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Now Showing: Government vs. Free Market

In the aftermath of the financial crisis, the lines between government and free markets are being fundamentally redrawn. As a new world financial order emerges, laying down some objective principles will help.

On November 15th, leaders of the world's top 20 economies will meet in Washington, D.C. to decide what financial regulation will look like in future. The creation of this new world financial order is at once a historic opportunity and a task of immense responsibility. People are already referring to the Nov. 15th summit as Bretton Woods II, thus equating it with the conference that created the post-war world financial order that endures to this day.

With the notable exception of the US, almost all the leaders who will be in attendance have already weighed in in favor of greater regulation of the financial markets (see, for example, here, here, here, here and here ) and so we are inevitably entering an era of increased regulation. In this 2-part essay I will analyze past trends in financial regulation, and outline some principles that a financial regulatory regime must adhere to. I will revisit this topic after mid-Nov. and evaluate the outcomes of the Nov. 15th summit in the light of these principles.

 

By and large, most people agree that government should play a role in reining in the free play of markets, with a view to promoting various social goals. In the world of finance, this translates into the government playing the role of financial regulator, or the overseer of banks and allied financial institutions to ensure systemic stability and to protect the small investor.

Regulatory fervor, and government's role in it, has waxed and waned over the past century or so. Various events that have occurred from time to time have caused the intensity of regulation to increase or decrease. A series of ruinous runs on banks over the centuries, the US panic of 1907 and of course the Great Depression of the 1930s are a few cataclysmic events that brought home the need for greater financial regulation*. Then, in the 1970s, a series of developments including the abolition of the gold standard, the oil shock and stubborn stagflation brought about a reversal in thinking. Led by intellectual gurus such as Milton Friedman and political leaders such as Reagan and Thatcher, a long period of deregulation began that continued into the 21st century riding on the able shoulders of Alan Greenspan. Thus, the winds of financial regulation can be said to have peaked around 1970 and have been in decline ever since.

Until last month. When any system fails, the tide of opinion often turns against whatever that system represents. Sure enough, when the bottom fell out of the world's financial markets in mid-September, there was clamor (much of it an over-reaction) to the effect that this was nothing less than a failure of free markets. As I noted in my post on this blog on Sep 23rd, voices emerged which held that the upheavals prove that the free market system is fundamentally flawed. As the crisis played out, these voices only strengthened, prompting the Economist to write on Oct. 16th that  "economic liberty is under attack and capitalism, the system which embodies it, is at bay". Newsweek in its Oct 13th cover story said, "it's not just bank solvency that's being questioned, but the entire Anglo-Saxon capitalist system". And on Oct. 23rd, Uber-regulator Alan Greenspan acknowledged in congressional testimony that his belief in the "self-correcting power of free markets", and in banks' ability to self-regulate was shaken.

While it was sad to see the man who so recently strode the world of finance as a colossus being reduced to defending his legacy against accusations of laxity in regulatory duties, this was also a sobering lesson that regulation is too important to be left to the banks - government must play a bigger role.

But how much bigger a role? Where do we draw the line between government and free markets? How much regulation is "just right"?

While nobody in the world knows the definitive answer to that question, I believe it is both a necessary and a feasible endeavor to outline some objective principles that can help define what this "right" level of regulation should be. And in Part 2 of this essay, to be published early next week, I will do precisely that.

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* Indeed, much of today's regulatory infrastructure - the Federal Reserve, the FDIC and the SEC in the US, and many similar authorities worldwide - is a product of these cataclysmic events.

Comments

I will wait for minutes of this meeting and hope that leaders don't question the basics too much.

The top economies shouldn't interfere with free markets but they must regulate the greed of top management of financial institutes. It looks childish but the governments should put a cap on bonuses and link it with dividend distribution to shareholders in proportion with total profits earned and total revenue.

My opinion is it may not be the right time to review risk models and regulations. The present scenario may not be suitable to have a neutral debate because the emotions and frustration from the current turmoil will throw its weight behind more government control.

I found today an editorial in Business Standard relevant to our discussion. Hence,am sharing the link.

http://www.business-standard.com/india/storypage.php?autono=339665

Santosh, thanks for the link to the edit.

Broadening the IMF's mandate to act as some kind of super-regulator broadly fits into the 'regulation by coordinated action' pattern I've outlined in Part 2 of this post. Such a regulatory action would be 'high cost' because, as the Business Standard edit observes, getting 180 countries to agree will be an uphill task. Also the IMF, which already does some regulation by 'proxy' of borrower nations (by stipulating inflation targets, for example) is likely to need extensive reengineering to do more.
The benefits may be slim as any multilateral institution has to cater to a great diversity of expectations, and usually ends up catering to the lowest common denominator. This lowest denominator is most often so low that it pleases hardly any one at all. Thus, such an action would not be recommended by the principles outlined in that post.

When any system fails, the tide of opinion often turns against whatever that system represents. Sure enough, when the bottom fell out of the world's financial markets in mid-September, there was clamor (much of it an over-reaction) to the effect that this was nothing less than a failure of free markets.

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