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.

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