Memo to Ben: Forget Making Rules - Get the Incentives Right

(MoneyWatch)  Federal Reserve Chairman Ben Bernanke and financial sage Paul Volcker were on Capitol Hill today arguing that the U.S. central bank should lead the fight against systemic risk.

But Carnegie Mellon University economist Allan Meltzer, who testified before the same House panel, explained why that's a losing battle: No one knows what the hell systemic risk really is. In his written testimony, Meltzer noted:

"Regulators talk a lot about systemic risk. They do not, and I believe cannot, give a tight operational definition. Setting up an agency to prevent systemic risk without a precise, operational definition is just another way to pick the public's purse. Systemic risk will forever remain in the eye of the viewer. Instead of shifting losses onto those that caused them, systemic-risk regulation will continue to transfer cost to the taxpayers. The regulators protect the bankers. They continue to lose sight of their responsibility to protect the public."

That's why it's foolish, in Meltzer's opinion, to think that a supreme council of financial regulators can deter whatever nameless economic menace is massing on the horizon. Especially if the head of that Super Friends-like assembly is the Treasury Secretary, as proposed under the financial reform plans circulating around Congress.

"This is not financial reform," Meltzer wrote. "It puts the biggest wolf in charge of the hen-house. Real financial reform requires that bankers, not regulators, monitor the risk on their balance sheet and accept their losses from mistakes."

He makes an important point, especially as lawmakers gnash their teeth over how best to configure U.S. regulatory agencies. It's not that sound financial supervision isn't necessary. It's that the free market -- if such a thing can still be said to exist -- is sometimes a better guardian of the financial system than regulation. Banks must fail. Investors must lose their shirts, and probably their pants, too. Bondholders must feel the pain.

Good rules matter, but economic incentives matter more.

Image from Flickr user Talwand