Friday, December 19, 2008

More regulation will create more panic

The capitalist fat cat has long held a treasured place in popular demonology. Russians used to deride casino capitalism before showing us how to do it really well - by playing with the house's money. British trade union leaders castigated the City of London even as it created jobs at many times the pace at which their own mulish Luddism destroyed them.

Even for Americans - perhaps especially for Americans - Wall Street has been the target of popular revulsion and caricature almost since the first banks opened in Lower Manhattan. From William Jennings Bryan's philippics against the “idle holders of idle capital” in 1896 to Michael Douglas' portrayal of Gordon “Greed is Good” Gekko almost a century later, the susceptibility of the American public consciousness to the perceived cupidity and selfishness of Wall Street is every bit as acute as that of any European.

When crises unfold and the idlers and greed merchants get their comeuppance, the instant reaction is a mix of anger and Schadenfreude. The public experiences a sort of K├╝bler-Ross style progression through the various stages of socialist grievance.

The inner Marxist rather enjoys the spectacle of rich bankers becoming victims of their own unsustainable excess, proof of the inevitable internal contradictions of the market process. Picture editors never tire of those photographs of some trader holding his head in his hands as the numbers on the screen behind him bleed red.

Then the inner Stalinist takes over and rages at the injustice of it all. How dare these Masters of the Universe with their Porsches and their incomprehensible gobbledygook bring us to our knees? Annihilate the options traders!

Finally, we get to the inner Leninist, surveying the economic wreckage and calmly insisting that Something Must be Done.

That is roughly where we are now in the Great Panic of 2008.

There is a compelling narrative that spans the transatlantic political space - all the way from Barack Obama through John McCain to the Labour Left and, for all I know, the British Conservatives too.

We got into this mess, it says, because we unleashed the forces of free-market capitalism. This is what you get when you let the animal spirits loose. We bought too willingly into all that 1980s ideology of deregulation and the primacy of markets. Government bowed out of the business of supervising and constraining the financial system. We need to realise the destructive folly of free markets and put the Government back in control. It's a convenient and compelling narrative but is deeply flawed both in its historical account and its prescription.

First, the mess we're in cannot simply be ascribed to an insufficiency of government intervention. It's true that some better regulation would have helped but in important respects there has been way too much government intervention.

Take the US mortgage market at the heart of the present crisis. One of the largest sources of the problem is the role of Fannie Mae and Freddie Mac, the giant US mortgage companies, government-sponsored enterprises that hold or guarantee almost half of America's $11 trillion mortgage market. They facilitated much of the explosion of the mortgage-backed securities market in the US and they did so because investors always believed that these oddly public-private hybrids carried an implicit government guarantee. (They were right.)

Critics gave warning repeatedly that if they were not scaled back they would threaten the stability of the whole financial system. (They were right again.)

The idea that these two collapsing behemoths somehow represent a failure of the market is about as plausible as saying that the collapsing boxer falling to his knees somehow represents a failure of the canvas.

Nor is it the case, as capitalism's critics maintain, that the regulatory structure has been dismantled. On the contrary, the US system of financial regulation has been built up over the years into a staggering skyscraper of rules and institutions that induce a sort of governing paralysis.

The regulatory framework is not too small. It is a mess, multiplicated in many areas among different state and federal agencies, and completely lacking in others. It is developed on a base that was created in the 1930s to deal with a wholly different financial environment. Most of those still extant rules that deal, for example with commercial banks, are redundant, while others that should be in place to deal, for example, with investment banks, are not there.

Or take the UK model - please, take the UK model. Tripartite regulation between the Treasury, the Bank of England and the Financial Services Authority was a work of genius - until someone rediscovered the old truth that when you have three people in charge of something no one is really in charge. Again this is not lack of regulation. It is the wrong sort of regulation, misdirected, incoherent and in some respects, excessive.

Or consider another example in which tight regulation is actually hampering economic recovery. Under international financial rules, banks are required to maintain a core capital base as a proportion of their total balance sheet. But in a financial catastrophe, as capital dwindles and assets become riskier, those rules require banks to cut their lending and investments, driving deeper into the vicious circle

The need is not for more regulation but for more relevant regulation, a more intelligent and targeted role for government that acknowledges the essential wisdom of markets but acts to protect the weakest from their excesses.

That might certainly mean a more active role for supervisors in examining bank balance sheets. But it is more likely to require not aggressive government intervention, but simply the insistence on better provision of information to avoid the chaos created in the past year because investors didn't have a clue about the quality of many of the assets that they held. And in some respects it might even require less public involvement in, or restraint of, the economy: for example, the dismantling of the US mortgage giants and perhaps less onerous restrictions on bank lending when the economy is contracting.

We certainly don't need a system based on the wholly implausible proposition that, in the end, government knows better than people. We should resist at all costs the historically challenged claim that politicians, or the officials they appoint, can possibly know better than free, liquid, well-informed markets in which, every day, hundreds of millions of people put their own money on the line to choose their own future.