Not More Regulation, Please
French President Nicolas Sarkozys recent statement in Quebec that he favours more state regulation to fix capitalism and the financial markets should not have come as a surprise. Regulation works well for the French in France. It resulted in the European Common Agricultural Policy, which brings billions in transfers to French farmers, mainly from Germany. It also works well for the French in Canada. Quebec is the recipient of billions of equalization payments every year. Marketing boards drain more billions from Canadians to Quebec dairy farmers.
Regulation reduces economic productivity, but that does not matter if you can force others to make up for its economic costs.
Making regulation work to ones advantage is nice, if others let you do it. But making regulation work for the common good is a very difficult task. Failures litter history because the regulated always capture the regulators and make them work in their interest.
The outstanding historic example of this capture involves the U.S. airline industry. The regulators allowed airlines to raise ticket prices whenever costs rose. Unionized pilots, flight attendants and machinists successfully obtained very high wages for themselves since employers had no incentives to resist them. So what if passengers paid for these high wages through high ticket prices that allowed only few people to travel by air?
How high was high? The answer to this question became clear when it was discovered that the cost of flying between Boston and Washington was twice that of flying the same distance between San Francisco and Los Angeles. The difference? The first flight crossed state borders and was regulated in Washington while the second was unregulated intrastate. The first allegedly protected the interests of the flying public by regulation, the second in fact by market competition.
Another example of problems caused by regulation involves regulation Q, which was designed in the 1930s to protect banks from damaging competition that was thought to lead to bank failures by forbidding the payment of any interest on demand deposits. Banks loved it, but during the high inflation of the 1970s, Americans took their money out of the banks and bought real estates, coins, antiques, and other assets that rose in value with inflation. The result was a banking crisis that ended with the removal of regulation Q and the setting of interest rates on demand deposits through market forces.
Regulation also is the main villain in the present financial crisis. Yes, the housing bubble burst the way all such bubbles do, but the relatively minor losses for some investors that this adjustment would have brought have turned into a major financial crisis because regulations forced banks to act in ways that brought havoc to the entire financial system.
The first regulation involves the so-called mark-to-market rule. This rule was imposed on financial institutions in the wake of the Enron bankruptcy in December 2001. Enron had deceived the public by using unrealistic asset values in reporting profits and losses. The mark-to-market rule was designed to end this practice and requires that financial institutions report the value of their assets on the basis of the prices at which transactions took place the day before their report.
So why blame this rule for the present crisis? As the housing bubble burst and some borrowers defaulted on their mortgages anywhere in the United States, all U.S. banks had to write down the value of all mortgages held in their asset portfolios directly or through mortgage-backed securities. There is nothing wrong with that in principle. Banks make provisions for such losses and would have absorbed them without the creation of a crisis.
At this stage, however, a second regulation kicked in. It required banks to maintain equity at a certain level relative to the risk-adjusted value of their assets. This regulation was imposed in the wake of the failure of the Long-term Capital Hedge Fund in September 1998, whose highly leveraged assets fell in value so much that they were worth less than its financial obligations, even after the firms equity was zero.
To meet this capital requirement, also known as Basel II, banks facing a lowering of the value of their mortgage assets had no choice but to sell some to restore their equity ratio to the mandated level. These sales lowered the market value of mortgages even further. The result was the vicious cycle of asset sales, declines in market values, capital inadequacies requiring further sales and so on.
The regulators have recognized the crucial role of the mark-to-market regulation in the present financial crisis. They have replaced it with a regulation that basically reintroduces market forces. Banks are allowed to value assets according to some market principles, which have to be spelled out in their financial reports. Market participants are required to assess the realism of these applied principles before they invest or make deposits with such banks.
Funny, if it were not so tragic, how regulators always return to use market mechanisms to save the bacon from being devoured by their own rules.
Of course, the true believers in the wisdom and incorruptibility of regulators and their political bosses never admit that fundamental problems exist with all regulation. They will only admit that the particular regulation was bad. The new ones they will design tomorrow will solve all past and future problems in financial markets. After all, these new regulations will be designed by well-meaning, intelligent bureaucrats and politicians who never put private over public interests.
The tragedy is that leaders like Sarkozy and his admirers never learn the lessons from history. Almost all government regulations have either failed to achieve their objectives in the longer run or they have produced costly unintended side effects greater than those unregulated markets would have imposed. There is no need to have more of this tragedy, but history shows that we will get it anyway.
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