Friday, February 25, 2011

Financial Regulation and Efficient Markets

Mark J. Perry (left) authors the Carpe Diem blog, on my favorite blog list. If you only read one economics blog, that would be the one. He exposes myths that surround economic thought, and is my counterweight to Krugman, along with Greg Mankiw. Recently, he authored an article that takes an approach to financial regulation that I have been advocating for some time. (Yes, I am bragging, but sometimes it's good to get confirmation about one's approach to the issues.) The article argues that what is really necessary for more effective regulation of banks is higher capital requirements. Along with co-author Robert Dell, they discuss the inadequacy of risk assessment in capital markets.

Through coincidental timing these concepts dovetail nicely with Roman Frydman's (right) concepts advanced in his latest book. Interestingly, Frydman ultimately argues for greater regulation of banks, but I believe that his work can be used to show that while regulation is possible and even necessary, it can be accomplished at lower cost and with greater transparency than accrues to the Dodd-Frank bill.

But a word of caution. For many years, as a libertarian, I subscribed to theories of efficient markets that underpinned my beliefs regarding financial regulation. Events and research have shown that markets are not always efficient in this sense, asset prices do not always accurately reflect all publicly available information. How can this be? There is no incentive for a prospective buyer to pay more for an asset than it is worth, nor for a seller to receive less, so market forces should force prices to equilibrium reflecting known information. Empirically, we have seen that this does not happen. Bubbles exist, the most recent one in housing, before that in technology stocks and the original one in tulips. However, in libertarian thought, there is a strong belief that since markets are efficient, governments should never try to "outsmart" the markets in an attempt to prevent the collapse of bubbles that bring with them attendant economic calamity. If we give up the efficient markets argument, we must make the argument for non-intervention with more subtlety.

As to why markets aren't always efficient, Frydman hypothesizes that investors focus on a subset of all available information because of the uncertainties surrounding the relationships between given information, and more importantly the greater uncertainty of how other investors will respond to new information. He claims that these processes can never be fully modeled. He goes on to argue that central banks and regulators should intervene to limit excessive asset-price swings on the upside, just as they have on the downside. However, it is not explained how the central bank is to understand to any greater degree of certainty than investors as a group, what the correct range for an asset class would be.

Our response to the call for greater market intervention on the part of the federal government is countered not by citing efficient market theory, but only that government is prone to the same forces that cause investors as a class to make mistakes. That would be the end of it except for the fact that we have socialized the costs of asset price bubbles in our country, so we still cannot ignore the issue, even as Tea Partyers. Assets in a bubble are bought with loans from banks, or are used to secure loans from banks that in turn are insured by the public at large. Both the deposit insurance schemes and the operations of the Federal Reserve socialize these costs to the public as a whole through the government. (Even though deposit insurance is paid for by the banks, it is well understood that the government would not let the fund go broke.) This is the real problem addressed by the Dodd-Frank bill. However, the approach is unlikely to be effective because it relies on a shifting set of risk measurements that Frydman has shown might be subject to the same psychological forces that caused the asset bubble in the first place.

Perry and Dell point out that the issue of insolvency of these financial institutions can be easily rectified by strict capital reserve requirements. They show that actual capital reserves have fallen over the last century, despite various standards and treaties. Requiring more adequate reserves prevents bankruptcy and reduces the chance that your tax dollars or even worse, inflation will be used to make up these losses. Further, with reduced complexity of regulation, the cost to banks' operations will go down:One sensible reform is to reduce those subsidies to put debt and equity on a more equal footing.
Another is to substantially reduce regulatory costs, which, for depository institutions, may well exceed the cost of corporate income taxes. For example, the bank-affected provisions of the 2001 Patriot Act have not (to the best of our knowledge) led to the conviction of a single terrorist, but in 2003 raised the average labor costs of opening a new account from $7.75 to $22, according to an industry consultant.
Time does not permit an examination of the role of credit rating agencies in this space, but suffice to say that increased reserves would reduce dependency on this legally protected oligopoly.

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