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We Don't Need Red Tape. We Need Red Rope.

Justin Fox joins the call for cruder, stupider regulation. He makes a good case:

The argument goes like this: the biggest flaw in current financial regulation is not that there is too little of it or too much, but that it relies on regulators knowing best. We regulate because financial systems are fragile, prone to booms and busts that can have harmful effects on the real economy. But regulators aren't immune to the boom-bust cycle. They have an understandable habit of easing up when times are good and cracking down when they're not. In doing so, they often amplify the ups and downs of markets rather than modulate them.

You can spin this into a case for reduced regulation--regulators are likely to mess up, so why bother? But it can also point toward an approach based not so much on discretion as on rules, the simpler the better. I first encountered this argument last fall in the work of left-leaning blogger Matthew Yglesias--he advocated "crude measures" like the old ban on interstate banking. Lately, though, I've been hearing similar suggestions from those of a conservative, University of Chicago bent. "When you give a lot of discretion to regulators, they don't use the tools that are given to them," Chicago economist Gary Becker said at a conference this spring. His prescription: rules, not leeway.

Another way of saying this is that when evaluating a particular financial regulation proposal, ask yourself this question: Would these regulations have worked if Alan Greenspan hadn't wanted to implement them? Because that's the world we were in during the rise of the subprime bubble. And some things worked, and some things didn't. The Federal Deposit Insurance Corp., for instance, worked beautifully. No one asked regulators if they wanted to insure individual deposits up to $100,000. It was just the rule. And there was, amazingly, not a single instance of an old-fashioned bank run.

Conversely, the Federal Reserve had plenty of authority to regulate subprime mortgages. In fact, Ed Gramlich, of the Fed governors, brought the issue to Greenspan's direct attention. He was shot down. Bubbles, we know, are accompanied by manias. People think this time is different. They have equations and rationalizations. They write books like "Dow 36,000" and "Why the Real Estate Boom Will Not Bust - And How You Can Profit from It." And Ronald Reagan's protestations aside, regulators are people too. A regulatory strategy built around the presupposition that regulators will resist the prevailing sentiment of the day is a regulatory strategy that will fail when it most needs to succeed. After all, when everyone knows the market shouldn't be doing something, you rarely need regulators to convince it of that fact.

By Ezra Klein  |  June 26, 2009; 5:45 PM ET
Categories:  Financial Regulation , Solutions  
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Here's how it goes: First, standards (the reasonable man) and, when standards don't work, then rules (35 mph). It's a very old debate in law and politics. Then, someone sneaks in a discretionary enforcement proviso into the "strict" rules and away we go again... because, then, those being regulated accomplish regulatory capture as first promoted by Tommy "the Cork" Cochran to his business clients in the 30s when regulatory commissions (ICC, etc.) were first proposed. And so it goes....

Posted by: glewiss | June 26, 2009 6:23 PM | Report abuse

Rules, strict 'the law says just what it says' rules. There should be very little discretionary wiggle room for the regulators on many/most of the rules. Regulators get captured, doors revolve, people get boom/bust hysteria, ideologues get appointed as regulators, folks make bad judgements just as often as good.

Yep, rope! Tie them up: we all know now that finance and banking is too important to get swooned into 'innovation' rather than security/safety/prudence.

Frankly, I can't think of a single reason for huge banks operating across the nation. Set a limit on size. Set a limit on leverage. Set limits on operating expense percentages for things like advertising and managerial/executive compensation (including bonuses, which should be long-range performance oriented, and with clawbacks. Make executives fiduciaries who can be sued for recklessness and put in jail for fraud.

Banks should be like utilities. Rates and services set by guidelines in the law. Forbid revolving doors for regulators with the regulated without 2-4 year cooling off periods.

Tough love is still love, but tougher love is what they need and what the nation deserves.

Posted by: JimPortlandOR | June 26, 2009 6:34 PM | Report abuse

"We regulate because financial systems are fragile, prone to booms and busts that can have harmful effects on the real economy."

This is a false premise. Booms and busts are both parts of long-term economic growth, and we actually need the booms. We are in this mess today because regulation was tailored, first, to maximize the boom, and now, to somehow stave off the bust. Not going to happen. But if you want to see some real "harmful effects on the economy," then just keep meddling.

Posted by: whoisjohngaltcom | June 27, 2009 9:13 AM | Report abuse

I spent 20 years trying to do oversight on federal programs whose regulations were deliberately designed to 'tweak' behavior instead of actually regulate it. Never works. If something is important enough to control, control it directly and strictly. Otherwise, leave it alone, the amount of time and energy spent wiggling around the provisions on both the sides of the regulators and the regulated accomplishes exactly nothing.

Posted by: exgovgirl | June 28, 2009 1:24 AM | Report abuse

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