Saturday, October 24, 2009

Idealogy for regulators

In today’s FT supplement on the Future of Finance, John Authors describes two ideologically different approaches to regulation, each requiring a different response to the financial crisis.

First, there are Minsky-ists, who believe governments should intervene to stabilise inherently flawed markets, he writes. Then there are Mises-ites, who believe government should never intervene because they always distorts things.

Followers of both economists correctly predicted the crunch and Authors concludes that regulatory reform can only be achieved after a nasty and ideological fight between them.

He is right that ideology is at the heart of regulatory reform, as proved by the comedy protests against Lord Turner after the FSA chairman dared to ask if the financial sector had grown too big for its boots, and the slow progress resolving the Too Big Too Fail problem.

Ideologically, whether you follow Hyman Minsky or Ludwig von Mises depends on whether you think markets can ever work properly.

In the fairy-tale world of economic theory, markets operate in “perfect competition” when certain pre-conditions exist: an infinite pool of buyers and sellers, no barriers to entry, equal and full access to information, no transaction costs, homogeneity of goods from different suppliers, and an in-built motivation to profit.

In the real world, or at least in financial markets, the only one of these you can rely on is the profit motive. The others are mostly fantasy, and it is the regulators' job to bridge the gap.

For example, buyers and sellers are limited so we have liquidity rules; information is tricky, so we have disclosure and insider dealing rules. And so on.

But in the post-crisis world, regulation should not limit itself to perfecting competition. Lord Turner’s sensible questions about social utility and size remind us that finance is about more than just economics.

So while regulators are in philosophical mood, here are some extra ideals they could think about, which might also help the financial sector win back some trust:
  1. Assess financial activity by its real economic impact. Discourage rent-seeking and favour wealth creation over wealth transfer. Demand enough transparency to make this assessment
  2. Keep ownership and responsibility together wherever possible. Permit separations, for example in securitsation, only where it is proved to create growth and not endanger the system
  3. Enforce the duty of care that agents owe to their principals, actively police conflicts of interest, and ensure transaction fees are disclosed
  4. Require pre-approval of excessive renumeration packages to ensure they are not one-way bets or wealth transfers
  5. Pre-license financial innovations
  6. Allow enough speculation to keep secondary markets liquid but no more

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