Monday, September 22, 2008

You Can Never Have "Just One" Regulation

Arnold Kling at Econ Log,

Why worry about the clog in the first place? Because banks have some of these securities, they are marking these securities to market value, which means marking them way down. As a result, their balance sheets show a shortage of capital. To come back into compliance with regulations, they either have to sell new shares of stock (good luck with that) or curb lending. As they curb lending, the economy suffers.

So in order to comply with one regulation (mark to market, an accounting regulation), banks begin to violate another regulation (capital reserve requirements, a banking regulation). See once you regulate in one area, the incentive distortions lead to problems in others. Therefore, a regulation is needed to correct the distortion. Of course this inevitably leads to further incentive distortions. The process never ends.

In some modes of business people seem unfazed by unregulated activity. In others the thought is horrifying. I'll put banking in the horrifying category (along with education, health care, etc.). If you look at contagion effects due to psychology, you can make a case.

In unregulated activity it often may be difficult to perfectly align incentives. Markets don't always work perfectly. Two points though. First, we don't really know how a market in many areas would work since it have never enjoyed a true laissez-fair state. Second, simply because incentives are misaligned in an unregulated state doesn't justify regulation. The analysis is one of degree: to what degree are incentives aligned without the regulation vs. with the regulation. Just because a market can create unfavorable outcomes doesn't mean that there is automatically a top down regulatory solution to create more favorable outcomes.

Wednesday, September 17, 2008

American Revolution

Many Americans fiercely believe that the American revolution was justified. But a strong case can be made that it wasn't. Regardless of the moral justification of a revolution, revolution in general is pretty messy business. Revolution often results in a bloody mess ending with similar system of governance as before. The winning faction gains power and proceeds to abuse it.

A practical man in 1776 probably would have placed only a slight probably of success for the American revolution. Consider the odds against military victory alone. Next consider the odds of the formation of a stable, democratic government. Cost of defeat? Thousands of lives and a likely loss in degree of civil liberties. The benefit of victory? A gain in degree of civil liberties, but with a high variance in outcomes minus the cost of thousands of lives.

With this perspective maybe our founding fathers took some pretty large risks to secure a relatively small degree of liberties.

How did a stable government form? A big question in history for sure. I'll blurt out that it might have something to do with numerous competing factions instead of a single overthrowing party. The revolution succeeded militarily through the consolidation of the states. The same may be true for the success of government, but for opposite reasons. In order to remain a viable government they needed to consolidate to ward off future invaders. The initial pressure to form united states may have provided the pressure needed to keep diverse groups practical, enabling compromise. Although some states were clearly more powerful than others, the disparity of power seems thin. Equal yet competing agents may have been a critical ingredient towards the acceptance of disagreement and establishment of a tradition of compromise. The emergence of these cultural norms may have contributed to the production of both governmental stability and liberty.

Financial Crises and Regulation

Following a financial crisis the topic of regulation in inescapable. The default response by an overwhelming majority seems to be "we need more." Isn't there logically another response though? Couldn't it just as well be that we need less?