Arnold Kling  

Metaphors for Financial Reform

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It occurs to me that one way to think of people's views on financial regulatory reform is to treat people as using one or more of the following three metaphors:

1. Machismo

Those who are driven by this metaphor think of regulation/de-regulation as a male dominance game between the government and the private sector. Those who think in terms of this metaphor feel comfortable when government is on top. In their view, a breakdown like the current financial crisis comes from government wimping out, caving in to free-market ideology. It's time to show the markets who's boss.

In the male-dominance view, the specifics of regulation are not so important. What we need is for regulators to be tough. Think of Eliot Spitzer in his glory days ("I'm a bleeping steamroller."), bringing the corporate titans to heel.

My view is that when politicians succeed in becoming the top dogs in this manner, you get a situation like Communist China or Montgomery County, Maryland. There, it is quite possible to make a fortune on a business, but it is essential to have the right political connections and to align your business with the agenda of the Party that is in charge.

I fear that's where we're headed in the U.S. Think of Freddie Mac and Fannie Mae, able to make a profit in the mortgage business, but only with the right political connections and only if they devoted the required share of lending to so-called affordable housing. Or think of the auto makers, whose political connections will generate government support, and who will probably be held hostage by the environmental movement.

2. Architecture

This metaphor is the belief is that wise technocrats need to make sure that the wild, rambunctious private sector has a safe place to play. By designing the right sorts of circuit breakers and thermostats, the technocrats can ensure that nothing catches fire or causes injury.

The architects are keen on transparency, international co-operation, and unified command. Achieving an optimal social outcome is a matter of getting the top-down design right.

My problem with this metaphor is that I do not believe that the technocrats are any wiser than the markets that they are trying to regulate. In particular, they tend to see only the intended consequences of regulations, not unintended consequences. Moreover, the architecture metaphor misses the reality that in a dynamic world, trial-and-error makes more progress than static design.

3. Housecleaning

This is the metaphor that seems to be driving my thinking. I see a lot of institutions and practices that I want to toss into the garbage:

--mortgage loans with low down payments
--amateur housing speculators owning multiple homes
--people occupying homes they cannot afford
--mortgage securitization, based on "originate to sell" rather than old-fashioned originate to keep
--credit default swaps

My point is not that regulators should ban these practices. But we should cull out policies, including capital regulations, that either deliberately or inadvertently promoted them. Insteaad of trying to prop up Freddie, Fannie, and the insolvent banks, I would try to foster a transition toward safer lending practices undertaken by healthy institutions. I think that if we would just do the housecleaning, the economy would right itself. We wouldn't need all these bailouts and stimulus packages and other nonsense.


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COMMENTS (9 to date)
Matt C writes:

It's an interesting framing, though not an encouraging one.

If you have political ambitions, you might attract support as a tough guy who will fight for the people, or as a profound thinker who will plan for the people, but as a dutiful maid who will clean up for the people? Forget it.

george writes:

Is there any country you would use as an example for the Housecleaning type?

cato writes:

thankyou for being skeptical of the technocrat approach...

i am increasingly worried about the people that think we can let the technocrats get it right.

the one positive of democracy might be that it holds back the over-confident technocrats (eg anecdotally more laypeople are skeptical of climate change fixes than technocrats) although i'm sure bryan would argue to the contrary about the technocrats!

Ajay writes:

Sigh, Arnold, if only those in power actually read and followed your advice. Unfortunately, there has instead long been a bailout culture in this country, as evidenced by this 1998 quote from John Gutfreund, former Salomon Brothers CEO, "because of the size of the new Citicorp they'll be bailed out again when the cycle goes the other way, too big to fail will be the thesis as it was last time." I've transcribed that quote from this interesting and short 10-15 min. video interview from the Charlie Rose show: http://www.youtube.com/watch?v=C9moTo_F0m8

RubberCity Rebel writes:

Dr. Kling,

Your description of Housecleaning sounds something like architecture, except that you go to work after the house is a disaster.

You would "cull out policies, including capital regulations, that either deliberately or
inadvertently promoted" offending practices. So post hoc you can be wiser about how the market behaved. The architect's design was tried; it erred. Instead of just cleaning up the mess, it sounds like you'll then re-design things to prevent recurrence: "I would try to foster a transition toward safer lending practices undertaken by healthy institutions." You won't have regulators ban practices, but somehow you would try get the market behaving in certain ways rather than in the objectionable ways. Sounds like you want to improve on the previous architecture, based on your analysis of what went wrong.

Rather than housecleaning, is your method more akin to remodeling after storm damage? Though you don't want to be architect or technocrat, perhaps your role is "skilled craftsman."

Isaac K. writes:

Bravo! I like the characterizations.

The thing is, the whole Pigouvian club strikes me as falling under the technocratic architecture scheme. Unless we are very selective in the manner in which we raise gas taxes (which Mankiw isn't), you will cause massive unintended consequences.

Remember how truckers, at $4 diesel, couldn't AFFORD to drive their trucks, because they were making less per mile driving than they spent on gas? And this situation affected everyone living in small towns in the boondocks.

Having worked in the retail industry and with truckers, transportation is a major issue that is simply glossed over - the Pigouvian tax may be spread among producers and consumers, but the effect on dependent goods will be massive price shocks.
By targeting the proposed gas tax to specific areas (or just not taxing deisel), you can avoid bankrupting consumers who have no closer place to work. If deisel isn't taxed, people have more incentive to buy deisel cars, which are more efficient than standard combustion engines. Perhaps implementing this Pigouvian tax is the surest way of encouraging the switch to alternative fuels as they become available?

Regardless, I found Mankiw's declaration to be a bit short-sighted, as he failed to consider the possible negative consequences of an increased gas tax.

Related point - raising gas tax will raise prices for ALL consumer goods - since they all need transportation. This will increase inflation and, consequently, our expecteed Social Security COLAs.

So the tax he suggests to solve the Social Security "crisis" (which, by the way, it isn't one) will actually AGGRAVATE the problem.

Marcus writes:

It's interesting too how 1 relates to 2. After the grand plans of the technocrats fail, the failure is always blamed on the 'greedy' people who didn't do what they were suppose to.

Steve Sailer writes:

Good framework, although I'd rephrase the post hoc sounding "housecleaning" as the pre hoc "prudence."

Old traditions like requiring a down payment would have prevented the worst excesses of the mortgage bubble.

DWG writes:

I would offer a further variation of the model of regulation. This is the Physical model. And it dovetails well with the Housecleaning model.

In the Physical model, the system regulated is viewed like any other physical entity, i.e., as a separate reality that the regulator may influence, but which, unlike the Architectural model, exists independently from the regulator, and the regulator can only influence it externally. While the Physical model is subject to many of the concerns identified by Arnold with the Architectural model, such as the problem of whether the persons who regulate the system are as capable at addressing its problems as is the system itself, at least the Physical model has the benefit of denying the regulator the hubris of thinking (either explicitly or implicitly) that she/he created the system being regulated or can design it top-down. But the Physical model does entail some additional aspects of on-going oversight that the Housecleaning model does not.

Any physical system is subject to conditions that can lead to chaotic instability. Under the Physical model, the duty of the regulator is to recognize the potential of the system to become chaotic (in the mathematical sense) and to apply light countervailing forces to dampen the inevitable tendency of a trend to overshoot and become chaotic. The emphasis of the Physical model is not to control the system, as is the goal under the Machismo model or to design it from top-down as is the goal of the Architectural model. The goal is simply to moderate the inevitable extremes which can lead to chaotic instability.

Based on this model of regulation, in hindsight, several of the regulatory factors that have led to the current financial situation, such as mark-to-market pricing of the value of loan portfolios (which caused long-term valued assets to have little value based on short-term market conditions), expansion of federal guarantees for mortgages, etc., destabilized the situation and caused the instability to be magnified, rather than dampened, when the consequences of these factors came into play. This indeed was perverse regulation from the viewpoint of the Physical model.

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