Friday, May 1, 2009

HOW would Milton Friedman remake America's financial regulatory system?

From Free Exchange:

Posted by: | NEW YORK

HOW would Milton Friedman remake America's financial regulatory system? Alas, we will never know, but perhaps we can glean some insight from former colleagues and students.

Gary Becker is one of those former colleagues and students—he was also a close friend of Friedman—and he believes that simple rules work best because "regulators get caught up in the same type of optimism that market participants get caught up in" and "[w]hen you give a lot of discretion to regulators, they don't use the tools that are given to them." For example, Mr Becker would like banks to follow the straightforward Taylor rule, which forces them to hold more capital. This leads Justin Fox to comment

This wasn't entirely surprising coming from Becker, whose teacher Milton Friedman was a big advocate of rules-based monetary policy. And there are problems with the rules Becker cites—the financial system has a tendency to evolve in a way that leaves simple monetary rules outdated (this was certainly true of Friedman's proposed money-supply rule for Fed policy) and to find ways to game capital standards.

But rules-based monetary policy is quite different from rules-based financial regulation. You want simple, transparent monetary-policy rules so central bankers are not tempted to achieve short-term growth (by surprising markets with low rates) at the expense of long-term growth and stability. A credible and transparent policy minimises uncertainty and facilitates efficient markets by eliminating speculation on the central bank's next move. Policy rules align incentives and expectations of the central bank and investors.

Regulation is a different animal. Bankers always have a short- to medium-term incentive to take on more leverage and risk, so they will try to undermine any regulatory rule that constrains them. Investors may attempt to profit off of a particular interest rate, but they don't try to undermine it. Ideally, you need regulators to stay a step ahead of bankers, though this is rarely possible. So the trick is to align the interests of regulators and bankers. But unlike monetary policy this is not easily achieved with rules-based policy. Rules-based regulation can actually give bankers a road map on how to avoid the rules.

Going a step further, Sam Peltzman, a former colleague of Friedman and professor emeritus at Chicago’s Booth School of Business, thinks most regulation is futile. Via Caroline Baum:

Financial institutions respond to regulation in ways that offset the original intent, according to Peltzman.

When regulators increased capital requirements, banks took greater risk with their capital, Peltzman said.

When the Basel Accord sought to align capital requirements with risk, “banks took risk off their balance sheet,” creating structured investment vehicles to house the wayward assets, he said. “That made it worse.”

Regulation didn’t prevent the savings and loan industry from getting into trouble in the 1980s, he said. Nor did it prevent large banks from lending to Asia a decade later. Latin America’s “less developed countries” of the 1970s and 1980s may have morphed into Asia’s “emerging markets” by the 1990s, but that did nothing to change the nature of risky loans.

Regulation is unlikely to prevent the next crisis either, Peltzman said.

As Mr Peltzman suggests, sticking with simple rules-based regulation is not a magic bullet and can sometimes cause more harm than good. Simple rules may provide a useful guide, but effectively implementing them is a thorny task that must evolve with financial markets.

It's impossible to know how or if the current enviroment would have changed Friedman's stance on regulation. But Andrew Leonard has dug up an interview from 2005 that sheds some light on his thinking in this area.

ROBERT KUTTNER: Where do you think in the area of the honesty of financial markets themselves, markets are adequately self-policing, and where does the need for some kind of regulatory regime come in?

FRIEDMAN: Well I'm not sure that a regulatory regime should be the role of government. Government's job is to prevent fraud or theft. That's the real role of the government, in the financial market and everywhere else."


Don the libertarian Democrat wrote:

May 1, 2009 14:51

From Martin Wolf in the FT:

"What is new, however, is that, in the current crisis, this fragility has now been globalised to what is, I believe, a historically unprecedented degree. What I have learned (and Lex should have learned) is that the old fragility sensible people have always worried about (may I remind you that Milton Friedman, no less, was in favour of narrow banking) has now metastasised into something far more dangerous. Indeed, one of the things I am missing in the comments from the Lex writers is some sense of just how dangerous the situation now is. That is why we are thinking the unthinkable about the structure of the banking industry and its rewards. But the important point is that, if we make no changes, it seems to me reasonable to expect that our future banking crises will all be like this: a globalised mess of securitized toxic rubbish."

Point One: Narrow Banking:

From Peston:

"the Liberal Democrats, are in favour of the forced break-up of the likes of Barclays and Royal Bank of Scotland into so-called narrow banks, so that these sorts of competitive distortions are minimised and so that banks don't abuse ordinary depositors' cash by gambling it in the supposed casinos of wholesale markets."

He also advocated, as I am, a guaranteed income. Here are a few other points about Friedman in a Brittan post in the FT:

All very sensible. From the Kuttner interview:

"RK: I couldn't agree with you more. We have the worst mix of government and private, I could not agree with you more.

MF: We ought to have much more private or much more government. "

I agree completely, and here I have a big disagreement with him. I've thrown in the towel. We are not going to have a lot less government in health care. However, the current hybrid approach is an expensive and inefficient mess.

Finally, the use of the word 'regulation' makes that quote of Friedman's sound strange. We want regulators to root out fraud, etc. I think that he means we don't want the govt micro-managing the financial markets and directing their investments.

Don the libertarian Democrat wrote:

May 1, 2009 21:43

I realize that I'm not getting anywhere on Narrow Banking and a Guaranteed Income, but I'll state my views again:
1) A Narrow Bank is a secure foundation for a market economy. It was proposed by Frank Knight, Irving Fisher, Henry Simons, and Milton Friedman. Here is another view:

"This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.

With limited purpose banking, financial crises would largely disappear. Banks would never fail, never stop originating loans, never expose the public to massive liabilities, and never see their stock values evaporate. Banks would be stable, boring economic cogs - like gas stations.

The Fed would also gain full control of the money supply. To expand the money supply, the Fed would continue buying treasuries from the public and supplying cash. But banks wouldn’t be multiplying and contracting M1 (cash plus demand deposits) based on their ever changing decisions about lending deposited funds.

Milton Friedman, who also advocated narrow banking, blamed the Depression on the Fed’s failure to offset the M1 money multiplier’s collapse. In the past year the M1 multiplier has contracted by over 40 per cent, forcing the Fed to double base money. If the multiplier shoots back up, we could see the money supply and prices explode."

On Automatic Stabilizers, what could be more automatic and effective than a guaranteed income? I favor Charles Murray's plan that includes health care.

And, back to our original topic, I am advocating the policies of Milton Friedman.

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