What could financial reform accomplish?

Historical perspective on what could be achieved

A very interesting question people often overlook when discussing financial regulation is: whether it can work? Often they just substitute an ideological predisposition. Well, in the sprit of fair disclosure, The Hedged Economist’s is a healthy skepticism. Another approach is to substitute political self-interests (either large cap or small cap political). No aspirations there. There also seems to be a tendency to want to punish someone. Well, for that, there are plenty of other very popular web sites and blogs.

In all likelihood, both good and bad will result from regulatory reform; some of it will be intended; some will come as a complete surprise. Nevertheless, previous postings mapped out an opinion on what will and won’t “work.” All of it was done without defining “work.” So, readers deserve a discussion of what can realistically be expected. Hopefully, some of the posting stand alone in terms of addressing specific issues, but overall and, especially with respect to systemic risk, more needs to be said.

Two approaches are possible. One looks at historical experience. The other tries to foresee what could be expected in the future. Historical experience can take into account intended and unintended consequences. Trying to foresee how regulations would work obviously can not include the unintended since it was unanticipated. So, let’s start with historical perspective and put off futurecasting for a future date.

Just to set the tone, consider This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff. In about 400 pages they make the case that different economic and financial crises aren’t different. Crises occur fairly regularly and have patterns. The authors point out that the crises occur under different forms of government, in advance and developing economies, and with all sorts of different regulatory frameworks. The authors do a great job of constructing a dataset where none previously existed. The authors also point out some important impediments to understanding economic and financial crises. Two of the impediments are the opacity of government accounts and the all too frequent myopic focus on explaining individual events without reference to factors common to multiple similar events.

It is all true as far as they go, but despite the breath of their coverage, their overall conclusion is unavoidable at the 400-pages-to-present-eight-centuries level. But, at a more detailed level, different crises are different. Some are more severe than others, and each has unique features both in its cause and its effect. None occurred automatically and none was unaffected by the action of players in the drama. A wise sage once said: “History doesn’t repeat itself, it rhymes.”

Their book clearly points out that totally eliminating crises isn’t a realistic expectation. Indirectly, it shows periods of relative stability between crises and variations in how pervasive different crises were. Thus, it helps set realistic upper and lower bounds on expectations. It is worth reading for that alone.

So much for general tone; now on to details. Managing any risk is a four step process. The first step is recognizing the risk. Then, one needs to know what to do about it. That would all be for naught without the authority to do something about it. Finally, managing a risk requires the will to do something about it.

Regarding the first step, recognizing the risk, recent experience and history should temper enthusiasm. Jim Cramer’s rant that “They know nothing” pointed out the first limitation. In order to manage systemic risk, one has to recognize that it is there. If a media rant isn’t your style, a reading of A History of the Federal Reserve: Volume 1, 1913-1951 by Allen H. Meltzer is well worth the time. I don’t make that recommendation lightly; it is almost 800 pages long. Abstracting from all the detail, it makes clear that often bad things happened when risks were miss-measured. There is a tendency to find an approach that works (e.g., a theory, a policy rule, a way of measuring things) and sticking with it too long.

We are essentially in a race to learn new things about our economic and financial environment faster than the environment generates new things to learn to understand. One encouraging sign is the effort to develop new ways to measure the relative tightness of credit markets. But, bottom line; this is the aspect of systemic risk that leads this economist to seek hedges. We just don’t know as much as we think we know. Hopefully, more focus on systemic risk would help.

That said; systemic risk was explicitly discussed after postings about a number of other proposals. No accident there. Since we can’t always see systemic risks, it made no sense to discuss systemic oversight without first discussing a regulatory framework that might be robust enough to offer a chance of withstanding the limits of our ability to see risks.

The second step, knowing what to do, is a little easier if we know what the risk is. Recent events seem to indicate that once the risk is recognized, appropriate actions can be identified. That seems to be true historically, too, although sometimes the lags have been very painful. There is an element of “we wouldn’t be here if it wasn’t so” to the historical argument, but it seems to stand up despite that. Regarding recent events, one only has to think about how much was done and how much was changed in a short period of time.

There is a caveat. The appropriate actions are appropriate in the moment. With hindsight that is colored by subsequent developments, they are no longer appropriate. But, the actions themselves and the reactions they set off are what make them obsolete. If a systemic risk regulator sees a risk and takes steps to eliminate it, after the fact, the steps were unnecessary; the risk went away. Speculating about alternative histories is fun, but seldom convincing. The only thing we know is that the risk went away.

For that reason, systemic risk oversight is a thankless task. Successes were unnecessary; the risk went away. Failures will be obvious; it is systemic risk, after all. Thus, any action, and even no action, is wrong by definition. Given that, it is legitimate to question the need for systemic oversight. Just waiting for crises to surface and responding after the fact may be the only realistic option. But, that should be easier if a systemic regulator has been thinking about it ahead of time. Perhaps that should be the primary job of the systemic risk oversight.

The third step, insuring that the regulator has authority to take the appropriate actions, creates the most danger. It is dangerous because it can be back-cast. Yes, after the fact we can see what we needed to do and the factors that kept us from doing them. It is always possible to think up new authority that would have made life easier.

That doesn’t prove that having additional powers means the risk would have been handled. Further, it doesn’t prove that addressing the problem armed with the options that, in hindsight, look desirable, would yield better results than were accomplished without them. Contrary to popular belief, hindsight isn’t twenty-twenty. Nor does it say anything about whether having those powers would just have created a need for other additional powers.

Realistically, one should expect constant pressure to expand the scope of oversight. But, whenever possible, an alternative to active oversight should be found. For example, trading derivative on exchanges and trading fees were discussed in previous postings. It isn’t realistic to think we could or should provide regulators with all the authority they think they need. The continuous quest for power is a real risk and a legitimate reason to question. A good risk regulator should identify instances where regulations produce systemic risk. If they don’t, that should be questioned.

The fourth step, being willing to take action is not trivial. It is closely related to the first two steps. If the risk is in doubt, or the right response is in question, hesitation may be a legitimate response. More than likely, hubris will lead to times when hesitation is the right response, but action is taken anyway. Type one and type two errors are both possible.

However, for the moment, assume omnipotence on the part of regulators. (OK, you can stop laughing now). Even when the right action is known, all sorts of impediments can occur. Regulator capture will undoubtedly occur and down right corruption is a real risk. But regulatory reform should as least make it clearer who we should be point a finger at.

The mainstay of any regulatory reform has to be rules not regulators, but regulators have a role. A systemic risk regulator has a role, but it isn’t a second coming. Just a little bit better is all we should expect from regulatory reform and focused oversight. To expect more is unrealistic. But, to settle for less is unnecessary. If we can avoid repeating the mistakes of the past, we should. We will invent new mistakes to replace them.