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Why Self-Regulation of the Financial System Won't Work

I want to finish this up this Blog War by broadening the discussion beyond the regulation of hedge funds to how attitudes toward regulation in general have changed in recent years, and how that helped set the stage for the current crisis. In the process, I also want to take on Houman's point that we can't trust regulators because they fell down on the job and let this crisis happen.

As I described in my first post, after decades of instability in the 1800s and early 1900s, followed by the massive bank failures of the early 1930s, new regulations helped stabilize the banking system. The result was 60 years of calm in the financial sector. That's hardly a failure of regulation. It wasn't until the shadow banking system began growing outside of the regulatory umbrella that problems began to reemerge.

Two major regulatory mistakes
I believe we made two regulatory mistakes that contributed to the present financial crisis. First, the deregulation movement beginning in the 1970s was based upon the belief that markets are self-regulating, even to the extent of self-repairing market failures. Even the regulation that remained was, in many cases, not imposed vigorously.

Second, we didn't focus enough on macroeconomic stability. I think we came to believe that a large crash of the economy was extremely unlikely, particularly one driven by problems in the financial sector. Several factors were responsible for this. One was that the transformative financial innovation of recent decades -- particularly the slicing and dicing of mortgages and other assets into many complex financial products -- was supposed to distribute risk broadly and prevent collapse. After the mid-1980s we had the "Great Moderation" when the variability of output fell significantly and inflation stabilized at low levels, and this was widely attributed to the skill of policymakers and the deregulation of the economy. Because policy had improved, and because we believed the economy was more stable due to deregulation, we let our guard down and thought big crashes were a thing of the past.

Hopefully, we have been adequately reminded that large recessions can still happen, and that will motivate us to take the regulatory steps needed to bring more stability to the financial system. Some people argue that any new regulation needs to wait until the financial sector has stabilized to avoid creating another source of uncertainty, a view that has merit. But the will and hence our ability to impose new regulation will likely diminish when the economy recovers, and if we wait too long to get started, opposition to any new regulation may carry the day, and we'll fail to get the measures we need put into place. The time to start is now.

Final points
But what of the charge that regulators blew it and caused this crisis, and therefore we would be foolish to rely upon them for stability in the future? First, I don't think decades of stability is a failure by any definition, and the recent failure was driven by an ideological belief that markets are self-regulating and hence best left alone. Most markets can be left alone, but as even Alan Greenspan recently acknowledged, financial markets are not among them. Second, the recent failure didn't happen because regulators were incapable of doing better; it was their belief in the self-healing power of markets that stopped them from intervening as needed. With different beliefs and a different framework for approaching the problem, the outcome would have been much different.

So I'm not ready to throw up my hands and say this is too hard, and either the private sector finds a way to take care of itself or it doesn't get done at all. We have the capacity to learn from our mistakes, to drop ideologies and theoretical constructs that led us astray, and I have faith we will do just that. Greenspan's conversion is a prime example. But if we fail to take the steps that are needed and rely too much on private markets to regulate themselves, we are setting ourselves up for this to happen all over again.

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