Market Failure Cannot Be Resolved Without Regulation
Matthew Richardson, a professor at NYU Stern School of Business, offers his thoughts on risk management and the economy.
Market Failure Cannot Be Resolved Without Regulation
Matthew Richardson on November 23, 2010, 12:00 AM
I am all for free markets and not mucking them up with government intervention. But the economic theory of regulation tells us that if there is a market failure, it cannot be resolved privately. The public sector must get involved.
The most illustrative examples of such failures in U.S. financial markets were the frequent financial panics from the 1850s until the Great Depression. Those episodes taught us that when illiquid, asset holdings (e.g., loans) of the financial sector are financed short-term (e.g., by deposits), and are hit by a severe macroeconomic downturn, failures of financial firms can lead to system-wide runs on deposits. This in turn leads to a massive disruption of the system that provides credit to households and corporations. When economists bandy about the term systemic risk, this is the type of event they are referring to.
The market failure here is that, although each financial institution may have been behaving optimally on an individual basis, the firm had no incentive to take into account the effect of their actions on the system as a whole. In economics, we call this a negative externality and it is analogous to an industrial firm causing pollution. In the example above, financial failure of one bank increased the possibility of runs on other banks, leading to the system-wide collapse.
The government regulation to address the market failure in this case was to insure retail depositors against losses (today’s FDIC guarantee), thus stopping the cycle of bank runs. Of course, these government guarantees came at great cost, not least the resulting moral hazard. So the government had to enact offsetting regulation and charge banks premiums for deposit insurance, restrict them from certain risky activities, and subject them to prompt corrective action.
This served financial markets well for over a half century. As time passed, however, the regulation became antiquated. Over the last two decades, deposit premiums became mispriced, some financial firms like Fannie Mae and Freddie Mac grew so large that they became too-big-to-fail, and shadow banks—banks such as off-balance sheet vehicles, money market funds, and investment banks that operate outside of the system—proliferated, performing bank-like functions albeit with little or no regulation. In fact, in this financial crisis, we faced modern day equivalent runs on most of the shadow banking sector.
One might argue that the government is not capable of effective regulation and makes matters so much worse that it would be better to accept systemic risk and deregulate. But the legislative response to the Great Depression and its success would suggest otherwise.
And in terms of the government’s latest financial reform, the Dodd-Frank Act is clearly well intended by focusing regulation for the first time on systemic risk. Moreover, the legislation plugs some obvious holes in the financial system like off-balance sheet financing, OTC derivatives, rating agencies, and mortgage underwriting, among other areas. That said, the legislation ultimately falls short in both its approach and focus.
After a recent presentation to 170 or so risk management executives on Dodd-Frank, I took a quick poll and the vast majority believed another financial crisis was going to occur within the next ten years. This should not be surprising. The legislation does not charge systemically risky firms upfront for the systemic risk imposed upon others; instead, choosing to penalize surviving firms when a crisis occurs. This creates a free rider problem which will lead to a race to the bottom. Moreover, in terms of moral hazard, the legislation leaves in place mispriced government guarantees, and, with respect to excess leverage, conditions for regulatory arbitrage persist. There is also no attempt to create a level playing field by regulating shadow banks and banks similarly
Nevertheless, while there is little doubt that regulatory failure played an important role in the crisis, the solution should not be to walk away and leave systemic risk in place. I would still take Dodd-Frank over the current system or, more extreme, a world with zero financial regulation and frequent financial panics. But we still have plenty of wood to chop on the regulatory front. This is just the middle innings of a very long game ahead.
Matthew Richardson is a professor of finance at NYU Stern School of Business.
But since every market is plagued by some kind of market failure (if not several) — information asymmetries, market power, externalities — how can one realistically say this and still be in favour of free markets and opposed to government intervention
Marc, Maybe you can’t. Maybe there’s no such thing as a free market, because they all have to be regulated to some degree. Just recently here, we made something identical to fraud legal (XR GS and its short-sales of MBS’s designed to fail) while wiping out Glass-Stegal. Result–2007 when the derivatives and real estate bubbles busted. A law against fraud won’t make it disappear. But, since you have a penalty for outright it, you can enforce it. No regulators, no arrests and no penalties. Human nature is what it is. No human institution is self-regulating because people just can’t help being crooks. NancyO
Despite my being a free market zealot, I have to concur with Marc’s implied hypocrisy claim. If one believes in “market failures” at all, then one has no foundation from which to decry intervention.
Regarding financial panics, it’s instructive to explore what forces kept private bank rating agencies from arising, funded by bank consumers or sponsored by entities wishing to ingratiate themselves to those consumers. It’s also instructive to explore why bankers like “One Hundred Percent John” Nichols, president of the First National Bank of Englewood during the ’30s, were able to invite depositors to withdraw as much as they liked during panics.
Deposit insurance and other state “guarantees” can’t rid society of the risk inherent in human interactions. Such interventions simply disperse among all of society the pricing of the risk of credit transactions between private parties. They also perversely tend to foster more recklessness, and lead to an endless cycle of trying to plug holes as bankers find new ways to speculate.
“I am all for free markets and not mucking them up with government intervention.”
Government intervention? Is there such a thing as a market in the absence of enforced private property rights and enforced contracts?
Right you are, Rich. All property rights are legal constructs which are enforceable at law. Stealing is stealing whether it’s a whole house or a microwave. Nothing free about it. NO
It seems perfectly clear what the author meant. Whether you think he used the wrong terms is missing the point. Government involvement only insofar as is necessary for markets to function.
This means pricing externalities: theft, fraud, pricing consumption of public goods. A stable market is just as much a public good as a clean atmosphere. Someone who engages in transactions that destabilize a market is no different than someone who burns trash in their back yard or dumps toxic waste in a resevoir. They’re lowering their costs by increasing costs on everyone else.
Govenment is the ground upon which the field of markets is drawn.
Corporations do not exist without government, not to mention all contract law and land title. Implicit in all talk of ‘free markets’ is the assumption that markets and their institutional actors are emergent phenomena, from which springs the insane logic that corporations are people with rights. Rather they are abstractions.
Now one might say that government is an abstraction but 10,000 years of human history suggests it is a powerful one and in any case it predates the abstractions of law which governments used to create corporations and the ‘markets’ as we know them.
Or to put it another way the vast majority of free market true believers have their heads up their ass.
It seems a rather ho-hum observation at this point. I’ve even seen people dig up 250 year old Adam Smith quotes proving he was a closet pro-regulation type.
But this here may be news. All the SIVs we thought were hidden in Grand Cayman and Bermuda may really be in hidden Ireland…
http://golemxiv-credo.blogspot.com/2010/11/who-bankrupted-ireland.html
History does repeat. Regulations are “relaxed,” and the results are what we see today. This time around, we’re still suffering the consequences of Reagan’s deregulation frenzy.
Deregulation is a free pass for the rich to steal as much as they can.
I could be wrong, but I see where we are today, a two tier system, one side that has to adhere to the rules & regulations, the other who don’t. Somewhere along the line, the honest days wage for an honest days work, or the other way around, has ended up in the garbage can. The chase for the dollar has produced a culture that is unsustainable. The missing component here is when the lower tier take to the streets with the pitchforks? As we have witnessed, the gamming of the R & R’s seems to mirroe “Moore’s Law”, but at some point, like the “Ponzi” or “house of cards” reaches it’s limit and collapses upon itself. Yhis I believe is taking place today, which may be unstopable.
Regulation turns out to be cheap once you figure out how much the lack of it costs. I laugh derisively at the free market ideologues I work with who claimed that getting regulation out of transportation, telecom, finance, and energy would herald a new era of lower prices and greater efficiency…. “Really? Even after you pay for Enron, WorldCom, multiple major airline and bank bailouts and now clean up the BP mess? Really?”
Let’s make the defenders of deregulation factor in the costs of the (apparently inevitable) scams in their rhetoric. Account for the ripoffs then tell me how much we are going to save.
Please show me a market, any market, that operates under no regulation at all. All markets are backed by a set of rules because markets operate within societies. All societies operate under rules.
Wow! That is one of the most clear and concise explanations of what went wrong, why and how we’re failing to do anything about it. In your face academic program snobs; b-schools have good profs too (I had to add that as I am a b-school economics master).
To Rich S et al.: markets most certainly would exist in the absence of effective governement intervention. Contracts and property rights would simply be inforced by private armies and/or something like the mafia.
A great example is southern Italy. The Italian mafia serves a lot of the functions that elsewhere, including northern Italy, are occupied by government. (Sorry, I don’t recall where I read about this). I believe there is also some literature about the Mediterranean sea trade and how contracts were enforced by a type of private insurance scheme (again, forgetten reference).
What is generally meant by deregulation is “Regulation that suits me more so than it suits any other player.”
Regulation is a deterrent to our being ripped off. When you have it in place, it costs corporate thieves something to steal from us. When it’s not, the rip off costs them nothing. Of course, Milliken who spent a few years in jail during the 80’s for multiple counts of securities fraud, is now worth 2.1 billion dollars. The jail time was worth it because his personal wealth escaped unscathed and it was sufficient to set him up in business again. His wiki article describes him as a “financier and philanthropist.” It does not say, “convicted felon, financier and philanthropist.”
According to the article, Milliken “liberated vast sums of capital” from the outmoded businesses in which they were “buried”, thus pioneering the development of new methods of capital creation. Once liberated, the money just naturally followed him home and he took it in out of the kindness of his heart. I guess. I don’t see how any of this trickled down and I don’t see how what he did made the market free. Unless it’s a thieves’ market, not a free one. NancyO
Leroy–Yep. Good thinking. That’s also why hills in Europe often have the ruins of castles on ’em. In the past, the castles were how the local aristocrats kept people from stealing their stuff. They don’t need them any more because aristocrats don’t need private armies and household guards to keep people from stealing their stuff. They have laws and regulations to protect their property. We underlings benefit from the same laws/regs to a point. NancyO
i cannot understand why these conversations have so much life. How the devil would we be able to interact in a complex society if not for regulation of interaction, whether social, economic or political? The Constitution is a set of regulations. The bill of Rights is another set of regulations. The Amendments to the Constitution are yet another group of regulations which modified or added to the original list of regulations. That’s the definition of a political entity. We define acceptable behavior in all phases of society with regulations. That’s what we call a social organization, whether a club, city, corporation, state or country. Society, regulation is thy name.
Jack, rules/regulations can and do exist apart from territorial monopolies on violence (i.e., states). That distinction is why these conversations continue; many people are tired of the knee-jerk conflating of the state and order.
Poppies–You say that “…rules/regulations can and do exist apart from territorial monopolies on violence (i. e., states).” How do they exist apart from states? Also, how do you distinguish libertarian views on state regulation from anarchy? Finally, what do you put in place of the principle of social contract underlying modern Western democratic states? I assume you don’t want the mafia to govern. So, who would be acceptable as an arbitrator of disputes and reliable body to form agreements? NO
NO,
“How do (rules/regulations) exist apart from states?” – There are so many examples of purely market-derived rules and regulations that it’s hard to know where to begin. One simple example is the standardized shape of credit/debit cards; a firm could buck the rules, but no one would use their cards.
“How do you distinguish libertarian views… from anarchy?” – As an anarchist, I don’t really see much use for doing so. Historically, “libertarian” was a term used to describe anarchists.
“Finally, what do you put in place of the principle of social contract underlying modern Western democratic states? I assume you don’t want the mafia to govern. So, who would be acceptable as an arbitrator of disputes and reliable body to form agreements?” – If you’re truly interested in responses to these questions, I recommend “Responses to Ten Objections” by Roderick Long, it’s easily found online.
As I had said previously, “What is generally meant by deregulation is “Regulation that suits me more so than it suits any other player.” Play the semantic game all you like, but in the final analysis any and all societies are organized around complex sets of regulations. I can’t live in your apartment building without paying you rent because of a set of regulations. I can have some faith in the purity of the food that I buy regardless of its place of origin because of the existence of regulations. The roads I travel on, the airplanes that I fly in and the traffic controls on the roads where I travel are the result of regulations. How do I know that when I make a deposit of funds into my bank that I have a good likelihood of being able to access those funds at a later time if not for the existence of regulations? Free men may be free to risk their lives, but they are not free to risk mine as well, nor to adversely effect the quality of my life. That is the purpose of regulations, to keep the baser characteristics of human behavior in check in the public arena. The entire argument is little more than a sophomoric game of intellectual masturbation resulting in little more than smug self satisfaction encapsulated within a pretense of libertarianism. De Sade was a libertine in a time when the concept had some relevance, but recognized its own existence within a regulated environment. The modern libertarian would do well to follow his intellectual example.
In fact a large part of the fall of the roman empire was the rise of private armies and the feudal system where you went to a soldier for protection for a price. Eventually the local soldier became a nobleman and when central government in the west collapsed in 476 they became the de-facto government. If we go the no central government route we can go right back to the dark ages, which it appears the drug cartels in Mexico are trying to accomplish there, having accomplished it in Somalia. The Warlord evolves into the lord and then the aristocracy, and the winning warlord becomes king (see 1066 in England, for example)
Jack: “The entire argument is little more than a sophomoric game of intellectual masturbation resulting in little more than smug self satisfaction encapsulated within a pretense of libertarianism.”
Precisely.
Poppies–Thank you for your response. NancyO