"There are two big economic ideas that look substantially less appealing in the light of the current crisis.
The first is the macroeconomic hypothesis, often called the Great Moderation which combines the empirical observation that the frequency and severity of recessions declined greatly from 1990 to the recent past with the explanation that “the deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle”.
The second is the microeconomic idea, central to much of modern finance theory called the Efficient Markets Hypothesis. In its most relevant form, the EMH states that prices observed in asset markets (for stocks, bonds, foreign exchange and so on), reflect all known information, and provide the best possible estimate of the value of earnings that assets will generate."
Read the whole interesting post. Here's my comment:
Don the libertarian Democrat Says:
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You make a number of assumptions. Take CDS’s and CDO’s. You assume that a regulator would have understood these investments better than the actual investors and prohibited them. It is also possible that they would have not understood the risk involved, especially in investments that involve shifting risk to a third party or magnifying risk, where the problem of magnifying risk is partly trying to figure out the amount of collateral needed. I agree that we could have taken a look at these investments sooner in the U.S., but I’m not sure that regulators would have done a better job. Of course, you might be arguing that insurance like standards should have been applied to them from the first, and that might have worked. In any case, regulations need to be clear and effective, and need competent regulators.
Second, and here’s my biggest disagreement, the system of implicit government guarantees played a part in the creation of this crisis, and encouraged taking on more risk than was advisable. My main reason for believing this is how the markets behaved to Lehman, which showed that investors and banks were counting on a bailout, and had no plan B if the government didn’t intervene. Of course, the government did.
I call this moral hazard Bagehot’s warning. In the end, if you put certain institutions in place, they will be the final guarantor. In other words, there are certainly situations where the government will have to step in, as it has done here. However, a certain amount of minimal and effective regulation, real moral hazard for investors and banks in normal times, and very onerous conditions should a bailout be necessary, could well keep such a crisis from occurring.
In the current case, we had poor regulation, no moral hazard until the worst was upon us, and certainly less than onerous conditions, e.g., TARP.
Keynes believed such crises as this can be avoided. I know that most people will disagree with me, but a very minimal but well planned and executed regulation, clear bailout terms and conditions from the government, and better oversight from investors themselves could have kept this from occurring, with little bother to the market economy. The result of such negligence has been, as Greenspan said:
“It is important to remember, however, that whatever regulatory changes are made, they will pale in comparison to the change already evident in today’s markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime.”
In the end, we should view regulation and oversight like value investors view the market, and be most vigilant and frightened when things are going well.