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- Economist.com | 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with the rules Becker cites—the financial system has a tendency to evolve in a way that leaves simple monetary rules outdated (this was certainly true of Friedman's proposed money-supply rule for Fed policy) and to find ways to game capital standards.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."