The short essay on the financial crisis, and potential remedies, is here and it offers a Hayekian skepticism about many suggested solutions. Excerpt:
Attempts to repair the system from the top-down will fail. We must find ways to let bottom-up solutions emerge.
Is this a crazy question?
Why doesn’t a Hayekian view compel us to “leave the regulators alone,” since they are only individual actors (albeit with a lot of power) doing what seems best to them? And they are embedded within a system of incentives that rewards good performance (however imperfectly or indirectly).
If the answer is “the regulators are too powerful” or “their incentives aren’t aligned properly” then why doesn’t this also apply to very very powerful private actors? (Such as the multibillion-dollar financial bigwigs, with significant market power)
@mk
The regulators don’t have an incentive to make good, fair rules. They have incentives to change the rules to favor powerful political groups. Those political groups are the very powerful private actors you speak of. This is what regulatory capture is.
On their own, very powerful private actors can’t use their opponents money for their own gain. By co-opting regulators (or legislators), however, they can. This gives them much more power than their market power would be. In short regulators are a force multiplier for the politically powerful.
So, the problem with regulation isn’t government in a vacuum or private actors in a vacuume, its the union of both. Its easy to remember how this works if you think of it this way: “Good law is a public good, bad law is a private good.” This is why we see a large tragedy of the commons with regard to law in the united states.
Woops, sorry about the double post.
An airplane crashes and everyone on board dies. The investigatory committee decides to be novel and employs the famous economist Russel Roberts to investigate.
Eventually he returns with a report. “There was nothing wrong with the plane”, he declares.
To the stunned committee, he explains: “Well, asking any engineer to determine the causes of the crash is clearly flawed. Such an engineer – or, in fact, any expert – would be careless with other people’s lives and would benefit from none of the decentralized information in the market. And there are obvious symbiotic relationships between such engineers and those who construct planes. So, who to ask?
The market, of course! And who has the best incentives of all? The people on the plane! Mere CEOs have money on the line; these people have their lives on the line! Clearly the decentralized information in the market, which as Hayek might argue was superior to anything an engineer may imagine he can understand, would tell them whether the plane would crash.
And they boarded the plane anyway, so clearly there was nothing wrong with it.”
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The sword of Hayekian information decentralization cuts both ways. Roberts cites Stern and Feldman to suggest that CEOs only made mistakes because they were playing with someone else’s money; “They were more prudent with their own”. But that money they were playing with was ultimately their shareholder’s money – and shareholders ultimately appoint CEOs! Does Roberts have an explanation of why shareholders fouled up with their own money?
@Doc : Do you also believe guns kill, not people who wield them.
Russ Roberts (and I suspect Tyler Cowen) has professed a world view where “natural feedback loops” will provide the balance between risk taking and prudence.
A couple of creases, though. The idea of natural feedback loops is extremely idealistic and seductively simple. However, it doesn’t explain for the principal-agent problem. When shareholder interests and those of the agents make decisions on their behalf diverge, it results in situations where Fuld and Cayne were able to stash away substantial compensations in cash with shareholders unwilling to do anything about it. And why were the shareholders unwilling and seemingly heedless of the excess leveraging built up by Bear and Lehman?
That brings me to the second crease. These “natural feedback loops” that regulate risk and return don’t act instantaneously. Because of the momentum effect within markets, extreme valuations build up in the market and the market frequently overshoots (both on the positive and negative side) what any theoretical equilibrium is supposed to dictate.
I don’t disagree with any of the other points made about the venality of politicians and policy makers, or about abandoning the “too-big-to-fail” doctrine. I think that’s all fine. But expecting that these adjustments will take place through bottom-up solutions is simplistic thoerizing. Bottom-up “feedback loops” have been given their chance as well and have not proven to succeed.
Krish, in practically every way, the regulations & regulators in place made the imperfections in the feedback loops much, much worse, for the simple matter that it’s all a feedback loop, but the top-down authorities can’t be dynamic enough. Why do you want to keep the regulation at the expense of the feedback?
Regulations & tax incentives: favor debt over equity, pull every corporation to a highly leveraged position & remove customer & investor checks that would punish leverage, pull consumers into highly leveraged & non-diversified real estate holdings, created the disconnect between mortgage originators & holders, favor highly leveraged deferred compensation schemes. The list goes on.
So, bottom-up feedback gets blamed because in reality it can lead to some boom & bust behavior, but the regulations that explode the boom & bust can’t be blamed because, in some alternate universe just the right regulations would make everything work just right?
You can’t possibly say that this industry, under this regulatory framework was a test & failure of bottom-up feedback. Some form of subordinated debt financing could single-handedly replace all the regulations concerning leverage & deposit insurance & do a much better job of it. If that was ever given a chance & failed, then you can blame bottom-up feedback.
mk: We can integrate skepticism of top-down concentrated power, whether public or private, into one holistic view. If we have a small number of regulatory institutions regulating a large number of corporations, then the latter are distributed or “bottom-up”. If we have a large number of regulators and a small number of companies, it is the reverse.
Jeffrey Friedman argues that Roberts is wrong about the importance of CEOs having “skin in the game”. I didn’t read Roberts’ essay, but I thought he had already heard the CRA angle was as debunked as that of Graham-Leach/Glass-Steagal.
@Floccina, sounds good to me.
Or to put it another way, is Roberts part of a “natural feedback loop”? If not, what the hell is he doing?
The entire Federal Reserve system encourages leveraged bets, something that in a zero-sum business hardly makes sense. This is on “unregulated” in that the supporters of this system cannot conceive of any alternative other than technoctratic over-control. If people want to leverage up to steal market share, they should bet with their own money, not guaranteed money from the government or dollars from The Fed.
The shareholders could have been informed about the risk to the banks, and been ok with it. Since they get rewarded on the upside, with dividends, they can accept a high-risk high-gain strategy. The banks bondholders don’t get the upside, but theirs was a low-risk low-gain strategy. After all, they did get bailed out.
A billionaire is responsible with his money because a fool and his money are soon parted.
I think I would find the quoted conclusion (“Attempts to repair the system from the top-down will fail. We must find ways to let bottom-up solutions emerge.”) somewhat more convincing, if I did not suspect it was the page footer that Russ Roberts has put into his document template.
@ Doc,
You claimed that Canadian bank regulation was less regulatory than US banking regulation.
Prove it.
Everything I’ve read says the contrary.
I appreciate the feedback, folks. A longer version that deals with some of your issues will be available soon.
One point to make here–the Hayekian view does not argue that people don’t make mistakes. They make mistakes all the time. The secret is to create a system where people make mistakes with their own money rather than mine. The current system let’s people make mistakes with taxpayer money. That creates recklessness and systemic risk. More on how that also allows the execs to loot the taxpayer is here: http://cafehayek.com/2009/11/heads-they-win-tails-we-lose.html and here: http://cafehayek.com/2009/11/heads-they-win-tails-we-lose.html
Marc,
It’s a fair point. And I worried about it when I wrote the piece. But I wanted to right a forceful piece so I was a bit arrogant about our ignorance. I could be wrong. Maybe this time will be different. Maybe we’ll find the right set of regulations that avoid another meltdown or massive transfer from us to them. We’ll see.
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