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?