Day By Day

Sunday, March 22, 2009

The Case Against Regulation

There's a terrific post by Scott Sumner on why Democrat proposals for strict federal regulation of credit markets are, in economic terms, complete nonsense.

One can look at the sub-prime fiasco from a theoretical perspective, or a empirical perspective, but what one cannot do is compare an ideal regulatory scheme to actual banking practices. No one doubts that we would be better off if we could go back in time and install a regulation banning sub-prime mortgages in 2004. But if we had that ability, the bankers would have also known what was coming, and would never had made the loans in the first place.

[I hope no one gives me the silly moralistic argument that the villains got off Scott-free, while innocent investors were left holding the bag. The villains are exactly the people who have lost $100s of billions of dollars, even after the bailouts. I know it is never that way in Hollywood movies, but real life is different. This never would have happened (even without regulation) if bankers could have seen into the future.]

So the anti-EMH [efficient market hypothesis] argument for regulation must be based on the following; bankers are irrational and make lots of foolish loans. Regulators are rational and can see that these loans are too risky, and can protect bankers from hurting themselves. At a theoretical level this doesn’t even pass the laugh test. But what happened in practice? What position did the “regulators” take in this crisis? First we need to define “regulators,” who are much more than just the low-paid Federal bureaucrats that oversee the banking industry. Regulators are the watchmen, those who watch the watchmen, and those who watch those who watch the watchmen. In other words:

1. The President
2. Congress
3. The Fed
4. The media
5. Most academics
6. Nouriel Roubini [economist who predicted the current crisis]

Guess how many of these institutions warned us about the sub-prime crisis. Now guess how many were encouraging banks to behave even more recklessly than they did. Unless we plan on making Roubini dictator of the world, there is zero evidence from the sub-prime crisis that simply giving regulators more power would have helped. And how do we know that even Roubini wasn’t just lucky, and might miss the next fiasco?

There's an extended argument attached -- it even dips into the realm of philosophy. Well worth your time. Read the whole thing here.