreement required banks to increase their capital if they increased mortgage loans and other risky assets.

The banks responded, however, by developing instruments that avoided higher reserves by moving risky loans off their balance sheets. Risk moved to all corners of the global marketplace. We find out who holds the risky assets when they announce they are about to fail.

The response to the Basel regulation is not unique. The first principle of regulation is: Lawyers and politicians write rules; and markets develop ways to circumvent these rules without violating them. ...

The perennial argument of regulators is: "If only I had more power. . ." Not so. Regulators did not see the chicanery at Enron. Nor did they prevent the dot-com bubble or the Latin American debt problems in the 1980s. A main reason is "capture" -- when the interests of the regulated dominate the interests of the public.

Capture is not the only reason regulation often fails. Regulators and most politicians are good at developing rules and restrictions, but poor at thinking about the incentives that the market will face. If the incentives are strong, the market circumvents the regulation. The Basel regulation encouraged a system that is far less transparent than the system it replaced. ...

Mr. Frank and Senate Banking Committee Chairman Christopher Dodd are planning more schemes to move the risk to the taxpayers from those who made bad decisions, such as buying mortgages that are now in default. As a result, ordinary citizens will ask themselves: Why should I pay my mortgage if my neighbors can get theirs reduced? These proposals have stark long-term consequences. The financial system cannot survive if the bankers make the profits and the taxpayers take the losses.

The government has a responsibility to prevent systemic crises and financial collapse. Long ago that job was given to the Federal Reserve. It serves as lender of last resort to the market. Today, the Fed should not rescue individual firms, but it must keep the payments system from failing. To carry out that responsibility, the Fed has auctioned reserves and exchanged marketable Treasury bills for illiquid mortgages, and it has succeeded so far. Now, it must stop responding to calls for lower interest rates.

If the government underwrites all the risks, call it socialism. If it underwrites only the failures, call it foolishness.

Other than citing Basel as a general example, and I'd argue that even though Basel was not perfect it was much better than having no regulation at all, Meltzer doesn't actually say how too much regulation brought about this particular crisis. His arguments are about the problems he sees with regulation more generally, but there are no specific details about how over regulation may have caused our current difficulties. If the regulations under Basel caused banks to move assets off the books, then without regulation they wouldn't have needed to move them, but the assets still could have been used in the same way, financial institutions could have taken the same risks and would have had the same or more incentive to do so without regulatory oversight, and they could have caused the same troubles. I don't see how the regulations themselves caused the risk taking. Regulation caused evasion of regulation, and Basel II is trying to deal with that problem, but the regulations did not cause the risk-taking itself. I think Meltzer would likely argue that the regulations caused complicated financial instruments to be created that had risk properties that were difficult to assess - without regulation money would have stayed in the regulated sector where the risks would have been more transparent. But that seems to me to be an argument for regulation that forces transparency (as in the regulated sector), not an argument against regulation.  Glaeser's argument that our economic troubles are due to regulations that interfere with housing construction doesn't seem to me to be able to explain what is happening either, and he doesn't explain the connection in any detail, so basically we have two people asserting our current troubles were caused by too much regulation, but no concrete story about how that occurred. If they had one, I'm sure they'd tell it.

Update: Here's a bit more on Basel from Mishkin's monetary theory and policy text (this was written before the current crisis hit, note that regulators were already worried about banks' off-balance-sheet activities and Basel was an attempt to reduce risk their exposure):

Bank capital requirements take two forms. The first type is based on the leverage ratio, the amount of capital divided by the bank's total assets. To be classified as well capitalized, a bank's leverage ratio must exceed 5%; a lower leverage ratio, especially one below 3%, triggers increased regulatory restrictions on the bank. Through most of the 1980s, minimum bank capital in the United States was set solely by specifying a minimum leverage ratio.

In the wake of the Continental Illinois and savings and loans bailouts, regulators in the United States and the rest of the world have become increasingly worried about banks' holdings of risky assets and about the increase in banks' off-balance-sheet activities, activities that involve trading financial instruments and generating income from fees, which do not appear on bank balance sheets but nevertheless expose banks to risk. An agreement among banking officials from industrialized nations set up the Basel Committee on Banking Supervision (because it meets under the auspices of the Bank for International Settlements in Basel, Switzerland), which has implemented the Basel Accord dealing with a second type of capital requirements, risk-based capital requirements. The Basel Accord, which required that banks hold as capital at least 8% of their risk-weighted assets, has been adopted by more than 100 countries, including the United States. Assets and off-balance-sheet activities were allocated into four categories, each with a different weight to reflect the degree of credit risk. The first category carries a zero weight and includes items that have little default risk, such as reserves and government securities in the Organization for Economic Cooperation and Development (OECD-industrialized) countries. The second category has a 20% weight and includes claims on banks in OECD countries. The third category has a weight of 50% and includes municipal bonds and residential mortgages. The fourth category has the maximum weight of 100% and includes loans to consumers and corporations. Off-balancesheet activities are treated in a similar manner by assigning a credit-equivalent percentage that converts them to on-balance-sheet items to which the appropriate risk weight applies. The 1996 Market Risk Amendment to the Basel Accord set minimum capital requirements for risks in banks' trading accounts.

Over time, limitations of the Basel Accord have become apparent, because the regulatory measure of bank risk as stipulated by the risk weights can differ substantially from the actual risk the bank faces. This has resulted in regulatory arbitrage, a practice in which banks keep on their books assets that have the same risk-based capital requirement but are relatively risky, such as a loan to a company with a very low credit rating, while taking off their books low-risk assets, such as a loan to a company with a very high credit rating. The Basel Accord could thus lead to increased risk taking, the opposite of its intent. To address these limitations, the Basel Committee on Bank Supervision has released proposals for a new capital accord, often referred to as Basel 2, but it is not clear if it is workable.

The Basel Committee's work on bank capital requirements is never-ending. As the banking industry changes, the regulation of bank capital must change with it to ensure the safety and soundness of the banking institutions.

    Posted by on Thursday, March 27, 2008 at 10:55 AM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (50)


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