Financial regulation and monetary policy - (1)

A week ago or so I wrote a comment on Thinkmarkets about regulations. The comment, as usual, was too long not to be boring and too short to be clear. As on my blog I don't mind being boring, I'll try at least to be clearer.

This was the original O'Driscoll's post, this my comment and this is an interesting paper by O'Driscoll regarding market-based regulations, which probably helps understanding the post and the following flame about bananas (banana is a technical term: check this comment). What I'm going to say can be partly found in this conference paper, although that paper focuses on a slightly different issue.

Financial regulation is a technical issue and as all technical issues is... ridden with technicalities. However, behind the intricacies of real markets and real attempts to steer and constrain them, there are a few theoretical principles of wide applicability which can be analyzed abstracting from the details. This is a result of the dicothomy between theory and history stressed by Mises.

This first post is largely introductory, and somewhat obvious, at least for those who have been exposed to some Austrian economics.

Decentralized decision making

The first point to notice is that on average a market works because profits and losses make bad decision making costly. This is not an obvious point: profits and losses depend on prices and prices shall depend on some underlying economic reality in order to make market coordination meaningful. For instance, in a lake subject to a tragedy of the commons, the price of using the lake is zero, the price of replenishing the lake with fishes is zero, and thus no one ever replenishes the lake and everybody fishes as long as the other costs of fishing (i.e., the fishing rod) are lower than the price of fishes.

In this case market coordination is not a free lunch and some redefinition of the structure of the game is required in order to make decentralized decisionmaking efficient: this process of restructuring the market is a form of entrepreneurship and constraints on entrepreneurship (i.e., transaction costs) stand in the way of this process of internalizing costs and benefits. The alternative to entrepreneurship is policy regulation, which however raises some important problems.

To summarize: the market process does not always work on autopilot (i.e., private optimality is not necessarily social optimality), but some assumptions are required for its smooth working, for instance the absence of relevant externalities not internalized by the entrepreneurial process. This process of "internalization" is part of the market process itself (at least as understood by Austrian economists), and it is one of the most important aspect of the market process.

Policy-induced "market failures"

The second point to notice, tightly related to the previous one, is that there are policies which create tragedies of the commons (or, more in general, "market failures": a term which is quite strange because it means "failure of the assumptions of standard neoclassical economics", which is tantamount to consider the existence of air friction as a failure of the universe instead of elementary mechanics).

Examples abound. For instance, if the cost of deposit insurance were not risk-weighted, or if risk weights do not adequately reflect true market risks (and how could they? Bureaucrats are not omniscient, and cannot recour to the market process without distorting it too much to learn from it), there will be profit opportunities which will not be exploited and false profit opportunities that will be created. Underpriced risks are a form of moral hazard, and will induce inefficient risk taking.

It is more seldom explicitly recognized that also monetary policy has a moral hazard effect, even without bailouts, recapitalizations, deposit insurance, monetization of private assets, credit guarantees by governments and government agencies (such as Fannie and Freddie)... the reason is that monetary injections have distributional effects: what I could have bought with my old money will be bought by someone else with his new money. The result is that when something is bought with new money, the costs are shared by everyone has to face (counterfactually) higher prices. For instance, if the entrepreneur who gets a loan from the bank makes the price of machinery rise, it will harm all other entrepreneurs.

Under these conditions, I'm rather surprised things work

At this point, a question must be asked: how can anyone think that the market process can ever work under widespread, systematic and long-term monetary policies which create this cost socialization problem? If entrepreneurs can buy and sell goods by shifting part of the costs on other entrepreneurs, on final money-holders, or on other market agents (for instance, bond-holders receiving lower returns, tax-payers which have to refinance banks, etcetera), how can this decentralized market process lead to socially beneficial results?

The standard answer, of course, is to regulate. However, there are several problems with this approach.

[continues]