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Wednesday, July 08, 2009


regulation and unintended consequences

john carney points up a very painful admission for many who see the firm hand of regulation as a solution to what has transpired in the markets in recent years.

The new enthusiasm for government regulation of the financial sector often rests on a double standard that sees markets as fever swamps of irrationalism and government as the well of refreshingly rational guidance. Unfortunately, there's no justification for this view of things.

In fact, regulatory pressure helped get us into the mess we're in. Sometimes this was an unintended consequence of regulations. Think risk capital requirements encouraging banks to manage risk through credit default swaps or off-balance sheet vehicles. Sometimes it was an intended consequence--such as the government pressuring bankers to make loans on "flexible" underwriting standards.

hard truths: regulators are neither rational nor particularly adept at avoiding unintended consequences. indeed, if they were, we would not have experienced this terrible bubble and bust. we've seen this cyclicality of mania run its course many times, and each time the aftermath has been characterized by a well-meaning and sometimes quite effective regulatory impulse. that hasn't yet ever prevented the next bubble.

it is profoundly misguided to place blame, as carney sometimes implies, for the mortgage bust on the head of the community reinvestment act. but there's little doubt that the broader regulatory effort to promote homeownership in the united states played a major role, especially through fannie mae and freddie mac, in creating the mortgage bubble -- particularly through its heavy efforts in 2002-3. there's little doubt that regulatory changes (most notoriously, the alternative net minimum capital rule for broker-dealers) subsequently gave rise to the wall street private-label mortgage securitization titan. there's further little doubt that the regulatory zeal of the FDIC for pinching capital reserves, in a well-meaning effort to keep banks from managing earnings through the cycle, has left the banking sector terribly vulnerable to the downturn we're now seeing.

there's no easy answer here. particularly with western political and social institutions in the condition they have devolved into, the process of reconciling regulation with both eternal law and the long experience of institutional memory is nearly impossible. rather, our society is given over to throwing a bowl of populist spaghetti at the wall and seeing what sticks, often without much notion or care of the complete consequence set provided the bread shows up and the circus opens on time. such are the exquisite hazards of demotic government.

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"western political and social institutions in the condition they have devolved into"

When you write this is reads as if you are harkening back to some better more enlightened time. When was that?

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for the life and health of western institution and society -- i would suggest several hundred years ago, though the full-blown collapse of decadence and rapid decline of the successor institutions under which we now live dates more obviously to the first world war.

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So I would have to disagree here, as the Age of Regulation in America, from the mid-30's to the late-70s, never-I repeat never-experienced such speculative bubbles as we have had in modern times.

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i would say, anon, that the lack of bubbles in the era of bretton-woods had less to do with the effectiveness of regulation than a de facto gold standard which visited terrible economic pain on any currency bloc which dared to run a significant current account imbalance over time. by severely circumscribing (until 1971) the imbalances that could exist and persist in global flows, bretton-woods -- and before it, the gold standard -- prevented bubble finance from arising, instead extracting much more sudden and harsher slowdowns from violating economies.

even the great depression -- which many link to the gold standard or even blame upon it -- was in its genesis i think very much about the massive international flows that the abandonment of the gold standard from 1914-24 enabled in order to finance the first world war. these imbalances -- improperly handled by britain and the united states -- led to the debt bubble of the late 1920s which ultimately crashed throughout the 1930s.

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