Arnold Kling  

Market Discipline vs. Regulation in Finance

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Ask a lefty what caused the financial crisis, and the answer will be that there was too little regulation and too much reliance on market discipline, which did not work.

Ask a righty the same question, and the answer will be that there was too much confidence in regulation, so that market discipline was undermined (creditors assumed they had government protection).

There is an inherent conflict. The more you insist that regulation (including deposit insurance, systemic risk regulation, "too big to fail," or what have you) will be effective, the less incentive you give to market participants to behave prudently. On the other hand, it is very hard to sell people on the notion that less regulation is the path toward safety. Particularly after the 2008 crisis, where Alan Greenspan says that he was wrong to assume that the market would discipline risk taking.

So now we have the lefty saying that regulation works, but it needs to be done ""correctly." And we have the righty saying that market discipline works, but it needs to be done "correctly." And we may end up with a compromise, with each undermining the other. And the lefty can justifiably complain that we allow markets more freedom than what he thinks is needed, while the righty can justifiably complain that we give less scope to market discipline that he thinks is needed.


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COMMENTS (11 to date)
Mercer writes:

In the fall of 2008 righty politicians and Wall Street did not act liked they believed in market discipline. I think they will act the same in any future crisis.

You might be able to persuade people that less regulation leads to safety if the big banks were broken up.

Doc Merlin writes:

"Particularly after the 2008 crisis, where Alan Greenspan says that he was wrong to assume that the market would discipline risk taking."

But the market DID discipline risk taking... until they were bailed out.

@Mercer:

NO NO NO! The market did discipline it. It did exactly what it was supposed to do.

Randy writes:

The problem isn't so much that we will end up with a compromise as that the compromise will work. That is, a compromise will enforce security at the expense of risk taking. That is, we will lose, we just won't know what we've lost.

Les writes:

There was plenty of regulation in:

1) The S&L crisis in the 1990's;
2) The Enron, WorldCom, etc. crisis in the early 2000's;
3) The 2007/2008 crisis.

Each and every time despite ample regulation, it has failed miserably. What better evidence is there of the high cost and ineffectiveness of regulation?

Pandaemoni writes:

Funny thing watching the Wall Street Journal Editorial Report yesterday, they suggested that Texas's relatively good economic health was in part based on legal limits on the amount of debt one could take on when buying a property.

It rolled out there and it seemed likely the whole panel agreed that was a good law. This happened just minutes after one person on the panel excitedly pointed to Michelle Bachman's reference to von Mises and his works as a sign that she'd be a good candidate for President.

I am not sure that they realized the conflict there.

Shane writes:

There are only mixed markets in the developed world - even relatively free market economies have some taxation and regulation - so we are never looking at absolutes when we compare economies. As a result we get this confusion of interpretations.

I see left-wingers pointing to the recent relative growth of Germany and Sweden (and the problems in Ireland and Iceland) as evidence that their more social democratic models are more successful.

I see right-wingers pointing to the recent relative growth of Hong Kong, Singapore and Estonia as evidence that their more free market policies are superior.

Personally I find it puzzling to see clear patterns.

Foobarista writes:

A good way to think of regulation is as a sort of computer program, complete with "bugs". "Hackers" find the bugs, in the form of holes or gaps in the regulatory structure, and exploit them to make money. The bigger the economy, the more you can make money with this sort of "hacking".

Any rule-based regulatory regime can be hacked this way, due to the simple fact that you can't completely regulate everything (any more than a computer sim can completely simulate "the universe").

Much of what Wall Street does is this sort of "regulatory hacking".

Andujar Cedeno writes:

There is an inherent conflict, risk is ever present and neither regulation nor the free market prevents the risk of total disaster. The individual can only rely on caveat emptor. The only question after accepting this undeniable reality is do we waste our treasure on an army of useless regulators, or do we leave the treasure in the hands of the individuals who earned it and let them rise and fall on their own devices.

R Richard Schweitzer writes:

Please refer to the works of Gordon Tullock for a fuller understanding of the "functions of regulations" and the forces for their development.

Lord writes:

One shouldn't presume these are predestined failures, but rather ongoing successes that eventually fail. The alternative is not freedom from failure, but more or less and larger or smaller. If you are going to rely on regulation then you must regulate and not ignore or relax them as time goes on relying on the market to do your job for you. If you are going to rely on the market they you must prevent the occurence of too large to fail entities even though that requires regulation to accomplish, or provide regulation that addresses them after the fact when they do fail. It is the notion that it is, must, or should be one or the other that is flawed.

Tom Grey writes:

The bailouts were precisely because the rich usually responsible investors speculated and lost.
They speculated based on gov't approved semi-private AAA ratings; ratings which were wrong.

The difference between 1 in 1000 and 1 in 100,000 is huge -- but risk models that choose the latter when it is really the former will blow up.

Until they blow up, they will appear to be returning a higher reward/risk ratio than strategies using a more "accurate" risk model; thus, lead to more investors tweaking their assumptions/ models to get similar returns.

The "useful economics" is that which produces laws/ results/ formulas/ that can be used to make money. That is, can be used to get higher rates of return (risk adjusted). The problem is that finding such a law (buy Mortgage Backed Securities! or derivatives based on them!) (or tulips!), and following it to make money, induces others to follow it, changing their behavior, and invalidating the law.


Voters want "no mistakes"; but they also want progress. New investments always require the possibility of it being a mistake. The regulation/ market questions are: who should pay for mistakes? Should investors be free to make bad/ mistaken investments?
I believe yes -- but that requires the investors to lose if their speculation turns bad.
The rich like to claim freedom ... until they demand bailouts.

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