Market Discipline vs. Regulation in Finance
By Arnold Kling
Ask a lefty what caused the financial crisis, and the answer will be that there was too little regulation and too much reliance on market discipline, which did not work.
Ask a righty the same question, and the answer will be that there was too much confidence in regulation, so that market discipline was undermined (creditors assumed they had government protection).
There is an inherent conflict. The more you insist that regulation (including deposit insurance, systemic risk regulation, “too big to fail,” or what have you) will be effective, the less incentive you give to market participants to behave prudently. On the other hand, it is very hard to sell people on the notion that less regulation is the path toward safety. Particularly after the 2008 crisis, where Alan Greenspan says that he was wrong to assume that the market would discipline risk taking.
So now we have the lefty saying that regulation works, but it needs to be done “”correctly.” And we have the righty saying that market discipline works, but it needs to be done “correctly.” And we may end up with a compromise, with each undermining the other. And the lefty can justifiably complain that we allow markets more freedom than what he thinks is needed, while the righty can justifiably complain that we give less scope to market discipline that he thinks is needed.