The Failure of Regulation or the Failure to Regulate?

Among the multiple questions that can be asked about the current financial turmoil, this is perhaps the most crucial one. The same issue was raised many times in the past. For instance after the fall of the Berlin wall in 1989, some said that while it showed that the economy in Eastern Europe couldn’t survive at the time, it didn’t prove that communism as a system could not work because its principles had perhaps been misapplied for all these years. This opinion didn’t survive long, however, in view of the successes of the reforms that were taking place in the world at the time (UK, USA, New Zealand, Australia, etc) and the rise of the so-called Washington consensus.

But here we are almost 20 years after the fall of communism in midst of what is perhaps the most serious financial downturn the world has known since the Great Depression. The question comes back again with a vengeance and the voices supporting the failure to regulate view are now pretty loud. See President Sarkozy of France for instance. In the tradition of the populist French right, he is now calling for a “renewal of capitalism” in order to end the abuses of financial speculation. As he put it: “Le marché qui a toujours raison, c'est fini” (the idea that market is always is right is over).

The failure to regulate has also a moral component in this crisis. It is not only the failure to regulate markets because they are prone to failures; it is the idea that society has let highly paid immoral beings prey on the common person (in Main Street). As Dick Meyer on NPR puts it:

I am now even more firmly convinced that there really is a predator class. The people responsible for creating and bingeing on the mortgage junk bonds, derivatives and financial insurance scams that are now being bailed out are our society's most educated, highly trained and wealthiest professionals. The Meltdown of '08 was not caused by con men, crazed moguls and panicked masses. It was caused by financial bureaucrats of the baby boom generation who were paid megabucks for office jobs, who wear Patagonia fleece, $12,000 Brioni suits and read books about "reinventing the Self."

While contenders of the free market thought they had lost the battle of implementation but won the battle of ideas, it is now becoming clearer that they lost both. Indeed, if the battle of ideas had been won, fewer voices would now speak against the free market. Instead, central banks are pumping more cash in markets around the world, downward adjustments of prices (and deflation) are seen as the devil, banks are not allowed to fail, and the US government is about to engage in the biggest market intervention it has done since WWII. In 2008 the ideas of the Reagan revolution are dead.

So how do we explain that the problem is the failure of regulation, not the failure to regulate? It is difficult because it goes at the heart of what is proof and truth in economics (i.e. the battle between empiricism and rationalism), but also it seems clear that arguments about market theory are not enough to convince policymakers and the public. One needs more.

Talking to people around me gives me an idea of the type of questions they have. For instance, some think that economists need to be more precise about what 'regulation' means, what regulation we are talking about, and why it could have unintended consequences. Some think that regular banks are more regulated than investment banks and are better off. Some don’t understand why standard rules such as prudential capital adequacy requirements are failing. Some believe that the SEC and other organisms lack power to intervene. But most can’t see the role of uncertainty in the system and the limit of knowledge on the part of regulators and actors in the market.

The trouble is that many economic problems are too complex to be understood by non-specialists and thus the public will always be ignorant (this relates to Bryan Caplan’s thesis). Economists have answers that the public won’t listen to or won't understand. It is a tough job because (free market) economists are permanently caught in some kind of Sisyphean nightmare: called to explain the workings of the market to see their advice ignored over and over again. It’s no wonder why so many decide to become the counselors of the prince.

Comments

[mt]

Awesome. A compelling summary both for tracing out the implications of the project for "proof and truth" in economics and relating it to the work that is going on, broadly, at Mason.

[Dave Raithel]

I love the juxtaposition of Mr. Sautet's observation that "The trouble is that many economic problems are too complex to be understood by non-specialists and thus the public will always be ignorant.." with Mr. Boettke's admonition that "Individuals must be equiped to embrace the troubles of thinking and the cares of living if they are to live free as a self-governing citizenry..." I'll let others medidate on the Zen qualities of the Austrian Economist's blog and pose a Third Way (which, of course, is some remembrance of things past): "... [W]hile the market mechanism is a good enough device for making social decisions about unimportant matters such as the mix of colors in the production of frocks, the length of the skirts, or the flavors of ice cream, it cannot and it should not be relied upon for important big matters such as the distribution of income, the maintenance of economic stability, the capital development of the economy and the education and training of the young." (Hyman Minksy.)

Maybe it is true that we are ignorant, but it is not because we are stupid. Maybe it's that the "cares of living" require we spend our time actually making the living and taking care as living requires. I was once ignorant of an interesting fact, until I learned it in Andrew Levitin's essay on how/why the Fed/Treasury will not be able to fix mortgages even if they acquire MBSs:
http://www.law.georgetown.edu/faculty/levitin/documents/MBSModificationIssues_000.pdf

I especially love the part about CMOs being comprised of the tranches of MBSs that cannot be sold to some parties because those MBS tranches are so "risky"... Now why in the world should the rest of us out here in flyover country have to put up with such witty inventions given they have done their part to bring us to here? Aren't there other things people could be learning (though I grant the paradox that I've learned this to figure out what I think I should say to "my" Congress people, on the the theory that any of them listen ... )What we who are too ignorant need are proposals grounded in actual concrete relations and the history we have lived - counter-factual arguments that pose possible worlds had things been done differently in the past do little good.

[Richard Ebeling]

An additional problem is not only the ignorance of the general public, due to the complexity of the economic processes and following the economist's "story' about how it all fits together.

There is the fact that the "intellectual class" reinforces these misunderstandings. I'm not sure if any on this blog has read the cover article in the current issue of "Newsweek" by Fareed Zakaria (who has a PhD from Harvard in the field of Government, and is a editor of "Foreign Affairs") on "Big Government to the Rescue."

A few paragraphs into the article we find the following passage:

"This crisis should put an end to false debates about government versus markets. Governments create markets, and markets can exist only with regulation. If you want to be truly free of regulation, try Haiti or Somalia. The real trick is to craft good regulations that allow markets to work well. No regulatory structure will be perfect, none will eliminate risk, nor should they. At best they can tame the wildest gyrations of the market economy while maintaining its efficiency."

How many additional paragraphs -- pages -- would anyone on this blog need to "unpack" the theoretical and empirical errors captured in this passage so the general reading public would not take it as "obvious" truth?

This, too, is part of our dilimma.

Richard Ebeling

[mt]

Dave,

I think Dr. Sautet’s note is immune to your point: "Maybe it is true that we are ignorant, but it is not because we are stupid. Maybe it's that the ‘cares of living’ require we spend our time actually making the living and taking care as living requires." He points to Brian Caplan's book which would be interesting reading if you want to flesh out your intuition with the help of years of research.
As far as theories of Distribution and Social Justice, the theory is that free-markets do a better job. This requires a lengthy defense, but it does exist. Capitalism and Freedom (1962) by Milton Friedman is the standard starting point (reformulated later as Free to Choose, 1980). David Friedman (his son) is another source here as well for the well written and popularly accessible argument. Summary, “All boats rise with a rising tide.”
I would resist the anthropomorphic analogy that markets decide and governments decide. The type of skirt that I choose to wear is my decision. The fact that I have a countless variety to choose from is a benefit of functioning markets. The type of tax I pay is less my decision because no one asks and I have very limited ability to choose my bundle of government.

[Winton Bates]

I am not sure that public responses to this crisis provide much support for the point that many economic problems are too complex to be understood by non-specialists.

It seems to me (as someone who doesn't claim to be one) that Austrian economists have done fairly well in getting their message across in the lead-up to this crisis and during it. For example, the role of monetary expansion in genesis of the problem seems to have been widely accepted by commentators outside the limited circle of those who have been exposed to Austrian economics.

[Unit]

Journalists are predictably bad at predicting. Whenever there's a crisis "the future will never be the same!". We've heard this after 9/11. After Katrina, I heard David Brooks say that this would cause a fundamental shift in how we deal with the poor, etc...Sorry but journalists are not very good at predicting large societal shifts.

This time the great debate between regulation and deregulation, between governments and markets, is supposed to have come to and end just because of a few firms that failed. First of all regulation often defines what government proper role should be. I'm all for that kind of regulation! Smart regulation. So what Fareed Zakaria says (Ebeling's post above) can be interpreted in a much more benign way.

[Alan Forrester]

"The trouble is that many economic problems are too complex to be understood by non-specialists and thus the public will always be ignorant (this relates to Bryan Caplan’s thesis). Economists have answers that the public won’t listen to or won't understand."

I can't say I've noticed anyone trying too hard to explain. Richard Dawkins has written lots of books on evolutionary biology with nice clear examples of what he's talking about. And he's not the only one doing this for evolutionary biology there are lots of good popular books on it. I like to think I understand economics a lot better than most people although I'm not an economist but that's because I spend most of my non-working trying to understand how the world works. How do you unpick all of the errors in bad theories? You don't. You don't start with bad theories and try to pick them apart piece by piece you explain the good theory in the simplest possible way.

An example, Austrian Business Cycle Theory:

"Machines for making dolls are different for machine for making sandwiches and so on. The more complicated the doll you want to make the longer it takes. To work out whether you can afford to make a dolls that pees its pants and cries mama you try to work out how long it would take and how much it would cost and what profit you would make and then you compare that to the money you would have to pay in interest and so on. Why do you have to pay interest? Because people who lend money want it back to do other things with it and the rate of interest they would charge if they were given a choice reflects how urgent they feel their other needs are. The government takes money from people through taxation and locks up anyone who tries to provide the services it provides in a different way (you can't start your own police force). So the government can take its tax money and lend it out at a lower rate of interest than the market because it doesn't ask for your money just takes what it wants. So the government, via the Fed, lends to businesses that can't make a profit without subsidy and then if they make money doing this they want to expand and so they seek more money and so more money gets sunk into making things people don't want. And eventually the problem gets noticed and then they start tightening up on loans and getting rid of unprofitable businesses. But a doll making machine can't easily be made into a sandwich making machine so if people want more sandwiches the doll machines have to be scrapped and the metal thrown or melted down or whatever, which costs time and effort. This means that budgets for businesses get a bit tighter for a while when the problem is revealed - recession."

Obviously that's just an outline and who knows maybe I've got it a bit wrong, or even a lot wrong. It doesn't seem that difficult to me. You have an advantage, your ideas make more sense. Start using those ideas.