Thursday, June 25, 2009

Posner on Financial Regulation

. Thursday, June 25, 2009

Judge Richard Posner, who runs the Becker-Posner Blog with Nobelist Gary Becker, has an op-ed on Financial Regulation in today's NY Times.


This excerpt on evaluating and responding to financial crises with new regulations caught my attention:
It is natural for a new president, taking office during an economic crisis, to want to emulate the extraordinary accomplishments of Franklin D. Roosevelt’s first months. Within what seemed the blink of an eye, the banking crisis was resolved, millions were hired into public-works jobs and economic output rose sharply. But that was 76 years ago, and the federal government has since grown fat and constipated. The program set forth in the new Treasury report, heavy on structural change, could take decades to put into effect.

The report is premature because there hasn’t been time to study causes of the current crisis in depth — and until these causes are determined we won’t know how to prevent a recurrence. We need some counterpart to the 9/11 commission’s investigation of a previous unforeseen disaster.
He then goes on to critique the report and proposes a few ideas for future financial regulation and reorganization. A few thoughts/questions came to mind after reading his op-ed, especially the two paragraphs above.

Our financial regulations seem to be mostly reactive to previous crises. Most if not all regulations come in the wake of a crisis as a response to the causes of that crisis. These regulations assume that future crises look eerily similar to past crises and thus implementing regulations aimed at repairing previous problems in the financial system will prevent these crises in the future. The fact that financial crises still happen provides three possible conclusions: 1) either future crises are not the same as past crises and thus regulations that are implemented to solve the problems associated with past crises are useless (they may be useful at preventing the same crisis from occurring again, but not at preventing future crises - which seems to be the main goal), 2) we are not very good at identifying the causes and lessons of past crises and thus have not yet identified the ways to remedy the structural problems that bring about these crises, or 3) we know what the lessons and causes of these crises are, but we just can't figure out how to tackle them and the regulatory reforms that we have put forward in the past, simply have not worked.

If future crises are the same as past crises, then we should be able to put together a typical blueprint for a financial crisis, including reasons why they begin, timing, and most effective responses. I point you to Frederic Mishkin's "The Anatomy of a Financial Crisis" which he published back in 1991 with (I think) this goal in mind. The paper does a good job at analyzing financial crises cross-sectionally and temporally. But, can we break down financial crises into there primary and secondary components like we can the human anatomy, and see how each piece works by itself and how they then interact with the other pieces? I don't think we can. I don't think it's possible to put together a blueprint of a typical crisis and thus create a basic foundation from which to evaluate all future crises.

Posner calls for more time to study and evaluate the causes and lessons of the Great Recession of 2007-2009. I definitely agree that many more studies of the causes of the crisis are needed (one of the reasons is because it gives me an interesting topic to research and write about and hopefully publish!), and we also need studies evaluating the effectiveness of the emergency measures taken by the federal government and the Federal Reserve as the crisis was unfolding. However, I'm a bit skeptical of his proposition that more time to study this crisis will greatly enhance our ability to regulate our way into preventing a future crisis. With absolutely zero data to back this up, I think all crises are fundamentally different, with different actors and different causes. I think we're oversimplifying financial crises if we think that they are all the same and that there is one magical package of regulations that have the power to prevent all future ones.

5 comments:

Sarah Bauerle said...

Placing so much stock in the process tracing of one case of crisis makes our understanding overly determined. But, the common factor from pretty much all financial crises is under-regulation. The problem is that politicians are reactive and only tighten regulation on the specific type of activity that created the previous crisis. Additionally, regulatory slippage is real. Political scientists who study financial crises would do well to study the process through which bargaining over regulation takes place and the process through which regulation decays. These are truly "political" rather than "economic" questions.

Alex Parets said...

Hey Sarah! Thanks for responding. Good points. I'd like to engage you on a couple of them.

Was it really under-regulation that was the main cause of the crisis or inefficient and under-enforced regulation? Many would argue that the regulations were there. They just weren't properly enforced, or the practices were mostly overlooked. So can we blame this on the regulations per se. Will another layer of regulation remedy the problem? Or would we be better off dedicating our efforts to oversight, transparency and enforcement? Just a question to think about.

I have no doubt that regulatory slippage is real. Even more so, the threat of future regulations "slippage" is an even bigger problem. After a crisis, there are countless threats of future regulatory regimes and structural changes that never materialize as the crisis gets farther and farther away in the rear-view mirror. But this doesn't get at my broader point. Even if these regulations were put in place, would they prevent a future crisis? This gets back to the question of whether or not crises are the same events or even similar events. If your answer is no, regulatory slippage may not matter.

I completely agree with your assessment of what political scientists should devote more time to study. However, in both of those research areas that you mention, I don't really see anything we can learn in order to prevent future crises. Both of those study post-crises events.

Sarah Bauerle said...

well, it's a joint problem of under-regulation and under-enforcement of regulations (I mean, Credit Default Swaps are SILL not regulated)

As far as what a political scientist is to do - I don't think our goal should be to prevent future crises. Our job is to study the regulatory bargaining space before and after crises to understand why regulation failed (both as why regulation was never enacted and why regulatory slippage occurred). I know it may sound depressingly post-hoc, but better understanding of the political processes that give us our (dys)functional regulatory regimes is an important political science question. Better understanding of these processes can then have real policy implications if those in charge choose to learn from the findings. As political scientists, that's all we can do. And, it doesn't matter what the economists say about what types of regulations are needed (and what types aren't needed) if such policies are not politically viable.

Kindred Winecoff said...

CDS and CDOs didn't exist until the 1980s, when they were invented to get around stricter regulations on capital adequacy requirements. and regulators did nothing to prevent their usage from growing and growing. in other words, without the last major overhaul of the regulatory structure this particular crisis wouldn't've occurred at all. of course, some other sort of financial crisis probably would have happened, but that's another story.

we have seen dozens of financial crises over the past 100 years in different countries, under different economic systems, and under different regulatory structures. the general trajectory of the past century is toward tighter and tighter regulations (in response to both previous crises and greater capital mobility), and yet financial crises have grown more common not less. the correlation between lax regulation and crises is not well established i don't think (but again... that's one question i'm hoping to answer).

i do agree that we need to look at the bargaining space, but we also need to know what we're bargaining over. if prudential regulations don't actually do what they intend to do -- at least not very well -- then what are they bargaining over?

Sarah Bauerle said...

but some did try to regulate CDS (remember Greenspan's impassioned speech that such regulation would be onerous). The point of looking at the bargaining space is just as much about understanding why some things never get regulated as it is about understanding why some things do. I would argue that if there is a trend toward tighter regulation, it is only because regulation becomes more specific, and therefore is not really regulating all that it needs to over the financial market. Specificity (often due to political pressures to clamp down on whatever type of financial instrument played a large rule in the previous crisis) may prevent the same type of crisis from happening again, but it does not do a good job at allowing regulation to evolve with financial product innovations.

Posner on Financial Regulation
 
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