Aspirin or Amphetamines?

Dani Rodrik categorizes the different approaches to regulation of financial markets:

Financial innovation: a case of aspirin or amphetamines?, by Dani Rodrik, Project Syndicate: ...[A] half-century of financial stability lulled advanced economies into complacency. That stability reflected a simple quid pro quo... Governments brought commercial banks under prudential regulation in exchange for public provision of deposit insurance and lender-of-last-resort functions. Equity markets were subjected to disclosure and transparency requirements.

But financial deregulation in the 1980s ushered us into uncharted territory. Deregulation promised to spawn financial innovations that would enhance access to credit, enable greater portfolio diversification, and allocate risk to those most able to bear it. Supervision and regulation would stand in the way, liberalizers argued...

What a difference today's crisis has made. We now realize even the most sophisticated market players were clueless about the new financial instruments..., and no one now doubts that the financial industry needs an overhaul.

But what, exactly, needs to be done? Economists who focus on such issues tend to fall into three groups.

First are the libertarians... If you are selling a piece of paper..., it is my responsibility to know what I am buying... If my purchase harms me, I have nobody to blame but myself. I cannot plead for a government bailout.

Non-libertarians recognize the fatal flaw in this argument : Financial blow-ups entail ... "systemic risk" - everyone pays a price..., the government may need to bail out private institutions to prevent a panic that would lead to worse consequences elsewhere. Thus, many financial institutions, especially the largest, operate with an implicit government guarantee. This justifies government regulation of lending and investment practices.

For this reason, economists in both the second and third groups - call them finance enthusiasts and finance skeptics - are more interventionist. But the extent of intervention they condone differs...

Finance enthusiasts tend to view every crisis as a learning opportunity. While prudential regulation and supervision can never be perfect, extending such oversight to hedge funds and other unregulated institutions can still moderate the downsides. If things get too complicated for regulators, the job can always be turned over to ... rating agencies and financial firms' own risk models. The gains from financial innovation are too large for more heavy-handed intervention.

Finance skeptics disagree. They are less convinced that recent financial innovation has created large gains..., and they doubt that prudential regulation can ever be sufficiently effective. True prudence requires ... a broader set of policy instruments, including quantitative ceilings, transaction taxes, restrictions on securitization, prohibitions, or other direct inhibitions... - all of which are anathema to most financial market participants. ...

In effect, finance enthusiasts are like America's gun advocates who argue that "guns don't kill people; people kill people." The implication is clear: Punish only people who use guns to commit crimes, but do not penalize others by restricting their access to guns. But, because we cannot be certain that the threat of punishment deters all crime, or that all criminals are caught, our ability to induce gun owners to behave responsibly is limited.

As a result, most advanced societies impose direct controls on gun ownership. Likewise, finance skeptics believe that our ability to prevent excessive risk-taking in financial markets is equally limited.

Whether one agrees with the enthusiasts or the skeptics depends on one's views about the net benefits of financial innovation. Returning to the example of drugs, the question is whether one believes that financial innovation is like aspirin, which generates huge benefits at low risk, or methamphetamine, which stimulates euphoria, followed by a dangerous crash.

I think the benefits of deregulation are large, there has been a lot of very useful financial innovation that we now take for granted that would not have occurred under the old regulatory regime. I don't want the same restrictions in place now that were in place in 1980 - I could hardly get cash out of state. But some restrictions should have stayed in place, and others should have evolved with the market but didn't. So I also think we need to bring a broad set of policy instruments to these markets to help them function effectively and to think about how to create more responsive regulatory structures going forward. Avoiding meltdowns will allow us realize the benefits of financial innovation on a consistent basis. And I don't think that's an impossible task, we had a "half-century of financial stability," that's not so bad, nor do I think regulation is necessarily inconsistent with the incentive to innovate - effective regulation can create the kinds of stable, competitive conditions where financial innovation can flourish. So, I guess I don't fit very well into any of the libertarian, finance enthusiast, or finance skeptic categories.