How should financial markets be regulated?

• Author: Dowd, Kevin
• Position: Column

It is hard to imagine a more stupid or dangerous way of making decisions than by putting those decisions in the hands of people who pay no price for being wrong.

--Thomas Sowell

Financial regulation is a recurring and central issue in contemporary policy discussions. Typically, leftists want more of it, while proponents of free markets want less, or preferably, none of it. We would suggest, however, that the central issue is not whether markets should be regulated, but by whom--by the market itself, which includes self-regulation by market practitioners, or by the state or one of its agencies. To put it in Coasean terms, what is the most appropriate institutional arrangement by which markets--including financial markets--should be regulated?

This question is of fundamental importance to a sound retrospective assessment of the Federal Reserve and is a prerequisite for sound analysis of contemporaiy reform issues.

To answer this question, we should first consider what the term "regulate" actually means. The primary and oldest meaning is "to govern or direct according to rules." (1) However, the term is often used in modern discussions to mean "control by government agencies." This is a very different meaning, not least because government bureaucrats often follow no rules themselves. Instead, they have a vast amount of discretion to do as they please, make up the rules as they go along, and issue lots of regulations in the process.

Thus, regulation pertains to rules, but the term "rule" is itself ambiguous. Sometimes the noun 'rule" means a bedrock principle, but in other cases it refers to a stipulation from a rulebook. In the former sense, a rule is long-lasting and there are not too many of them; an example might be "Thou shalt not kill." In the latter sense, a rule is reminiscent of the growing micro-regulations drat abound in modem life. In this sense, a rule might merely be bureaucratic discretion written down.

It is then clear that all conceivable systems have rules or regulation in one form or another and the question at issue is not whether to have rules or regulation but, rather, what form they should take.

In this article, we explore this issue in the context of financial regulation in the United States--and, more precisely, we compare the very different systems of financial regulation that existed before and since the founding of the Federal Reserve System a century ago. We examine these systems from the perspective of how well they managed to constrain (or alternatively, encourage) excessive risk taking on the part of financial and other institutions, and we are particularly interested in contemporary systems of government-sponsored financial regulation such as Basel, Dodd-Frank, and the financial regulation provided by the monetary policies of the Federal Reserve itself.

The storyline is one in which risk-taking discipline of the original system was eroded over time by a series of government interventions that not only kicked away the earlier constraints against excess risk taking but strongly encouraged such risk taking, and so made the financial system increasingly unstable. In the process, the "tight" rules and self-managing character of the earlier system gave way to more active management (or rather, mismanagement) and growing discretionary (and largely unaccountable) power on the part of the bureaucrats who ran the system with their ever-longer rulebooks. In short, a basically good system became bad, and then worse.

We also emphasize the importance of the monetary backdrop. In the old system, the discipline of the gold standard served to provide a stable monetary environment that helped to rein in excessive risk taking. Once the Fed was established, however, it began to manage the system and first supersede and then replace the gold standard. It then pursued activist monetary policies that produced boom-bust cycles, with periods of low interest rates and loose credit feeding speculative bubbles and inflation, and leading to one crisis after another.

How could this happen? The answer is the usual suspects--the influence of bad ideas and interest groups subverting the coercive powers of the state for their own ends.

Before the Federal Reserve: Regulation by the Market

In the years before the Fed, regulation was provided by the market itself--that is, by the big players operating under competitive conditions. When crises occurred, they would be dealt with by industry leaders or by clearinghouse associations (see Timberlake 1984). These provided emergency loans and in some cases issued emergency currency. A distressed institution would seek assistance from the relevant club, and club leaders would consider the request and respond in their own interest. They would take account of the applicant's financial health, its reputation, and the overall impact of their decision, including the impact of possible localized contagion if they allowed an institution to fail. An institution that was in otherwise good health, and had been well run and had a good reputation, would be likely to get a favorable response. A badly run and ill-regarded institution would not. The good were helped and the bad were thrown to the wolves. Crises were quickly resolved and any contagion, where it occurred at all, was limited. The most famous example was the resolution of the 1907 crisis, orchestrated by J. P. Morgan from his personal library, while the government played no active role at all. (2)

There was little or no government involvement in resolving financial crises, although government intervention and legal restrictions were often important contributory causes of them. This said, by modem standards there was limited government involvement. (3)

It is worth pausing to consider the main features of this type of regulatory system, if we can even call it that:

* There was little formal regulation in modern sense.

* Such regulation as existed was created and operated by private bankers' clubs.

* Rules were usually informal and left considerable room for discretion on the part of decisionmakers. Indeed, their rulebooks are best understood as codes of good practice or guidelines that evolved in response to changing circumstances and lessons learned. Rules were highly functional.

* Rules were created by industry practitioners who understood their own business, operated under unlimited or extended personal liability, and placed great emphasis on reputation, both personal and institutional.

* The rule-malting process was self-interested and constrained both by the profit motive and by market forces. Those involved understood that bad regulations were costly and that they themselves would bear the cost: this was why rules were few and the regulatory burden light. There was also a process by which bad rules would be identified and weeded out. One could say that the rule-generation process was modest and subject to a robust error-correction mechanism--namely, the market itself.

* The competitive process also applied to the regulatory systems themselves: competition encouraged good innovations, which would be widely copied. Individual member institutions also had the option of opting out or joining other regulatory clubs; they could also set up new clubs of their own.

* Participants operated against the backdrop of the monetary discipline provided by the gold standard. By limiting money and credit, the gold standard helped to counter speculative excess, allowing overextended banks to fail and encouraging the survivors to conduct their business in a more responsible and less system-threatening way. The discipline of the gold standard also meant that interest rates and the cost of credit were largely beyond the control of individual institutions and more in line with market fundamentals than was later the case.

Each of these features is very different from what we see in the modern system. Underlying this system--indeed, making it possible--was a conventional wisdom that was much more pro laissez-faire than that prevailing today. Associated with this ideology were high levels of personal liability and personal responsibility that created strong incentives to keep costs down and rein in excess risk taking. These incentives created a system that had strong governance features and was highly effective--though by no means perfect--in controlling risk taking and handling financial crises when they occurred.

We now discuss how these key features were each overturned.

The Establishment of the Federal Reserve System and an Expansionary Fiat Monetary System

As a preliminary, we should emphasize that the period before the Fed was not some monetary idyll; far from it. There were repeated experiments with central banking in the earlier years and a considerable amount of monetary instability throughout much of the 19th century. Among the most notable examples were the crash of 1819, caused by the monetary excesses of the Fed's predecessor, the Second Bank of the United States; the disruption caused by the suspension of specie payments and the move to a wartime economy with the onset of the Civil War in 1861; and the crisis of 1873, which was due in no small part to the U.S. Treasury's greenback scheme and by government promotion of the Northern Pacific Railroad.

The United States formally adopted the gold standard only in 1879--a move intended essentially to revert to the status quo ante bellum, but with the importance difference that the new system was a de jure gold standard and not a bimetallism that functioned de facto as a gold standard. However, the gold standard was still highly controversial and bitterly opposed by the silver movement in the last decades of the 19th century--and became firmly established only with the victory of William McKinley over William Jennings Bryan in the presidential election of 1896 and the subsequent passage of the Gold Standard Act of 1900.

By then Britain had been on the gold standard...