2-4-6-8! Time to overregulate!

Freddie has a typically thoughtful post on financial regulation:

In other words, what's good for individual banks and lenders is bad as a system, and so the markets need forceful intervention from a regulatory body. Now, Jim Manzi's true-blue capitalist cred is unimpeachable. As are those of the many i-bankers, venture capitalists, moneymen and corporate heads who have been applauding this near-nationalization of banks through direct investment to improve short-term solvency. So I don't think this is an example of just those who (like me) are inclined to be skeptical of some aspects of capitalism crowing about a turn towards socialism. I think it's a fact of most people who are invested (literally and figuratively) in the system on Wall Street recognizing that the best remedy for this problem involves ventures which might not fit with their usual ideological preferences.

Capitalism, after all, is the great adapter. I've idly wondered if a turn towards socialism might come not from a new peoples revolution, not from the ballot box, and not by government fiat, but through the capitalists becoming convinced that a socialist turn would be best for business. Of course, that's a hypothetical, largely, at this point. But it's possible. Capitalism has no ideology, it just has the profit motive, and I believe that if it became apparent that some system of government controls of wealth and industry led to greater profits, the Larry Kudlows of the world would run smiling into the arms of Trotsky.

As libertarians go, I'm relatively in favor of financial regulation.  But I think there are two ways to think about financial regulation:

1)  Wall Street people are tricky bastards who spend almost all of their time thinking of how they can best maximize their profits by screwing The Little People.  They must be rigidly controlled so that they cannot do most of the things they want to do, because almost anything they want to do is definitionally a bad idea.  It wouldn't hurt to punish them occasionally, for being such tricky, selfish bastards and taking all that money they don't really have any right to.  Most financial activity is useless paper shuffling that adds no value to society anyway, so there is no downside to clamping down on the banking system with an iron fist.

2)  There are multiple possible equilibria in financial markets, and one of the problems in those markets is that decisions which are individually highly rational can, in aggregate, move society to one of the bad equilibria.  Worse, those decisions may be sticky--it may be much harder to get out of the bad equilibria than into them.  The government should act to mitigate the systemic risks by doing the things that only it can do:  enforce transparency, solve collective action problems, and analyze the system for systemic rather than local risk.  This will necessarily involve sacrificing some potential upside in order to insure against catastrophic downsides.  But the government must remain aware of its own tendency to be excessively risk averse, because regulators are punished for visible failures, but not invisible lost benefits.  It must also worry about the way that the very regulations intended to ensure safety can create or enhance systemic risk, as has happened in this crisis with rules such as the mark-to-market rule, and various institutional requirements for high credit quality in investments.

Needless to say, I think the second approach is better.  Unfortunately, in crises like this, the general political attitude is closer to the first one.

Moreover, it seems to me that at least some of the people who are tremendously excited about the prospect of regulation are not excited because they are worried about the health of the financial system so much as they are intoxicated by the power that greater regulatory authority might give a liberal government to advance other goals, such as redirecting capital flows to more "deserving" uses, or reducing income inequality.  To the extent that you wish to reduce income inequality, there are much better ways to do it than crippling your banking system so that bankers can't get rich.  And the aggregate record of governments at directing capital flows in welfare-enhancing ways is, to put it mildly, abysmal.  Nor is there any evidence that the US government is better than average at making investment decisions--rather the reverse, in fact, since 540 legislators all want a piece of the action.

I think this is a very good time to strip down our regulatory system to its bare bones and rebuild it into something more effective:  streamlining regulatory authority, refocusing it on systemic risk and giving it the power to pursue those issues more effectively, purging the overreliance on single models that make things more convenient for the regulators, and figuring out how the hell Basel II went so deadly wrong.

But I do not think that this is anything close to what we will actually get.  We will get piecemeal patches designed to prevent the problems that just occurred without much attention to future issues (see, Enron and mark-to-market accounting).  We will probably see restrictions on various types of activity, without regard to lost upside from that activity.  There may well be some dramatic and pointless gesture, such as Glass-Steagall's drive to split off investment banking from commercial banking.  I expect some populist measures like letting judges rewrite mortgages in bankruptcy, which look swell until the cost of a mortgage goes up.  And we will very certainly increase the amount of paperwork that companies and financial institutions do, creating a larger mountain of data that our current regulatory structure will be unable to intelligently sift through.  As a side effect, it will raise the barriers to entry in both the market for public funds, and the financial industry, further consolidating power among the remaining incumbents.

This will make happy those who are definitionally in favor of more regulation.  But this approach sets up a direct tradeoff between growth and safety; in order to get more safety, we give up a lot of financial activity which ultimately reduces the supply of capital.  I don't think that's necessary. A lot of people writing today seem to think of regulatory agencies as quasi-prisons for Demon Finance, and think that the main problem with the current system is that it's mollycoddling the inmates.  Bankers are not criminals.  As a class, they are exactly as self-interested, self-destructive, and short-sighted as other classes of people that liberals want less highly regulated, such as unions and community organizers.  I don't view the purpose of regulation as punishment, or protection against a malevolent class.  I view it as an attempt to make our institutions more effectively channel self-interest into collectively welfare-enhancing activity.  Thus you can see why I might be somewhat uncomfortable with those who seem to view the crisis as an exciting opportunity to put those uppity bankers back in their place.