Wednesday, September 16, 2009

Not what they had in mind

For everyone wondering how we got here, where "here" is the current state of financial market problems, government regulation and policies, bank bailouts, etc., economist (and blogger) Arnold Kling has produced a fantastic paper - Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008.

It's an outstanding look at the way that the solutions to past crises have caused, or at least significantly contributed to, current crises. The takeaway, as I see it (emphasis mine):
While considering alternative points of view concerning the causes of the financial crisis, the paper concludes that bank capital regulations were the most important causal factor in the crisis and that the policy “solutions” to previous financial and economic crises sowed the seeds for this current is worth pointing out that housing policy and bank regulatory policy evolved out of previous crises. The lesson is that financial regulation is not like a math problem, where once you solve it the problem stays solved. Instead, a regulatory regime elicits responses from firms in the private sector. As financial institutions adapt to regulations, they seek to maximize returns within the regulatory constraints. This takes the institutions in the direction of constantly seeking to reduce the regulatory “tax” by pushing to amend rules and by coming up with practices that are within the letter of the rules but contrary to their spirit. This natural process of seeking to maximize profits places any regulatory regime under continual assault, so that over time the regime’s ability to prevent crises degrades.


history suggests that as policy makers respond to one crisis, their solutions can set the stage for the next crisis. There is a significant difference between hindsight and foresight
Given this contrast between hindsight and the realtime perspective, the government needs to display some humility in promising to prevent future financial crises. The history of past regulatory mistakes suggests that we will not come up with a fool-proof system going forward. In fact, there is a risk of creating a financial system even more dependent on centralized regulation, which could leave it at least as vulnerable to catastrophic failure.

Bottom-line - the law of unintended consequences is as remorseless and unavoidable as the law of gravity. It is a point that those who seek further government action and intervention, in the health care system, for example, would do well to consider.

(H/T: Veronique de Rugy in The Corner.)

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