Arnold Kling  

Thoughts on Financial Regulation

Thoughts on Housing Policy... No Price Gouging Here!...

1. I think that financial markets are inherently imperfectly transparent. The reason that we have financial intermediaries is to save the final investor the work of evaluating the risk of the ultimate borrower.

Markets promote a phenomenal division of labor. If we had to grow our own food, build our own communication tools from scratch, design and build our transportation vehicles...forget it. We need division of labor.

Similarly, if you had to evaluate the risk of each of your investments that your savings help to fund--the risk of developing a commercial shopping center, the risk of launching a new product, the risk of expanding a growing restaurant franchise...forget it. We need division of labor. We have to trust banks, mutual funds, pensions funds, insurance companies, and so on to evaluate the risks that they take. They in turn have to trust rating agencies, investment bankers, auditing firms, and many others involved in the process.

2. I believe in what I call the Austro-Keynesian model of financial cycles. Like the Austrians, I believe that interest rates are determined by subjective preferences. However, the Austrians focus on pure time preference. If people have little patience for future consumption, then interest rates are high and producers are incented to economize on capital. If people are willing to defer gratification, then interest rates are low and producers are incented to choose roundabout production methods, meaning methods that are more capital intensive.

Instead of looking at time preference, I focus on risk preference. For Keynes, savers are inherently risk averse. On the other hand, entrepreneurs are inherently willing to take risks, because of what Keynes called their "animal spirits."

Financial intermediaries find ways to overcome the natural mis-match between risk-averse savers and risk-taking entrepreneurs. The intermediaries analyze risks in an effort to manage them. They diversify risks in an effort to insulate individual investors as much as possible. As a result, the intermediaries bring down the risk premium that otherwise would be faced by borrowers.

3. With the division of labor in financial markets, risk premiums are related to one another. If A lends money to B to lend money to C to lend money to D, what happens when A starts to worry that B, C, or D might be riskier than previously thought? Well, A starts to demand a higher interest rate from B, which means that B demands a higher interest rate from C, which means that C demands a higher interest rate from D, and D may already be on the skids, so everything just comes crashing down.

4. Government has taken on the role of intermediary of last (or less than last) resort. The interest rate on U.S. government bonds still represents the "risk-free" rate of interest (although my latest worry is how long that status will persist). Government has that as a carrot and regulation as a stick to use to try to influence financial intermediaries. Proper use of the stick can help avert the need to over-use the carrot.

The regulators cannot prevent every problem. They ought to try to replicate what works, avoid what doesn't work, and do their best to try to anticipate what might go wrong. In my view, the 30-year fixed-rate mortgage with a 20 percent down payment usually works. It does not work if you let inflation get out of control, the way we did in the 1970's. But otherwise, it's a pretty easy loan for a borrower to understand and we have had a lot of good experience with it. We ought to encourage having that loan make a comeback.

Having financial institutions that are small enough to merge with other financial institutions also works. We know how to do mergers. What we cannot handle are problems at gigantic institutions, like Fannie Mae, Freddie Mac, and the biggest Wall Street firms. If I were the financial regulatory czar, I would try to break up the biggest firms before they fail.

It works to have regulation of financial firms that is tied to risk. When deposit insurance premiums and bank capital requirements became risk-based, the performance of banks improved.

Still, there are going to be potential systemic problems. A regulator is always going to have to ask, "What if?" What if house prices start falling? What if foreign investors change their currency preferences? And so on. Regulators who want to take away the punch bowl when the party is getting good will need independence from Congress. You can't have lobbyists outmaneuvering regulators.

Anyway, those are my thoughts.

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COMMENTS (5 to date)
Todd writes:

It seems to me that the conclusion in 3 assumes that the trusted financial intermediaries have done an exceptionally poor job of the underwriting and diversification that were expected of them in 2. Shouldn't the multitude of different parties at work in the economy help prevent any one of them taking down the whole system? The one case in which 3 seems more likely is if we are all ultimately borrowing from a single source.

It seems like the government would have to do a lot less with carrots and sticks if it got out of the business of printing money, and instead stuck to the business of enforcing contracts between private parties. Do you think, on balance, that society is better off under a government, fiat monetary system, or free-banking where the market determines the monetary base?

Larry writes:

It seems to me that the 20% down part is more important than the 30 year or the fixed part, both of which address the inflation uncertainty. Am I to focused on the current crisis?

tom writes:

1. I'd guess you have no objection to 10% or larger junior loans, as long as those are a separate product that don't go with the senior product? Or do you object to that too on the ground that it encourages the same borrower indifference to the true cost of the property that Fannie did?

2. I was surprised a year or so ago to find out that in most states banks cannot go after homeowner's assets; they must limit themselves to foreclosing on the house mortgage. I tend to think that should change (subject to bankruptcy laws...) so that at least you do not find solvent borrowers just walking away from homes when they have no equity in them. But that may be tinkering at the margins, even though it seems like a big deal to me.

parviziyi writes:

In international comparisons in the developed countries there's a clear and strong relationship between the availability of variable rate mortgages and the percentage of households who own their home. Italy and Spain have the highest rate of home ownership in Europe. In these two countries, variable-rate mortgages are the only type available; long term fixed rate mortgages are not available. In Spain the "tracker-rate" mortgage is the only type -- "tracker-rate" means the rate moves in strict tandem with the European Central Bank rate. In the United Kingdom, home ownership is substantially higher than in the US, and the great bulk of UK mortgages are variable rate (usually not quite the strict tracker kind, but close). Germany has one of the lowest rates of home ownership in Europe. In Germany the great bulk of mortgages are 20 or 25 year fixed rate. The same pattern is clear from the data over all countries: If you wish to increase home ownership you should facilitate variable rate mortgages. They reduce the bank's long-term interest-rate risk and make the bank more willing to lend at a lower rate.

Variable-rate mortgages have the further advantage that during economic good times, when interest rates will generally be higher, they have a dampening effect on house price inflation; while during bad times, when interest rates will generally be lower, they stimulate the housing market. The fixed-rate mortgage system has the opposite effect to a lesser degree, and that is not good.

If the aim is to increase homeownership, in international comparisons no clear benefit is seen from legislating tax deductibility for mortgage interest. E.g., Netherlands has 100% tax deductibility and UK has zero tax deductibility, yet homeownership in UK is substantially higher than in Netherlands. Families in Netherlands are more favorably disposed toward living in high-rise apartment buildings than families in the UK, which may perhaps be a partly persuasive explanation for the differing homeownership rates. In any case I think the story is compelling that variable rate mortgages improve the affordability of home ownership, which in turn increases actual homeownership.

How about requiring to meet threshhold economic competency/literacy/psychological stability to be eligible to receive a mortgage? This is similar to the 18 year old rule for signing contracts, but a bit more rational, imo.

yes, inspired by voting competency.

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