Acton Commentary: Motivation and Regulation in Financial Markets

by Brittany Hunter on Wednesday, May 27, 2009

“When designing rules for a game, one must take into account the moral character of the players,” Oskari Juurikkala reminds us in today’s Acton Commentary. “But there needs to be adequate variation: general laws designed for crooks will not produce any saints.”

Read the commentary at the Acton Website.

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http://www.riskfinanceadvisors.com Robert Arvanitis

The common moral framework has eroded severely under liberal assault. Virtue and shame are far less effective than ever.

We try to substitute specific rules, and find we are re-creating the difficulties in the Old Testament: how many steps exactly may one walk on the Sabbath?

When legalism fails, we give authority to regulators. But we find the same human frailties. Politicos love power and bureaucrats love bloat as much as businessmen love profit.

The only real solution is to enforce the premises of free markets — many independent agents, free flow of information, no subsidies, no monopolies and certainly no “too big to fail.”

Then we let markets run, separating failure from success.

And simply enforcing those premises does not allow too much leeway for politicos to favor friends or otherwise meddle.
http://eyesoffaith.info Fr. Larry Gearhart

It seems to me there are a few obvious rules that have been lost in the miasma of regulatory changes. For example: (1) Investments should require tight margins; (2) risky investments should require even tighter margins.

The biggest risk to an economy, however, is systemic risk, when a preponderance of investors all put their money in the same category of risky ventures. This suggests the need for a specific regulatory intervention, aimed at ensuring that all of these investors cover their risk in a reliable way, in particular, with solid, diversified collateral.

The main reason regulations fail, however, is their tendency to drift away from common sense. We could call this the law of entropy in economic regulation.
Roger McKinney

It seems to me that one’s position on regulation depends on one’s understanding of what causes crises such as our current one. If you follow the concensus view which adheres to the real business cycle (rbc), then you’ll favor regulation because the rbc sees nothing but random shocks damaging a normally well-regulated system. Of course, the downside of the rbc is that you can’t predict anything at all, as Mankiw admits on his blog. By definition, you can’t predict anything if everything is random.

On the other hand, Friedrich Hayek won the nobel prize in part for predicting the Great D. The business cycle theory that he improved upon came from Ludwig von Mises who got it from Cantillon via the Currency School in England. Hayek call it the monetary school of cycles, but it is best known as the Austrian Business Cycle theory, ABCT.

If you agree with the ABCT, then all crises other than those caused by war and nature happen as a result of monetary policy. If the ABCT is correct, and I think it is, then correcting monetary policy will make financial regulations unnecessary; if monetary policy is not corrected, then no amount of regulation at all will help prevent disaster.