Another interesting read from John.
Is This the Book that Inspired Jamie Dimon's Warnings About Regulation?
by John Carney | Senior Editor
The book is Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation by Jeffrey Friedman and Wladimir Kraus (September, 2011). Here is what the publisher's description says:
One of the lasting legacies of Reaganomics is a deep-seated distrust of government intervention in the markets. Despite this still-popular sentiment, the Basel Accords, a set of international standards for banking supervision and regulation, have been the subject of remarkably little public criticism. While academics and practitioners decry the enforcement of the Sarbanes-Oxley Act on accounting reform or attempts by Congress to regulate executive compensation, the Basel Accords have been quietly accepted.
In one of the first studies critically to examine the Basel Accords, Engineering the Financial Crisis reveals the crucial role that bank capital requirements and other government regulations played in the recent financial crisis. Jeffrey Friedman and Wladimir Kraus argue that by encouraging banks to invest in highly rated mortgage-backed bonds, the Basel Accords created an overconcentration of risk in the banking industry. In addition, accounting regulations required banks to reduce lending if the temporary market value of these bonds declined, as they did in 2007 and 2008 during the panic over subprime mortgage defaults.
The book begins by assessing leading theories about the crisis—deregulation, bank compensation practices, excessive leverage, "too big to fail," and Fannie Mae and Freddie Mac—and, through careful evidentiary scrutiny, debunks much of the conventional wisdom about what went wrong. It then discusses the Basel Accords and how they contributed to systemic risk. Finally, it presents an analysis of social-science expertise and the fallibility of economists and regulators. Engagingly written, theoretically inventive, yet empirically grounded,Engineering the Financial Crisis is a timely examination of the unintended—and sometimes disastrous—effects of regulation on complex economies.This implies that there is nothing that can be done to reform the financial system that will not just exacerbate the problem. The authors' solution is to deregulate and leave everything to the invisible hand of the market. Not very reassuring since the history of capitalism is the story of recurrent cycles of boom and bust. If the world economy can just look forward to repeating crises of possibly greater proportion as the global economy becomes more integrated, this implies an inherent failure of capitalism as it presently exists. Or the problems and solutions have not been correctly identified.
Read Dimon's view along with JPMorgan Chase Chief Investment Office Has A Whale Problem by Mark Gongloff at The Huffington Post.
I tend to agree that regulation is not a fix for capitalism as presently conceived and practiced. Capitalism is about risk assumption, and government has eliminated risk (failure) for the credit system as a whole, both nationally and internationally. This creates moral hazard that virtually guarantees overreach.
The alternative is to allow full accountability, but this risks either systemic collapse or nationalization of the credit system when there is a crisis. But it is questionable whether resolution would possible on the scale required at time of crisis. Finance capital is betting that governments will not take the chance of finding out and will perpetually bail them out. This is capitalism?
3 comments:
Tom Hickey,
I'm not sure if the correct conclusion is that all regulatory moves can only make things worse. But we should at least be aware that the modern financial economy is complex enough that even simple regulations can have profoundly perverse unintended consequences.
What's more, Jeffrey and Kraus make it very clear that repealing some regulations in the context of existing regulations is not "deregulation." It is changing the regulatory mix. A system without, say, capital requirements for banks backed by the FDIC and the Fed isn't necessarily more or less regulated than a system with capital requirements. And it certainly isn't more of a "free market."
Another point is that I think one can be skeptical about the effectiveness of regulation to improve stability without arguing that deregulation or free markets are a panacea. I sometimes call it the "permanent instability thesis" : we're cursed with fragility created by our financial system and economic structure; there's little hope of fundamental change; radical reform would tend to impoverish; and so the best thing we can hope for is to ameliorate the effects of instability, crashes, etc.
Thanks, John, and thanks for taking this on.
I agree that regulation is not completely powerless or worthless, and an attempt should be made to increase stability in what is an inherently instable situation in Minsky's analysis through some regulation, oversight and accountability. However, as Minsky observes, it is not possible to remove instability completely. This is a bug of capitalism as it is configured. But reconfiguring it would have its problems, too.
The dilemma is what to do with a credit system that is necessary to the economy but inherently instable. It's damned if you do (moral hazard) and damned if you don't (high risk of economic collapse).
But regulation is a mixed blessing, with workarounds and unforeseen consequences. It's not a credible fix although it may reduce some instability and reduce risk of systemic failure. Warren's proposals contain worthwhile suggestions, for example.
My point is that the underlying problem at the moment is a perverse institutional structure, what Bill Black calls a "criminogenic environment," with absence of oversight and accountability, and perverse incentives. That is what really needs to be addressed, and so far it is not on the radar. As a result Bill Black and Randy Wray are pessimistic about the outcome of this crisis, where nothing seems to have been learned and acted on.
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