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Saturday, September 13, 2008

"Too Few Regulations?"

Tyler Cowen on financial regulation:

Too Few Regulations? No, Just Ineffective Ones, by Tler Cowen, Economic View, NY Times: There is a misconception that President Bush’s years in office have been characterized by a hands-off approach to regulation. ... But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That’s dysfunctional governance, not laissez-faire.

When it comes to financial regulation, for example, until the crisis of the last few months, the administration did little to alter a regulatory structure that was built over many decades. Banks continue to be governed by a hodgepodge of rules and agencies including the Office of the Comptroller of the Currency, the international Basel accords on capital standards, state authorities, the Federal Reserve and the Federal Deposit Insurance Corporation. Publicly traded banks, like other corporations, are subject to the Sarbanes-Oxley Act. ... Perhaps the biggest long-term distortion in the housing market came from the tax code: the longstanding deduction for mortgage interest, which encouraged overinvestment in real estate.

In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. ... [F]inancial regulation has produced a lot of laws and a lot of spending but poor priorities and little success in using the most important laws to head off a disaster. ...

The biggest financial deregulation in recent times has been an implicit one — namely, that hedge funds and many new exotic financial instruments have grown in importance but have remained largely unregulated. To be sure, these institutions contributed to the severity of the Bear Stearns crisis and to the related global credit crisis. But it’s not obvious that the less regulated financial sector performed any worse than the highly regulated housing and bank mortgage lending sectors, including, of course, the government-sponsored mortgage agencies.

In other words, the regulation that we have didn’t work very well.

There are two ways to view this history. First, with the benefit of hindsight, one could argue that we needed only a stronger political will to regulate every corner of finance and avert a crisis.

Under the second view, which I prefer, regulators will never be in a position to accurately evaluate or second-guess many of the most important market transactions. In finance, trillions of dollars change hands, market players are very sophisticated, and much of the activity takes place outside the United States — or easily could.

Under these circumstances, the real issue is setting strong regulatory priorities to prevent outright fraud and to encourage market transparency, given that government scrutiny will never be universal or even close to it. Identifying underregulated sectors in hindsight isn’t a useful guide for what to do the next time. ...

[I]f you hear a call for more regulation, without a clear explanation of why regulation failed in the past, beware. The odds are that we’ll get additional regulation but with even less accountability and even less focus on solving our very real economic problems.

I have argued in the past that it's important to understand what went wrong - the particular market failure at work - in order to design an optimal solution for a poorly functioning market, so I agree that we need to do our best to understand problems before trying to solve them. Informational asymmetries, agency problems, moral hazard, excessive market power, and other failures were present. Where we differ is in whether the right regulatory medicine will do more harm than good - I have more faith than Tyler does that regulation can be used to overcome market failure and promote competitive outcomes. But like him, I believe transparency is one of the key issues, and increasing transparency would be helpful.

On one point, the statement that the outcomes for the regulated and unregulated firms were the same, so this shows regulation failed, if someone without a life-preserver who is struggling in the water grabs someone who is wearing one, and in the process takes them both down, that doesn't mean that the life-preserver failed to do its job. It simply got overwhelmed by the "unregulated." So the mere fact that outcomes are the same for the regulated and unregulated financial firms does not, in and of itself, show that life-preservers do not work, it may just mean not enough firms were wearing them.

    Posted by on Saturday, September 13, 2008 at 06:12 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (41)


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