The Future of Financial Regulation: Lessons from Adam Smith

Does addressing too big to fail mean also accepting a lower standard of living? In the short-term yes (greater regulation + higher capital requirements) but in the long-term definitely not (because it will hopefully prevent financial crisis).  Does it mean eminent collapse of the financial system as we know it? No, but it does mean slower growth and credit constraints.  Will regulation end macroeconomic fluctuations? No, but if done correctly and maintained adaptively we will most certainly curtail them from happening as frequently or as violently as they do. 

We need a Federal Reserve that maintains price stability and financial stability.  The success of maintaining price stability has been proven with the “Great Moderation.” This refers to a time period of over 20 years when there was price stability and mild recessions.  The one thing that slipped under everyone's nose (except of coarse Hyman P. Minsky's) was - in fact - in plain sight.  The idea that human beings live for self-preservation is something that Adam Smith first mentioned in his classic The Theory of Moral Sentiments:

“Every man is, no doubt, by nature, first and principally recommended to his own care; and as he is fitter to take care of himself than of any other person, it is fit and right that it should be so.”(Section 2, Ch. 2)

Put straightforwardly: people always do things for themselves, sometimes even at the expense of others.  Every action we take is out of our own self-love and as a result man will forever exploit the system in finding ways (not necessarily moral) to make money:

“In the same manner, to the selfish and original passions of human nature, the loss or gain of a very small interest of our own, appears to be of vastly more importance, excites a much more passionate joy or sorrow, a much more ardent desire or aversion, than the greatest concern of another with whom we have no particular connection.  His interests, as long as they are surveyed from this station, can never be put into the balance with our own, can never restrain us from doing whatever may tend to promote our own, how ruinous soever to him.”

Rational expectations theory suggests that everyone is always making the best decisions given that the information they have is perfect.  This so-called “perfect information” as we have seen is an extremely unrealistic assumption.  Asymmetric information does exist so I cannot agree with the idea of perfect information.  People are rational and are always seeking out the most advantageous position for themselves given the limited and incomplete amount of information available to them.  It is because people are rational (but lack perfect information) that we experience bubbles (or for all you fancy cats; "asset inflation").  Since we are all looking for the quickest buck (and you can't deny that people on all sides of this crises were looking to get rich and make that money) and are rational is why we had a bubble.  Given the fact that people are rational there will never exist perfect information.  Profit driven entrepreneurs will prevent information from being "perfect" as a barrier to entry into a market or the "in crowd." It is in our interest to prevent others from looking in and seeing what we are doing.  I don't want people to look into my business and observe how I make my money because that means less producer surplus for me as they free ride all over my hard earned intellectual work.  Furthermore, information costs money and once it is purchased it can be subject to the free-rider problem. 

Now we ask ourselves:

What is the real problem and cause of crisis and how do we minimize the possibility of "it" happening in the future?  Does the problem lie in asymmetric information or in the fundamental lack of regulation?

So we hit the fork in the road- either we deal with all these asymmetric information problems or we deal with what they lead to.  I vote we deal with what they lead to because I still prefer some privacy when it comes to making my money (and it is impossible to eliminate asymmetric information).  This is where regulation comes in. 

Regulators -if given the right tools and information collecting ability- will be able to see the whole picture.  If power (and by power I mean a HUGE MAGNIFYING GLASS) is properly given to them, they will be the insider and the outsider.  They will be able to see the whole picture and the frame, not just one side of the story that the majority gets exposed to.  When the Fed did the stress tests (or Supervisory Capital Assessment Program as it was formally known) it reduced the uncertainty and information failures that were present in the market.  It was able to say (by bundling a group of banks and without naming names) that some of these banks are required to improve their capital positions.  This did miracles to reduce the uncertainty surrounding the liquidity positions of the banking industry.   

We also see how increasing information helps bring asset prices back to fundamental values.  Hence the boom- a period when more people are misinformed than informed- and the bust - when information becomes available (to the majority) that should have been available from the get-go.  If all the information on derivatives and sub-prime mortgage backed securities were readily available and extremely transparent we would not be in this predicament.  But we can't make all the information needed available! Why? Information costs too much and no one would pay for it due to the free rider problem.  Does it cost more than a financial meltdown? Perfect information would be a perfect insurance policy against global meltdown. 

The Federal Reserve should be the regulator of all regulators as it is in an ideal place to monitor systemic risks from all angles.  In order to get the whole picture (and not a ripped piece of a shredded photo) the Fed needs to be everywhere there is money.  Not to impede with Americans rights, but just to take a look around and make an independent assessment of the situation.  The only way this can go wrong is if regulators are bribed or purposely misled.  To avoid being misled, greater surveillance will allow the Fed to check facts with multiple sources to see if everything adds up.  The Fed could regulate groups of firms without ever revealing any information about those firms, or they could regulate all firms and reveal all information about every firm. 

That being said Congress should abandon the Federal Reserve mandate of full employment and add financial stability alongside the price stability mandate.  Fredric S. Mishkin argued against output stabilization in the conduct of monetary policy in his Monetary Policy Strategy (2007): 

 "1. Too great a focus on output fluctuations may produce undesirable outcomes: greater fluctuations of output and inflation around their targets. 

2. On the other hand, monetary policy that targets inflation is likely to produce better outcomes for both output and inflation fluctuations.

3. In addition, language which stresses output goals can make a central bank’s communication strategy less effective and can, thereby, weaken monetary policy credibility.  

4. A communication strategy that, instead, focuses on the control of inflation, is likely to make it easier for the monetary policy authorities to focus on the long run, thereby enhancing monetary policy credibility.”

The Fed already uses the three rates it has (interest on excess reserves, federal funds rate, discount rate) to their maximum potential.  To force the Fed (by law) to maintain full employment with the interest rate is upsetting.  The effective federal funds rate can only go so low before a liquidity trap ensues at the zero bound.  The Fed was pressured by Congress to maintain too low of rates for too long in the first place to help bolster home ownership.  This resulted in the Fed reaching the zero bound rather quickly when the crisis hit, thus impairing the ability of the interest rate channel.  The Fed cannot control the level of employment and at the same time maintain the price stability and financial stability mandate.  They really should abandon the full employment mandate as it leads to harmful discretionary policy.  The full employment mandate also subjects the Fed to additional scrutiny from Congress thus threatening both its independence and credibility.

  Congress should be the ones that have a full employment mandate as government stimulus leads to more jobs created directly (and with shorter policy lags) not indirectly through the slow moving transmission mechanisms of the interest rate.  The Fed should have two main objectives: price stability and financial stability.  Otherwise there is a severe conflict of interest as the Fed gets politicized and slowly loses its independence.