Monday, June 28, 2010

Three Questions to Frame A Problem

Mark Thoma writes,
Regulators certainly made mistakes, and there is plenty of room for improvement, but does that mean we should abandon attempts to regulate? Of course not.

It is hard to argue against the proposition that better regulation would be better. But for regulation to be better, I think there has to be some correspondence between the narrative of what went wrong and the proposed regulatory change.
I am to be talking on this at a conference in a couple of days. My current thoughts.
1. My own narrative is that the causes of the problem were a) clumsy capital regulations, which induced a lot of financial innovation that was primarily aimed at regulatory arbitrage; b) housing policy that encouraged lenient, subsidized mortgage credit; c) the suits vs. geeks divide, with people in power (in both large banks and among regulators) having too much confidence and too little knowledge.
2. My policy recommendations match my narrative. Assume that regulation will be clumsy, and aim for a system that is easy to fix as opposed to hard to break; get rid of all policies that encourage lenient subsidized mortgage credit. and break up the 10 largest banks into about 40 banks.
3. The current financial regulation bill matches nobody's narrative. I will explain this view in more detail subsequently. Briefly:
--if the problem was that we deregulated too much over the past 20 years, then why doesn't the bill simply reset regulations to what they were 20 years ago? or 30 years ago?
--if the problem was that house price increases and mortgage leverage got out of hand, then why does government policy continue to try to push mortgage loans with low down payments?
--if the problem is that lenders were exploiting borrowers (which would justify a focus on consumer protection), then why is it that we ended up bailing out the lenders?

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