Arnold Kling  

Outline for Talk on Financial Regulation

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To some folks at Treasury (not Tim Geithner). I'm inclined to try to structure it as a discussion, since I may know less than many of the other attendees. Here is what I might contribute.

1. I predict that in the future the issue of financial stability will replace the issue of monetary control as the main issue in macroeconomics. The macroeconomics of the last thirty years will be discarded. The pseudo-physics of Taylor rules, dynamic stochastic general equilibrium models, and most of what macroeconomists have done since World War II will find its way to the ash heap of history.

2. What I learned at Freddie Mac:

--mortgages have embedded options. People who do not understand the option theory of mortgage default do not understand mortgage credit risk, mortgage securities, or related securities. Too many suits (top executives and regulators) fail to appreciate this.

--asking an honest person for documentation to support their income, assets, or employment is a waste of everyone's time. But not asking for that documentation is a way to select for dishonest people, and there are plenty of dishonest people around, particularly in the mortgage broker industry.

--the competition among various financial institutions in the mortgage markets is won on the basis of capital requirements. When I was there, Freddie and Fannie had an advantage over banks in buying low-risk loans, because our capital requirements were lower.

3. Some questions to ponder going forward.

--How do you balanced market discipline with regulatory discipline? Too much of the latter may undermine the former (Tyler Cowen's point in his column today). But Greenspan's mea culpa is that market discipline failed.

--Is it better to have uniformity of regulation or diversity? Do we want to go so far as to have international uniformity?

--To the extent that regulations are determined by multinational bodies, what does that do to electoral accountability?

--Should we be trying for a system that is hard to break or one that is easy to fix?


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COMMENTS (4 to date)
Ed Hanson writes:

Arnold

I think the greatest question comes from your first issue.

"1. I predict that in the future the issue of financial stability will replace the issue of monetary control as the main issue in macroeconomics. The macroeconomics of the last thirty years will be discarded. The pseudo-physics of Taylor rules, dynamic stochastic general equilibrium models, and most of what macroeconomists have done since World War II will find its way to the ash heap of history."

Are you saying that all monetary controls will be gone or are you predicting a return to hard currency such as a classical gold standard which controls 100% of issued currency?

Brian writes:

How can any regulatory discussion not include the issue of management incentives, liability, and corporate governance. You have alluded to this in previous posts, suggesting criminal penalties. While that's a bit unrealistic, is it not clear that no system is sustainable where employees of a firm can walk away enriched while, intentionally or not, bankrupting the company?

As to actual crimes, we are hearing that perhaps many of the CDS's written by AIG included a wink and nod that payout would never take place. For all the shenanigans going on, from lying mortgage borrowers on up to sham regulatory "arbitrage," there have been precious few reports of indictments or civil suits. Do the SEC, or the FBI or DOJ for that matter, have any ability to recognize, let alone prosecute, fraud? And is this a problem with the law, or just a result of the political power of Wall Street?

fundamentalist writes:

How many decades have we tried to get regulation right? The creation of the Fed was an attempt at regulating the financial markets to ensure stability, so we have been trying almost a full century. Shouldn’t we draw some conclusions for a century of failure?

I really don’t care what regulations the state invents. They will all be intended to fight the last war and I’m 97.3% confident that we will never have another crisis exactly like this one. We will have another crisis within the next ten years, but it will come about in a way that no one today can possibly imagine and therefore write the necessary regulations to prevent it. We will have another crisis because so few economists, and only one politician, understand the real cause of this one.

“I predict that in the future the issue of financial stability will replace the issue of monetary control as the main issue in macroeconomics.”

Stability may not have been the main issue in macro, but it was the light that guided the Feds, which has always tried for price stability. I would suspect that stability wasn’t a part of macro for the past 30 years because economists thought the Fed had achieved stability, in spite of us having a depression every decade.

“Greenspan's mea culpa is that market discipline failed.”

I don’t understand what Greenspan meant by that. He knows we have a highly regulated market in banking or finance with little room allowed for market discipline. The state implemented every tool it could get its hands on to prevent market discipline in finance from working. But market discipline means that businesses fail when management fails. The market cannot prevent management from making stupid decisions. The crisis is market discipline. Greenspan seems to be saying that the market should keep businesses from failing. I don’t see how that makes any sense. Market discipline works by causing businesses that have made stupid decisions to fail. What other kind of market discipline is their?

Tom writes:

“I predict that in the future the issue of financial stability will replace the issue of monetary control as the main issue in macroeconomics. The macroeconomics of the last thirty years will be discarded. The pseudo-physics of Taylor rules, dynamic stochastic general equilibrium models, and most of what macroeconomists have done since World War II will find its way to the ash heap of history.”

You might be right, but have the advances in macroeconomics been applied in practice in the application of macroeconomic policy. Because it seems like the practice of macroeconomics by governments haven’t changed in 30 years. Why discard something that hasn’t been used? The same thing with the Taylor rule: why discard (blame) the Taylor rule if the rule hadn’t been followed for the past 8 years preceding the bubble.

“…asking an honest person for documentation to support their income, assets, or employment is a waste of everyone's time.”

I don’t understand this. I thought a part of the problem was that there mortgages that didn’t require proper documentation, either not required by the lender or falsified by the borrower (in this case, not an honest person). But how does a lender know if a borrower is honest in advance.

Finally,”How do you balanced market discipline with regulatory discipline?”

Can you ever have market discipline with a Central Bank? That is, aren’t booms and bust here to stay as long as the Central Bank engineers bubbles through inflationary credit expansion? I don’t think you can regulate the business cycle out of existence as long as there is a Central Bank.

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