Reform how we regulate the financial system? And then what?
COMMENTARY | June 03, 2009
Along the lines of be-careful-in-what-you-wish-for, Henry Banta says “the creativity, imagination, cunning, and occasional duplicity of financial asset traders are boundless,” that regulators themselves may get caught up in bubbles, that there is plenty of regulating already in place, and that, given the huge stakes involved, “regulation outlawing financial incredulity or mass euphoria is not a practical possibility.”
By Henry M. Banta
Before we get too deep into a debate on how to reform the regulation of our financial system we ought to ask what can we realistically expect regulation to accomplish. We frequently hear that the goal should be to prevent the kind of massive melt down we just experienced. But there is good reason to question whether that goal is obtainable at all.
The press reports, as in a recent New York Times story, that the Administration is considering the consolidation of bank regulation into a single agency and that the White House and the Treasury Department have proposed new regulations for certain kinds of derivative trading. These proposals could improve the current system. But can they really achieve their stated goal of preventing future financial crises? Are we looking at an effort to patch a regulatory system that is fundamentally flawed? Are we asking the ordinary mortals who run government agencies to do what simply cannot be done?
It is fashionable to blame the regulatory failure on a blind faith in the “efficient market theory” – the notion that the market will always correctly value capital assets in a timely and efficient manner. Indeed a number of prominent promoters of this theory have mumbled their mea-culpas and headed off in sack cloth and ashes.
But if the efficient market theory is dead, what are we left with? The economy’s current nose dive has refocused attention on the economics of J.M. Keynes. Economists are paying closer attention, not just to Keynes’s views about the government’s role in stimulating the economy in a depression, but his views on the role of capital markets as a cause of economic instability. Keynes believed that capital markets were inherently unstable – their own internal dynamics led them into self-reinforcing cycles of boom and bust without any help from outside forces. This thesis was elaborately developed by the American economist, Hyman Minsky. (For those unwilling to slog through Minsky’s dense prose, George Cooper has given us a readable and witty guide to the Keynes/Minsky thesis in his book “The Origin of Financial Crises.”)
For those tone deaf to economic theory, there is a lot of history that seems to support the Keynes/Minsky theory. A good place to start is with Edward Chancellor’s “Devil Take the Hindmost, a History of Financial Speculation.” Chancellor begins with imperial Rome and runs through the dot-com bubble of the 1980s, with great deal of attention given to such infamous affairs as Holland’s Tulip Mania in the 17th century and England’s South Sea stock scheme in the 18th century. One is left with the impression that there has hardly been a time when financial markets were not subject to some kind of irrationality.
A brief and very funny account of the same history is provided by John Kenneth Galbraith’s “A Short History of Financial Euphoria.” Galbraith begins his account with the observation that “the free-enterprise economy is given to recurrent episodes of speculation “ which, he says, “must conservatively be described as mass insanity.” (P. 2.)
Suppose Keynes and Minsky got their theory right; suppose Chancellor and Galbraith got their history right. What does this say about the possibility of successful regulatory reform? Several thoughts come to mind. First, the rewards of financial speculation for a few can be spectacular. The temptation to foster irrational speculation may be more than people of ordinary virtue can withstand. Second, the creativity, imagination, cunning, and occasional duplicity of financial asset traders are boundless. Third, long history demonstrates that government regulators are not immune from getting caught up in the euphoria of speculative bubbles. Fourth, despite deregulation, a great deal of the authority necessary to prevent the current crisis was in place; it simply was not used. The financial bubble was not caused because the agencies did not have the authority to raise interest rates or margin requirements. It was not because the CFTC did not have the authority to impose restraints on credit default swaps. Rather, it was because those like the Secretary of the Treasury, the Chairman of the Federal Reserve, and the Chairman of the SEC did not believe such authority should be used.
Minsky, citing Keynes, actually argues that an effective policy of market stabilization can in the long run be self defeating: “...[I]n his [Keynes’] system, stability, even if it is the result of policy, is destabilizing”. (“John Maynard Keynes” p. 11.) In effect an apparently successful stabilization policy can create an illusion of safety and security that makes the runaway boom even worse.
Galbraith expresses similar pessimism about a regulatory solution. As he wrote in “A Short History of Financial Euphoria: “ “…beyond a better perception of the speculative tendency and process itself, there probably is not a great deal that can be done. Regulation outlawing financial incredulity or mass euphoria is not a practical possibility. If applied generally to such human condition, the result would be an impressive, perhaps oppressive and certainly ineffective body of law.”
This not to say we should not attempt to reform our regulations and regulatory agencies. But the idea that merely reorganizing the enforcement agencies and outlawing the more outrageous practices of the past will prevent future financial crises is close to the kind delusional thinking that got us into trouble in the first place.