Fire and Ice (Updated)

Martin Wolf, writing at Financial Times, makes the point I’ve been making for the last ten days about the Fed’s orderly liquidation of Bear Stearns

The implications of this decision are evident: there will have to be far greater regulation of such institutions. The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices (see chart below). This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions. Greater regulation must be on the way.

and considers the global implications:

If the US itself has passed the high water mark of financial deregulation, this will have wide global implications. Until recently, it was possible to tell the Chinese, the Indians or those who suffered significant financial crises in the past two decades that there existed a financial system both free and robust. That is the case no longer. It will be hard, indeed, to persuade such countries that the market failures revealed in the US and other high-income countries are not a dire warning. If the US, with its vast experience and resources, was unable to avoid these traps, why, they will ask, should we expect to do better?

I think we need to be careful about taking our conclusions too far. That a completely free market is too unstable to be allowed needn’t drive us to the conclusion that every aspect of the financial markets require minute regulation. Isn’t there some prudent level of regulation between laissez-faire and a command economy?

Reaching that point requires engineering rather than mathematics; judgment rather than ideology.

Update

Mark Thoma wisely notes:

Free markets is not the point. Producing well-functioning, competitive markets is the goal, that’s when our models say the outcome is optimal. If removing restrictions gets you in the vicinity of the competitive outcome, and most often it does, then that is the right thing to do. But if making markets as free as we can doesn’t produce a competitive outcome, then another approach is needed (and the extent to which an intervention that overcomes a market failure and produces a more competitive market reduces freedom is a debate for another day, but I don’t see why it necessarily does).

Judgment rather than ideology.

Update 2

The flip side of the coin is presented by John Kay (also at Financial Times):

The notion that future banking crises can be averted by better regulation demonstrates unrealistic expectations of what regulation might achieve. Banking supervision asks public agencies to second-guess the decisions of executives who earn millions in bonuses and business strategies that yield billions in profit. If Hank Paulson, US Treasury secretary, were doing the job of day-to-day regulation personally, he might – just about – have the respect and competence to get away with it. But the work is done by relatively junior administrators who lack the authority to intimidate the bankers and who have little confidence that their controversial decisions will win political support.

Or, if you’re so rich you must be smart.

I think this view presents a false dichotomy. The objective isn’t to prevent future banking crises outright. The objective is to reduce their likelihood just as designing storm drains for 20 year floods or 50 year floods reduces the likelihood of being flooded out. Engineering not mathematics.