Financial regulation and monetary policy - (3)

While safety nets are probably much more harmful than useful, as they create the illusion of stability and incentize instability-creating risk taking in the long run, the case for or against regulations is probably more complicated.

A distinction could be made between actions which add to risk without adding to efficiency, which could be regulated with no opportunity costs in terms of foregone output; and actions which add to risk but also add to efficiency. In the latter case, regulations will impact both bad entrepreneurial decisions induced by moral hazard and good ones which result in a better allocation of productive resources: distinguishing between the two is necessary to minimize the output loss due to the quest for higher stability, but involves a knowledge problem, as market information about risks and returns are distorted, by assumption, and regulators cannot use them as guidelines.

Prudential regulations avoiding the former type of market actions are good for the economy, whereas prudential regulations of the latter type will be difficult to evaluate, and probably harmful for growth and efficiency. Public choice problems could be added to the bill, but I would like to highlight another potential problem which is more seldom taken into account: the very same "market failure" which induces entrepreneurs to make bad decisions will also induce entrepreneurs to circumvent regulations hampering his ability to exploit these profit opportunities.

If we consider the probably most relevant case (relevance is a concept that cannot be derived a priori but it is always relevant in the assessment of real market phenomena), i.e., "market failures" induced by safety nets, which we may dub "policy market failures", we have some sort of a schizophrenic policy.

Let's call "Ben" the source of policy moral hazard and "Dolly" the regulator (in the US, there are scores of regulators, and Dolly being the cloned sheep, I guess the name is quite apt). Ben induces policy moral hazard and entrepreneurs start behaving as masochistic morons; Dolly sees that there is something wrong with the process and starts regulating what entrepreneurs can do in order to limit their stupid behavior. Ben, however, will keep on inducing masochism on the market process by socializing risks and credit costs, and so entrepreneurs will have to forego profits in order to obey Dolly: the most likely result is that they will try to circumvent, and sometimes maybe corrupt, Dolly.

Ben increases the enforcement costs of Dolly's diktats. It undermines the effectiveness of her attempts and increases the real costs of turning entrepreuneurs away from dangerous activities. This doesn't mean that regulations are never useful, but that regulatory policies imposed upon a decentralized system which is subject to perverse incentives is likely to be terribly complicated, expensive and inefficient. All sorts of tricks, from off-balance sheet accounting to off-shore corporate chartering.

The usefulness of exogenous regulations without policy moral hazard would be probably quite limited, and, besides, the entrepreneurial process is quite likely to be able to internalize many possible sources of "market failure". This implies that regulations may be mostly a solution (and quite often an additional problem) to a problem created by policymakers: if the political process were rational and efficient, it is likely that no such policies would exist.

However, it is so evident that policies often tend to be counterproductive, and that their inefficiency is quite never considered sufficient reason to avoid them, that it comes as no surprise that the best strategy is not often the chosen one. Even if it were intellectually evident that interventionist monetary policies are always counterproductive and that regulations wouldn't be necessary without them (I think these two statements are too strong, but not too much), it would be extremely unlikely that governments avoided the abuse of a policy instrument capable of reducing the cost of their debt, please voters by causing booms, postpone the redde rationem of economic restructuring when an unsustainable boom comes to its end, fund their activities, and give privileges to lobbies.

We have an aut aut. Either we have free markets that, because of policy moral hazard, will be rather dysfunctional and unstable, or we have a constrained market system, possibly with an evergrowing web of regulations imposed upon it, which will cause inefficiency in terms of foregone output and growth. We could solve the problem, or at least reduce it very much, by restablishing entrepreneurial responsibility by removing countercyclical policies, and this would likely reduce the usefulness of external regulations (endogeneous, i.e., entrepreneurial, regulations is led astray by policy moral hazard and thus cannot be trusted upon in these conditions); or we can keep on having the present system, but it is unlikely to be beneficial to society as a whole, other than politicians and lobbyists.

I think there must be some sort of a universal tendency in politics to hamper the working of decentralized institutions in order to substitute political subordination to market coordination. Cost socialization is the weapon of choice to convince everybody to evolve power toward the ruling elite in order to avoid the dysfunctionalities of a market process turned tragedy of the commons.