Tuesday, October 27, 2009

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

6. We need more regulation

Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets, [including] tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily….

House Financial Services Committee Chairman Barney Frank … said any changes would [also] have to discourage “excessive risk taking.”

Treasury Secretary Timothy Geithner said there would have to be “more focused accountability” and a “much stronger set of oversight over all financial institutions that could pose risk of damage to the system. He said core parts of the financial markets, such as markets for derivatives and other complex products, must “have a basic framework of oversight around them.” [T]here would be stiffer capital requirements to deter companies from becoming overleveraged “so that a mess like this never happens again.”

“Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking …, and be held to high capital and liquidity standards,” Mr. Bernanke said.

Damian Paletta, Wall Street Journal, March 11, 2009.

All this is empty or disingenuous bombast for two reasons.

A. Financial regulation as pursued in the United States is, if honestly intended to protect the public, is impossible. Financial intermediation is a full-time, complicated, skillful, and costly task. Part-time amateurs removed from the scenes of action cannot assess expected returns or risk. They have neither the means nor the incentives to do so. Those who expect otherwise deny the principles of economics. Economic analysis rests on incentives and information, which itself depends on incentives as well as experience. Official and often artificial portfolio rules are accommodated while their intentions are thwarted by substitutions or innovations. Capital requirements, deposit insurance, and leverage restrictions induce riskier investments. Interest ceilings broke down because of evasions. Ed Kane (1981) has described the process as the regulatory dialectic of interactions between political and economic pressures in regulated markets. Avoidance leads to more regulation which leads to more …. Normally changing conditions further reduce the effectiveness of regulation. Many of the derivatives and other instruments that government agencies hope to regulate did not exist a few years ago, and will be succeeded by new and imperfectly understood instruments, partly to avoid regulation and partly in the normal course of events. The capitalistic system that has made us rich -- as well as secure compared with earlier times – requires the taking of risks in a free environment. Effective regulation would be self-defeating, but we need not fear because it is impossible.

B. Nor is it honestly attempted.

As a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.

George Stigler, “The theory of economic regulation,” Bell J. of Economics and Management Science, Spring 1971.

The history of regulation is better described as one of protection. The Federal Reserve was created by and for the big banks, primarily to support bank loan markets, guarantee cheap credit (the Greenspan put dates from 1913), and help fix prices and procedures (Wood 2009, pp. 105-110). The FDIC was created to forestall legislation favoring competition after the bank failures of the Great Depression (Golembe 1960). The Securities and Exchange Commission has discouraged small firms by increasing the cost of capital, it has cut the number of exchanges and retarded price and service competition in the financial services industry, nominally in support of “standards” but actually in opposition to competition. Whatever new regulations and regulators are decided by Congress, they will not threaten the profits of the politically powerful.

So what to do? The most essential change (one we can believe in) required of governments is to behave -- to stop supplying incentives for risky and inefficient behavior. The degeneration of loan qualities caused by the push for home ownership by government-sponsored enterprises, the easy money (negative real interest-rate) policies of the Federal Reserve, and the government’s too-big-to-fail commitment were the three main causes of the crisis.

If the urge to regulate is irresistible, it should be directed to results rather than rules. If we wish to reduce a bank’s chance of failure, we could (1) require more capital, less leverage, and/or fewer mobile-home loans; or (2) confiscate the assets of and/or imprison management if failure occurs. Can there be any question which would be more effective? Can there be any question which will be adopted?

It should be noted that the recent discovery of “systemic risk” is manufactured. The reason for the greater regulation of banks, which is as old as the republic, has always been the tendency of banks to fail in groups together with the perception that bank failures are worse for the economy than those of other firms.


Carter Golembe. “The deposit insurance legislation of 1933: an examination of its antecedents and purposes,” Political Science Quarterly, June 1960.

Edward Kane. “Good intentions and unintended evil: the case against selective credit allocation,” J. Money, Credit and Banking, Feb. 1977.

John Wood. A History of Macroeconomic Policy in the U.S. Routledge, 2009.