Self-Regulation Doesn't Work

The last entry in the Blog War over regulation of the financial sector:

Why Self-Regulation of the Financial System Won’t Work, by Mark Thoma: I want to finish up by broadening the discussion beyond the regulation of hedge funds to the more general topic of how attitudes toward regulation have changed in recent years, how that helped to set the stage for the crisis we are in, and what we need to do to prevent it from happening again. In the process, I also want to take on Houman's point that regulators fell down on the job and let this crisis happen, so we cannot trust them in the future.

As I described in my first post, after decades and decades of instability in the 1800s and early 1900s, followed by the massive bank failures of the early 1930s, regulations were imposed to stabilize the banking system. The result was sixty years of calm in the financial sector. That's hardly a failure of regulation. It wasn't until the shadow banking system began growing outside of the regulatory umbrella that problems began to reemerge. A central theme of the posts this week has been that bringing about another decades long period of relative stability will require the regulatory umbrella to be extended to cover all firms within both the traditional and non-traditional (or shadow) banking system, hedge funds included.

I believe we made two regulatory mistakes that contributed to the present financial crisis. First, there was a push for deregulation beginning in the 1970s based upon the belief that markets are self-regulating - even to the extent of self-repairing market failures - and that caused us to go too far toward deregulation. Even the regulation that was left in place was, in many cases, not enforced vigorously, and there was little chance of new, substantial regulatory changes being put in place to match the changes in the financial marketplace brought about by rapid financial innovation. In some cases, deregulation was needed, but in many other cases the deregulation went much too far.

Second, we didn’t focus enough on macroeconomic stability. I think we came to believe that a large crash of the economy was extremely unlikely, particularly one driven by problems in the financial sector. Several factors were responsible for this. The transformative financial innovation of recent decades - particularly the slicing and dicing (securitization) of mortgages and other assets into many complex financial products - was supposed to distribute risk broadly and prevent collapse. We had the "Great Moderation" after the mid 1980s when the variability of output fell significantly and inflation stabilized at low levels, and this was widely attributed to the skill of policymakers and the deregulation of the economy. Because policy had improved, and because we believed the economy was more stable due to deregulation, we let our guard down. We continued to recognize that garden variety fluctuations in output were still possible, though we thought the Fed could mostly handle those, but big crashes were a thing of the past. Or so we thought.

Hopefully, we have been adequately reminded that large recessions can still happen, and that will motivate us to take the regulatory steps needed to bring more stability to the financial system. Some people argue that any new regulation needs to wait until the financial sector has re-stabilized to avoid creating another source of uncertainty, a view that has merit. But the will and hence our ability to impose new regulation tends to diminish when the economy recovers, and if we wait too long to get started, the opposition to any new regulation may carry the day and we'll fail to get the measures we need put into place. The time to start is now.

But what of the charge that regulators blew it and caused this crisis, and therefore we are foolish to rely upon them for stability in the future? First, as I've said, I don't think decades of stability is a failure by any definition, and the recent failure was driven by an ideological belief that markets are self-regulating and hence best left alone. Most markets can be left alone, but as Alan Greenspan has recently acknowledged, financial markets are not among them. Second, I believe the recent failure did not happen because regulators were incapable of doing better than they did, it was their belief in the self-healing power of markets - their belief that what just happened was next to impossible - that stopped them from intervening as needed. With different beliefs and a different framework for approaching the problem, the outcome is much different.

So I am not ready to throw up my hands and say this is too hard, either the private sector finds a way to take care of itself, or it doesn't get done at all. We have the capacity to learn from our mistakes, to drop ideologies and theoretical constructs that led us astray, and I have faith we will do just that (Alan Greenspan's conversion is a prime example). With comprehensive regulation to prevent the excesses that caused the problems we are having, with the flexibility for regulations to evolve as new innovations come to the financial marketplace, and with regulators who have learned the lessons of the past, we can look forward to another decades long period of stability. But if we fail to take the steps that are needed and rely too much on private markets to regulate themselves, we are setting ourselves up for this to happen again.

Houman's response is here (it's partly in response to the previous post).