Regulatory Failure

January 19, 2009

ThinkMarkets is very pleased to present the following post by the first of our guest bloggers, Jerry O’Driscoll.  Jerry is a senior fellow at the Cato Institute. He has written on a wide variety of subjects in monetary economics and on Hayek’s economics. He and I are also coauthors of The Economics of Time and Ignorance (Routledge, 1996).  

 

by Jerry O’Driscoll

 

Ludwig Lachmann frequently remarked that people learn from experience, but asked “what do they learn?”  The recent financial crisis illustrates his point.  For many, it has been labeled a failure of free-market capitalism. In reality, it was a systemic failure of regulation.  Indeed, I would argue the very idea of government regulation of industry has been tested and failed.

 

With the exception of health care, financial services is the most highly regulated industry in America (and, generally speaking, in all developed countries).  No segment of the industry escaped regulation.  For commercial banks, there were multiple layers of regulation: the Fed; the Office of the Comptroller of the Currency (part of Treasury); the FDIC; and the SEC.  For state chartered banks, a state banking regulator substituted for the OCC.

 

Around the world, financial services regulation varied enough to test whether institutional differences matter.  For example, in some countries, such as the U.S., the central bank has important regulatory authority.  In others, such as the U.K., Australia, and New Zealand (an innovator in both regulation and monetary policy), the central bank had no regulatory authority.  Around the world, banking regulators failed to detect much less prevent the widespread abuses, declining underwriting standards, and possible fraud perpetrated in and by banking institutions.  Banking regulation failed in its most basic duty to preserve the safety and soundness of the banking system.

 

We have witnessed a great failure, but it was a failure of regulation. No statutory deregulation has occurred in financial services since 1999. And Gramm-Bliley-Leach, contrary to myth, did not repeal the Glass-Steagall Act of 1933.  Nor did it effectively lighten regulation, but re-arranged the regulatory chairs and formalized the melding of financial services that had already occurred. It did lighten somewhat the burden of the Community Reinvestment Act.

 

In my paper (“Money and the Present Crisis”) for last November’s Cato monetary conference, I suggest that the behavior of financial services regulators exemplifies the problem of “regulatory capture.”  As Stigler predicted, regulators (individually and institutionally) will eventually come to identify their interests with those they regulate.  They will consequently advance those interests against the general interests of the public. In his paper for the annual Jackson Hole conference sponsored by the Kansas City, Buiter argued that point at length and to the reported discomfort of Fed officials.

 

So I pose two questions.  First, I repeat Lachmann’s: how can we confidently predict that experience will inform?  Second, suppose a cost-benefit case could be made for government regulation. How could government regulation work in a world populated by self-interested agents acting in conformity to standard Public Choice theory?

 

15 Responses to “Regulatory Failure”

  1. Mario Rizzo Says:

    Jerry,

    What about the argument that financial innovation raced ahead of the existing regulations and so the failure was one of regulations not increasing in the appropriate fashion? So there were all of these bundled, sliced, and diced mortagages in new kinds of securities for which there was insufficient regulation.

  2. Joe Calhoun Says:

    Mario,

    Financial innovation, if that is what you want to call it, will always run ahead of the regulators. The innovation is usually designed to get around some regulation which has hampered the ability of the firm to do what it wants. An example would be the use of SIVs to get around capital requirements.


  3. Mario,

    I think Joe Calhoun is on the mark. It’s another aspect of the problem. The banks successfully gamed the capital standards.

  4. koppl Says:

    Great post, Jerry. Thanks for that.

    I think Ed Kane’s regulatory dialectics should come in for a mention. He pointed out that regulators are always a step behind as far back as 1977.

    There might be a way to make regulation work, namely, competing regulatory authorities. Roberta Romano has probably pushed the idea further than anyone, but Hans Stoll has picked up on it, citing Romano. Let each issuer choose its regulator. Regulators live off fees. The market will price the risk differentials across regulators.

  5. saifedean Says:

    On the first question, I’d say it’s quite clear that economics in America is now an Iatrogenic science: the posionous cause of the disease continues to be mistaken for the cure. The only prescription it offers is more poison.

    By positing the all-mighty and mysterious “market failure” as an explanation for anything bad that happens anywhere, economists and policy-makers are now completely sold on the idea that nothing they can do can possibly have adverse effects. Whatever bad things will happen will never be identified as results of bad policies and regulations, but will instead be viewed as a result of the lack of policies and regulation and will necessitate more intervention.

    It is remarkable that 10 months after the Fed started handing out trillions to banks, and after all the terrible things that have happened, no one (in the mainstream) has paused for a second to ask whether all these interventions have made things worse or better.

    The situation is identical to medieval medicine. Some mysterious mythical ailment is diagnosed and doctors will try all sorts of harmful procedures and medicines to cure it. These will make the patient worse off, which to the doctor will appear as a clear argument for doing more of the same.

    It took double-blind randomized trials with control-groups for medicine to start realizing that most of what it prescribed was harmful. I am not optimistic at all about the prospects of America’s Iatrogenic economists ever realizing that the solution is the problem.


  6. [...] contributor Gerald O’Driscoll’s ThinkMarkets blog post on the failure of regulation in the current economic turmoil is worth reading. Here’s a taste: With the exception of [...]

  7. lxm Says:

    Let me see if I understand this:

    Since regulators were unable to prevent the world wide market failure, then the cause of the market failure was the failure of the regulators?

    Or is it: We’ve had a world wide market failure that the regulators didn’t prevent, therefore, there should be no more regulators.

    I guess it is this: We’ve had a world wide market failure and no matter what we do we will have another one someday. Live with it.

  8. koppl Says:

    Oh come on, lxm. If your “Bayesian prior” puts zero weight on the idea that regulation is weak, then indeed no accumulation of regulatory failures will induce you to question the basic premise. Your post gives me very much that impression. But if your priors put positive weight on “free markets” as the least-worst option, then each failure of regulation causes you update by, in part, increasing the weight on that “free market” option. That’s not wacky, but rational.

    Please note that I put “free market” in quotes. IMHO it’s a kind of ambiguous term because any market has rules and it’s not always clear which rules should be considered “interventions” or “regulations.” In other words, I think I recognize some of the subtleties here, but I don’t thing they change the basic logic of the case.

  9. Doug55 Says:

    1-Experience is a good tool, just that. We cannot confidently predict that experience will inform.
    2-Regulations are effective when they are the rules of the game, as in the stock exchange.
    When players assume new risks, we should not look at the regulators for blame. The players are the responsible party and should be the only ones to assume the consequences. Central planners tend to put all in the pot and come out with a bright solution (Government intervention). Lets learn form experience….


  10. In reply to Koppl’s first response, Ed Kane has clearly done the most work on regulatory failure in financial services. My argument only updated his for the current epsiode and I’m pleased to acknowledge that. I made a modest contribution to the idea of market-based regulation in the Cato Journal in one of the 2006 issues.

    On the Lachmann question, I could add the whole debate over fiscal stimulus as another example. Almost everyone in the debate assumes that the New Deal was successful and proves that fiscal stimulus works. Robert Barro debunked that idea in yesterday’s Wall Street. Echoes of Robert Higgs. Amith Shlaes is a more popular account.


  11. [...] Gerald O’Driscoll notes that the entire bailout was predicated on regulatory failure.  In that case, what’s the best thing to do?  That’s right:  more regulations!  Because nobody’s ever heard of “regulatory capture” or “self-interested regulators” or “incomplete information” before. [...]

  12. History & Empirics Over Theory Says:

    “With the exception of health care, financial services is the most highly regulated industry in America…”

    Oh my, has the author really never heard of the shadow banking system?

    Credit Default Swaps are not regulated. Insurance is regulated. AIG was taken down by CDS… their insurance business (not counting CDS as insurance as they are principally a tool of speculation) was very robust and profitable.

    Warren Buffett, George Soros and the greatest capitalists of our time are calling for cds to be traded on an exchange with rules for posting collateral.

    Alan Rand Greenspan admitted to a flaw in his ideology and the ceo of Deutsche Bank remarked he no longer believes in the markets ability to regulate itself. Its tough to shift paradigms, or at least challenge yours honestly, but if these men can, surely you can too!


  13. The un-named author is making my point. Despite all the regulation, regulated firms innovated unregulated products like CDOs. And the shadow banking sector arose. Put in any new regulation you like, and the market will innovate around it with new, unregulated products and new, less regulated institutions. Challenge yourelf.

  14. Carol Cross Says:

    No place are your findings more apparent than in the regulation of Franchising where the captured FTC has promulgated a Rule to govern franchising that promotes outright FRAUD.

    Who knows how many thousands of American middle class individuals have lost their entire investments in franchises that are touted as the American dream —a business of your own? They die slow deaths and are silent in failure. Now, the VETS and their family members are targets of the franchisors because of the SBA initiative of The Patriot Express Loan with its 90% guarantee.

    The status quo of regulation and public policy permits the franchisors to sell “unprofitable” and high “failure rate” franchises to the public because, under the law of contract, the assets of the failures often continue to serve the franchisor. The “churning” of failed units becomes a management practice for franchisors who didn’t bear the cost of building the physical unit to begin with, and don’t then bear the cost of failed units taken over for nothing, who continue to wear the brand name and pay royalties and fees to the franchisor.

    No doubt that regulation that permits churning is why franchising has become so durable in our economy. But, maybe there is a price for churning unsustainable small businesses in Recessions that become Depressions.

    The SBA subsidizes Big Business Franchisors and Small Business Franchisors alike, and the banks and lenders sell the guaranteed portions of the loans that have high failure rates in the secondary markets.

    Regulation of franchising has enabled rampant fraud under cover of government regulation. Our courts become tainted because of the necessity to protect the commercial paper of the franchisors.


  15. I normally don’t take the time out to thank people when i read their information but this was really informative.
    I look forward to reading more on your blog.
    Thank You.


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