Saturday, November 13, 2010

EconomicsUSA: Dodd-Frank Law: Prof Bainbridge on Edward Kane's call for regulating the regulators of the economy blog has a long quote that I'm requoting from Edward Kane.  Stepen Bainbridge himself gets in on the topic, and sets out his gu+dl+inz on the matter:

Regulating Regulators: 
The Missing Element in Dodd-Frank

I really liked this post by Edward Kane on the flaw in Dodd-Frank:

The Act purports to reduce systemic risk by expanding and reallocating regulatory authority. But officials’ way of thinking about systemic risk neglects the pivotal role that political pressure and their own incentive structure play in generating it. During the pre-crisis housing bubble, regulatory and supervisory entities misdiagnosed and mishandled the buildup of systemic risk in part to transfer subsidies to financial institutions, homeowners, and builders. When the bubble burst, regulators billed taxpayers for financial-institution losses without weighing rescue costs against those of alternative programs and without documenting how their program would distribute benefits and costs across the populace. Along with the policy of near-zero interest rates (which also help to recapitalize insolvent institutions), the rescue policies chosen inflicted substantial losses on depositors, on future taxpayers, on pension plans, and on persons living on interest income. ...

The Act’s treatment plan presumes that the current crisis was caused by “defective” risk management at private institutions. This narrow theory of blame is inadequate in four ways. First, it excuses safety-net officials for caving to political pressure to expand the safety net during the bubble and subsequent crisis. Second, without addressing ongoing weaknesses in their incentive structures, it calls upon government agencies that failed society during the buildup (such as the SEC) to devise and enforce rules tough enough to prevent their clienteles from engendering future crisis. Third, by accepting this assignment without protest, agency leaders have set their staffs up to be scapegoated for future crisis. Fourth, the theory accepts the unlikely hypothesis that the interest-rate and default risk inherent in long-term nonrecourse mortgage instruments can be fairly and efficiently financed for years on end by short-term debt protected by the safety-net guarantees.

The idea that you can't understand the financial crisis and that you can't fix it without regulating the regulators themselves strikes me as absolutely right.

I don't think I agree with his solution to the problem, however:

... the US and other countries would be well advised to make regulatory careers more prestigious by establishing the equivalent of a publicly funded academy (i.e., a nonmilitary West Point) for financial regulators and welcome cadets from anywhere in the world.

I'm not sure a system of mandarins would be all that much of an improvement. Indeed, the French system of Écoles normales supérieures, which produces most French governmental and regulatory elites, has come under increasing criticism both for lacking true meritocracy and for producing like-minded graduates lacking true creativity.

Indeed, I am reminded of something Walter Bagehot wrote:

A bureaucracy is sure to think that its duty is to augment official power, official business, or official members, rather than to leave free the energies of mankind; it overdoes the quantity of government, as well as impairs its quality.   
Or, I would add, the art of government.

Imposing some form of market discipline on regulators strikes me as a far preferable solution.
-- EconoMix

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