Arnold Kling  

Reihan Salam on Financial Regulation

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He writes,


it is not just craven financial elites that clamor for stabilization policies that invariably benefit craven financial elites: it is virtually everyone in the crisis-plagued societies, as financialization gives everyone a stake, direct or indirect, in the fate of asset prices, etc.

Not sure I buy that entirely. Anyway, en passant, Salam calls Engineering the Financial Crisis "one of the most brilliant books I've read in years."

Salam cites Arpit Gupta, who also channels Jeffrey Friedman and Wladimir Kraus.


The global "shortgage" or demand for safe assets was really a demand for ways to conduct regulatory arbitrage; and the growth in structured products (as well as sovereign European debt) was a supply-side response to that demand.

Salam also cites a very provocative post from Ashwin Parameswaran, who tries to make a general point:

The fundamental reason why interventions fail in complex adaptive systems is the adaptive response triggered by the intervention that subverts the aim of the intervention. Moreover once the system is artificially stabilised and system agents have adapted to this new stability, the system cannot cope with any abrupt withdrawal of the stabilising force.

when a central bank protects incumbent banks against liquidity risk, the banks choose to hold progressively more illiquid portfolios. When central banks provide incumbent banks with cheap funding in times of crisis to prevent failure and creditor losses, the banks choose to take on more leverage. This is similar to what John Adams has termed the 'risk thermostat' - the system readjusts to get back to its preferred risk profile. The protection once provided is almost impossible to withdraw without causing systemic havoc as agents adapt to the new stabilised reality and lose the ability to survive in an unstabilised environment.

He appropriately cites Hyman Minsky, who was known for saying that stability breeds instability. My line is that instead of trying to make the financial system harder to break, we need to try to make it easier to fix.


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COMMENTS (2 to date)
Becky Hargrove writes:

Yep. Happy New Year!

AS writes:

I haven't read through Parameswaran's argument, but it sounds similar to the argument that George Soros makes in the Alchemy of Finance.

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