Monday, August 17, 2009

Why We Can't Prevent Financial Crises with Regulation

. Monday, August 17, 2009

The U.S. Federal Reserve, for instance, could hardly stand idly by while the Bank of America or Citibank became unable to meet its liabilities. Yet this responsibility creates a problem of moral hazard, since the largest banks, in effect, have automatic insurance against disastrous consequences of risky but (in the short-run at least) profitable loans. They have incentives to follow risk-seeking rather than risk-averse behavior.

That is Robert Keohane in After Hegemony. It was published in 1984, before financial "weapons of mass destruction" were yet to be dreamed of, much less utilized (and Keohane was far from the first to think about these issues). The current crisis wasn't created by credit default swaps or mortgage-backed securities; it's an artifact of the structure of the system*. Since we do not know of any way to transform the structure of the system in a positive way, we are left with marginal regulatory tweaks. If well-constructed, these marginal tweaks can bestow marginal improvements. But we should not convince ourselves that we can transform a structural problem with marginal tweaks. We can't.

Yes, this means that we'll always have financial crises (although they won't always be as bad as this one). We could throw every Wall Street banker and AIG insurance underwriter in prison, abolish all derivatives, require huge down-payments for mortgages, and we'd still have periodic crises. Just as we face a tradeoff between security and liberty, we face a tradeoff between financial stability and dynamism. We'll have to accept some of the one in order to get any of the other.


Why We Can't Prevent Financial Crises with Regulation
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