More on the Limits of Regulation

What if the cause of the financial crisis was regulation itself?

My own narrative is that the causes of the problem were a) clumsy capital regulations, which induced a lot of financial innovation that was primarily aimed at regulatory arbitrage; b) housing policy that encouraged lenient, subsidized mortgage credit; c) the suits vs. geeks divide, with people in power (in both large banks and among regulators) having too much confidence and too little knowledge.

It’s hard to argue that better regulation, whether of the financial system or deep well drilling in the Gulf of Mexico, wouldn’t be a Good Thing. It’s somewhat harder to see how that comes about, particularly when the regulators tend to develop ever cozier relationships with those they’re supposed to be regulating. I suppose for some that’s a feature rather than a bug.

7 comments… add one
  • Maxwell James Link

    Well, one way to not make it come about would be to systematically dismantle existing regulations that had operated pretty well for decades.

    I’ll also note that if one wants to improve the quality of regulation and decrease coziness with the regulated, proposing dramatic cuts to government salaries is probably not the best place to start.

  • Maxwell James Link

    Start negotiations, I mean.

  • I’ve repeatedly proposed forms of incentive pay for federal regulators for just that reason.

    However, do you really believe that there is some level of ordinary wages, politically possible and acceptable to the Congress, that would materially reduce regulatory capture? I don’t. Further, I believe that increasing federal salaries doesn’t do much to raise the quality of the employees but generally just pays more to the people who are already there.

  • PD Shaw Link

    A key difference btw/ the financial and environmental regulations is that the environmental regulations assume contamination will occur regardless of whether best efforts are used to avoid it. In that case, the National Contingency Plan kicks in, and coordinates the response. In other words, the environmental regulatory world is divided into two components — pre-incident (permitting and operating standards) and post-incident (response and clean-up).

    Financial regs appear to mainly operate on pre-incident controls; there is no national contingency plan for systemic risk in the financial sector. Congress appears to be proposing one and I wonder if the analogy is sound.

    Also, I’m starting to have concerns about the government response here. Certainly, the government has little ability and experience to draw upon to stop the oil release. But the stuff away from the release, such as limiting its extension, coordinating local, state and federal agencies, and protecting remediation workers appears wanting.

  • Maxwell James Link

    No, I don’t think that either. And I am all for incentive pay in this and many other situations.

    I do think however that it is important to not look at political problems in isolation from each other, which is something wonks and politicians tend to do (including amateur wonks and back-seat politicians). For example: unions greatly weakened the “cadillac tax” provision in the healthcare bill, which itself was a weakening of the elimination of the employer tax exemption. This in turn diminished the potential cost savings in the bill, making it both harder to pass and less likely to succeed.

    It happens that a few months prior to the healthcare debate, the Congress shied away from even attempting to enact EFCA, which was the unions’ #1 priority at the time. EFCA wasn’t a great piece of legislation in my opinion but a compromise on it was certainly possible (one was proposed by Starbucks IIRC). Had Obama and the Congress actually taken steps to enact such a compromise, they might have had a much easier time keeping that cost-saving provision in the bill. But that would have required a touch of foresight, plus an ability to not look at political problems in isolation from each other.

  • steve Link

    “It’s somewhat harder to see how that comes about, particularly when the regulators tend to develop ever cozier relationships with those they’re supposed to be regulating. ”

    Then you need some way to explain why the financial system did not collapse until the 2000s. There has always been an incentive to develop cozy relationships (by this I assume you mean financial incentives). I think the larger problem was deep capture. The dominant school of economic thought in undergrad schools for the last 30 years emphasized deregulating as businesses were seen as best regulating themselves.


  • Unfortunately when we get new reguation it’s extremely rare for it to be better regulation. By the time it’s gone through the legislative sausage grinder it’s rarely an improvement.

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