18 April 2008

Financial Regulation

I think its fair to say that the financial industry has not been admirable over the last few years. One of the best accounts of what went wrong is this:

Prince was saying he was constrained to follow the conventional wisdom, even when it was palpably insane.

It is therefore understandable that people are saying the manifest errors of the industry should have been restrained by regulators. Given that governments end up bailing out the casualties, it cannot be denied that government has the authority to attempt to prevent such bailouts becoming necessary.

The question is not whether the government is entitled to prevent excesses, it's whether it would actually succeed in doing so. Is it really the case that politicians or civil servants will be less influenced by the crowd effect of conventional wisdom than are financial executives with, in some cases, millions of their own on their line?

One year ago, there was no motivation for regulators to get banks to cut down on lending, to stop buying mortgages, and so on, even if the powers existed for them to do that (which, to a degree, they do). If you are asking regulators to prevent bubbles, you are asking them to outguess the market, which, while not impossible, is not something I would generally expect them to achieve.

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