On The Impossibility of Deregulation

Bernanke and Paulson

My friend Biella made a really good point about the financial crisis and the government bailouts this week:

Consider the position of politicians and free-market theorists who decry government regulation of financial markets. Compare that with our situation today: effectively, we now have government nationalization of much of the financial services industry. As Biella observed, the strongest possible form of regulation is to simply own the regulated entity, or to lend it money under terms so strict that they are the equivalent of owning it.

We have regulation either way; the only question is whether we admit it. If our policy is to bail out anything that’s “too big to fail”, then the form of our regulation is after the fact and improvisatory; that is, our policy is to regulate, but only on an emergency basis. We could choose a different policy: to regulate before the fact and on a non-emergency basis.

What we cannot choose, however, is not to regulate. That is clearly impossible.

David Brooks wrote an Op-Ed column (“The Post-Lehman World”) in the New York Times today, in which he argues, half-persuasively, that current calls for greater regulation in the future are unrealistic and possibly the result of the same herd mentality that got us here in the first place. He makes a number of good points, but I think he missed some as well. I wrote a letter to the editor in response; probably they get a ton of those and the chances of its being published are very low. For what it’s worth, here it is:

To the Editor,

David Brooks' "The Post-Lehman World" (Op-Ed, September 19th) is
excellent, but he overlooks a subtle point when he writes: "As McArdle
notes, cracking down on subprime loans just when they were getting
frothy would have meant issuing an edict that effectively said: `Don't
lend money to poor people.'  Good luck with that."

This is a misunderstanding of what was happening.  Poor people do not
benefit by being made loans they cannot repay.  And, ordinarily,
lenders do not benefit by making loans they cannot collect.  However,
a lender who makes many such loans and then sells them off, packaged
as something less risky than they actually are, does benefit -- and it
is precisely this deceptive practice that cried out for regulation.

It was easy to detect; we cannot plead ignorance.  When large numbers
of unqualified borrowers are being given inappropriate loans, it's not
hard to figure out that it's happening.  Everyone who worked in the
mortgage industry knew -- even if those on the bottom rung were not
aware that the ultimate driving force was the desire to sell
mislabeled debt packages.

Regulating that mislabeling would have left everyone better off: poor
people, lenders, and now all U.S. taxpayers.  Despite Brooks'
pessimism, stopping the cycle would have been politically possible, by
an administration that cared to stop it and knew how to explain to the
public that overly-easy credit helps no one.  Certainly, much of the
public understands it now.

-Karl Fogel


  1. I agree that it’s absurd to think that we’re not already heavily regulating things — post-facto regulation is still regulation.

    But the argument I’ve heard from thoughtful conservatives is that the status quo is messed up not because we’re regulating things, it’s because we’re *halfway* regulating things. In other words, we’ve failed to achieve the “free market ideal” because everyone *knows* that the government will bail them out. In a true free market system, failure is actual failure. In our half-regulated system, we have this insane situation where Wall Street execs can take crazy risks and KEEP all private profit (if successful), but run crying to the government if they fail. It’s not possible to evaluate risk sanely if there are no consequences, is it? In any case, the argument is that if the government absolutely swore *not* to bail out whole sectors no matter what, then the industry would be evaluating risks as they really ought to — and probably wouldn’t have been so dumb as to partake in massive trading of unreliable loans. It’s the existence of the safety net — the improvised regulation — which caused the reckless behavior in the first place.

    Anyway, it’s a nice argument for the free market purist, but I’m not one of them. 🙂 I’ve always believed that capitalism needs to be deliberately regulated with forethought, just ilke you.

  2. Of course we know the government could never swear such a thing and mean it. Nobody would believe them, no matter how loudly they proclaimed it :-).

    But also, I’m not sure the existence of the assumed safety net is what caused those risks to be taken. Rather, consider the difference between an individual executive’s career span and the lifetime of the institution(s) for which that executive works. If you make a billion dollars for your company by selling something now while deferring the costs to a decade in the future, you could look like a financial genius right up to and including your retirement day. Then, while you’re sunning yourself on your yacht off Patagonia, the bill comes due and the firm has to deal with it. What do you care? Your private finances are not on the hook for the consequences of bad decisions, except to the extent that you’re still invested in that company. But you would have been smart enough to diversify, probably.

    The difference between what’s good for individual executives versus what would be good for their companies’ long-term health has been explored in detail in a few really good articles I’ve read in the past year… I only wish I could remember one of their titles :-).

    I don’t deny that the presence or absence of a government-backed safety net has some effect here, but I’m not sure it’s the major factor.

  3. @Karl Fogel: I think you have hit on an important point regarding incentives and constraints—but I believe you are assuming no-one in the institution understands economics, so that effectively an executive’s political goals are realized (implemented) without anyone going through the logical process of analysing the consequences of the incentives and constraints created by that implementation. I think that is unrealistic, it requires that a large number of executives and managerial-level employees—who do understand economics—deliberately decide to push the consequences onto someone else, given this option: in this case, the taxpayer. Thus, they were actually given the incentives to do this by the regulation framework.

    @Ben Collins-Sussman: I agree with you about the risk-management, meaning I probably agree with the conservative viewpoint. I am not so sure about the requirement for regualation. In essence, what a market system which is free requires is a legal system that creates stability in lieu of individual trust relationship (which are still important and much much stronger than the legal system, but cannot practically be as wide in coverage). Regulation, or ownership, is when the government decides that the costs of something are worth bearing regardless of the cost, because the subject is seen as vital or critical. Whether that viewpoint is justified is then empirically measurable by the results on that country’s economy.

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