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Back to the Myth of the Rational Market

So Eric, you're saying that some financial regulations are pointless, some are counterproductive, and some actually do good. Sounds about right to me. But it's not what the die-hard rational marketeers of the 1970s and 1980s were saying. They didn't think any regulation (including the ones banning insider trading) made any sense. That's one of the key points of my book -- that this extremist view that markets always knew best took hold a generation ago, and even as it was picked apart by academic researchers in the 1990s, it continued to strengthen its hold on the popular imagination.

It strengthened its hold on the regulatory imagination, too: the Basel II capital standards are an unholy mix of (a) the conviction that financial regulation is needed and (b) the belief that said regulation should rely on market prices and on risk formulas devised by finance professors and their ilk.

Financial regulation is not going away
This makes me think of a saying I've heard attributed to the excellent economics blogger Arnold Kling (although I can't find it anywhere in his oeuvre):

MIT economists think markets are imperfect, therefore we need regulation.

Chicago economists think markets are perfect, therefore we don't need regulation.

George Mason economists think markets are imperfect, therefore we don't need regulation.

There's much to be said for the latter approach: Bad stuff's going to happen from time to time. Get used it. But political and regulatory reality is such that this mindset is never going to prevail. We will have financial regulations. So they ought to take explicitly into account the reality that financial markets tend to overshoot. In an opinion piece in the Financial Times on Wednesday, economist Richard Thaler offered this verdict:
While imperfect, financial markets are still the best way to allocate capital. Even so, knowing that prices can be wrong suggests that governments could usefully adopt automatic stabilising activity, such as linking the down-payment for mortgages to a measure of real estate frothiness or ensuring that bank reserve requirements are set dynamically according to market conditions. After all, the market price is not always right.
Again, that sounds about right to me.

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