sabato 20 febbraio 2010

Financial regulation and monetary policy - (2)

Proven that decentralized decision making (e.g., the market process) can be lead astray by policies socializing costs and risks, because entrepreneurs will start exploiting the fake profit opportunities created by policy safety nets, and the entrepreneurial process of internalizing external costs is hampered by the possibility of exploiting the safety net, we are left with the option of regulating at least the most absurd aspects of market risk taking, for instance 30:1 financial leverage or 120 months/ 3 months maturity mismatch (mortgages vs abcp).

However, there are several problems with this approach.

First of all, regulations will both limit the entrepreneurial capacity of exploiting fake profit opportunities, thus increasing efficiency and lowering instability (moral hazard involves excessive risk taking, so limiting its effects involves increasing stability), and of exploiting real profit opportunities, thus hampering efficiency and growth.

Secondly, regulations will create an awful lot of public choice problems, which, considering that politics is rarely even close to be rational and efficient, will be usually beneficial to those in power and to organized pressure groups, but more rarely beneficial to society as a whole: I consider a matter of fact that few or no policies can be explained by assuming rational and benevolent politicians. In the field of monetary policies, given that the Fed in one century of existence has caused the Great Depression, the Great Inflation and now the Great Delevaring, I hold my tenet to be even more evident.

Thirdly, regulators can only use market-data conditional on other policies and regulations: risk prices distorted by moral hazard are all that a regulator can use to constrain risk-taking. As every market agent, policymakers included, cannot know more about the global state of the economy than prices tell them, distorted prices are a problem for the entrepreneur (which may be induced in error) and the regulator alike. It shall not be expected that the information destroyed by monetary policy interventions is available to regulators (and entrepreneurs): regulators are as blind as any other market participants when the price system is systematically distorted. This cost of hampering the market process will never be countervailed by regulations.

The first bottom line is that eliminating the source of moral hazard will enable the market process to work more stably and efficiently, and that no real alternative exists when the use of the market process is necessary to find and exploit information and to coordinate complex production plans. The intellectual division of labor enabled by the price system is effective as long as entrepreneurs foot their own bills. That's not what has been happening in financial markets, at least since Greenspan started his policy of systematic bailing out of those markets, if not in 1987, at least in 1990.

The second bottom line is that a systematic network of cost-socializing institutions and policies will hamper the market process and will result in squandering of resources and unproductive instability (this has nothing to do, contrary to Cowen's theory in "risk and business cycles", with choosing a point on the risk-return efficient frontier: moral hazard will enable additional risk taking even if it is not balanced by higher growth, so I'm talking of something completely different).

Bottom lines are, however, generally too clear cut. In Mises's terms, theory is accurate, often simple, and of universal validity, but history doesn't share these properties, and economic policies, like economic history and entrepreneurship, requires judgement and is never only a matter of pure theory. Thus, in the real world there are fuzzier cases than "the pure unhampered market process with no non-internalized relevant externalities" and "economic policies which systematically fail because of the knowledge problem", and, the causes of economic phenomena being never visible, the problem of causal imputation is never a theoretical problem, and often an untractable problem (in plain english: you can know that A causes C and that B causes C, but when you observe C, it's usually very difficult to say how much of the effect is due to A and how much to B).

What happens when markets have some element of inherent instability, other than that resulting from monetary policies and other sources of coordination failures among market participants? Can safety nets be justified? And can regulations be justified?

And, given that some safety net exists, is there a "second best" theory of optimal regulations that enable to smooth at least some of the problems created by moral hazard (or similar problems) which is not bound to failure because of some sort of a knowledge problem?

For what concerns the former objection, I would say that the existence of some tendency to instability inherent in the market process does not imply that market agents shall be shielded from the results of their own actions by safety nets. Unruly children are not made less unruly by overprotective parents: on the contrary, the more they smash their head against the floor, the less they will be likely to do stupid things. More seriously, to counteract the effects of some potential inherent instability by removing the private costs of bad decision making adds to the problem: it eliminates the only force that can internalize the potential sources of inefficiency, by removing the symptoms of the disease.

This is not, however, an argument against regulations limiting the possibilities of action of market participants, but only against safety nets: unruly children which are impeded to do stupid things may really cause less harm to themselves.


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