Regulating Regulation

Government regulation wouldn’t get so much flak if administrations would only define and limit the activities they insure.

The Public Debate Misses an Important Point

Mention regulation and people often go ballistic. One set will moan about government interference in markets preventing people from doing what they want with their own property. Words like “freedom” and “liberty” might even come up. Another set of people will condemn capitalism, decrying the economic destruction wrought by market failures, and demanding that only governments be entrusted with something as important as the economy.

Debates such as these draw out the extreme notions behind regulation, but by doing so they obscure a critical function market regulation performs. These debates portray regulation as being all about prevention: regulate mortgage lending to prevent people from taking on dumb loans; regulate international finance to prevent banks from exposing themselves to significant risks that currencies will shift in value; and so on. Regulations should prevent some actions, especially if those actors are expecting to get bailed out by the government. The government in these cases should limit the sort of activities it insures.

Regulation and information

Regulation also generates information. Lack of information both underpinned this financial meltdown and led to bad policy decisions, then helped accelerate the pace of the crash in financial markets. No one appreciated the exposure of certain financial actors to specific types of risk. Some were overexposed to mortgage-backed securities; others had issued billions in cross-default swaps (a form of insurance). Since the market was unregulated, no one knew exactly who owed what to whom, or how much was at stake in these contracts. The U.S. government was willing to let Lehmann Brothers fail back in September because Lehmann Brothers had taken risks in unregulated markets. Why, then, should the government provide a bailout?

What the government had not foreseen was the knock-on effect. Many firms had purchased a form of insurance against Lehmann Brothers faltering on their contracts with AIG. That had been in another unregulated market. The collapse of Lehmann Brothers meant a massive loss for AIG, which, since it lacked information, the government could not foresee. Regulating markets doesn’t have to translate into blocking transactions; it can also mean monitoring the situation. Regulations that generate information about the sorts of risks actors are taking can lead to better policy decisions by government actors, but they can also allow private actors to make more informed decisions.

Public discussion about regulation needs to move away from the rhetoric generated by ideological views, and centre in on the more practical issues. Regulation can make private actors better off by providing them with better information, allowing markets to function better than they otherwise would. Who should be against improving the functioning of financial markets?

Takeaway Points

i) Regulation isn’t always about preventing or blocking private actors. It is also about providing information.

ii) Regulation can support wiser policy decisions by government, because on market activities, more information is better.

iii) Financial actors themselves need to know more about who has taken on what risks, if they want to make wiser decisions with their own money.