Thoughts on Financial Regulation
By Arnold Kling
1. I think that financial markets are inherently imperfectly transparent. The reason that we have financial intermediaries is to save the final investor the work of evaluating the risk of the ultimate borrower.
Markets promote a phenomenal division of labor. If we had to grow our own food, build our own communication tools from scratch, design and build our transportation vehicles…forget it. We need division of labor.
Similarly, if you had to evaluate the risk of each of your investments that your savings help to fund–the risk of developing a commercial shopping center, the risk of launching a new product, the risk of expanding a growing restaurant franchise…forget it. We need division of labor. We have to trust banks, mutual funds, pensions funds, insurance companies, and so on to evaluate the risks that they take. They in turn have to trust rating agencies, investment bankers, auditing firms, and many others involved in the process.
2. I believe in what I call the Austro-Keynesian model of financial cycles. Like the Austrians, I believe that interest rates are determined by subjective preferences. However, the Austrians focus on pure time preference. If people have little patience for future consumption, then interest rates are high and producers are incented to economize on capital. If people are willing to defer gratification, then interest rates are low and producers are incented to choose roundabout production methods, meaning methods that are more capital intensive.
Instead of looking at time preference, I focus on risk preference. For Keynes, savers are inherently risk averse. On the other hand, entrepreneurs are inherently willing to take risks, because of what Keynes called their “animal spirits.”
Financial intermediaries find ways to overcome the natural mis-match between risk-averse savers and risk-taking entrepreneurs. The intermediaries analyze risks in an effort to manage them. They diversify risks in an effort to insulate individual investors as much as possible. As a result, the intermediaries bring down the risk premium that otherwise would be faced by borrowers.
3. With the division of labor in financial markets, risk premiums are related to one another. If A lends money to B to lend money to C to lend money to D, what happens when A starts to worry that B, C, or D might be riskier than previously thought? Well, A starts to demand a higher interest rate from B, which means that B demands a higher interest rate from C, which means that C demands a higher interest rate from D, and D may already be on the skids, so everything just comes crashing down.
4. Government has taken on the role of intermediary of last (or less than last) resort. The interest rate on U.S. government bonds still represents the “risk-free” rate of interest (although my latest worry is how long that status will persist). Government has that as a carrot and regulation as a stick to use to try to influence financial intermediaries. Proper use of the stick can help avert the need to over-use the carrot.
The regulators cannot prevent every problem. They ought to try to replicate what works, avoid what doesn’t work, and do their best to try to anticipate what might go wrong. In my view, the 30-year fixed-rate mortgage with a 20 percent down payment usually works. It does not work if you let inflation get out of control, the way we did in the 1970’s. But otherwise, it’s a pretty easy loan for a borrower to understand and we have had a lot of good experience with it. We ought to encourage having that loan make a comeback.
Having financial institutions that are small enough to merge with other financial institutions also works. We know how to do mergers. What we cannot handle are problems at gigantic institutions, like Fannie Mae, Freddie Mac, and the biggest Wall Street firms. If I were the financial regulatory czar, I would try to break up the biggest firms before they fail.
It works to have regulation of financial firms that is tied to risk. When deposit insurance premiums and bank capital requirements became risk-based, the performance of banks improved.
Still, there are going to be potential systemic problems. A regulator is always going to have to ask, “What if?” What if house prices start falling? What if foreign investors change their currency preferences? And so on. Regulators who want to take away the punch bowl when the party is getting good will need independence from Congress. You can’t have lobbyists outmaneuvering regulators.
Anyway, those are my thoughts.