Not
More Regulation, Please
Many
Canadians cheered the French President Nicolas Sarkozy’s recent announcement
made in Quebec that he advocates more state regulation to fix capitalism and
financial markets. They should not,
unless they are Quebecois.
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 are French or
Quebecois and you can make others make up for its economic costs.
Making
regulation work to one’s 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 US 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 US 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 firm’s 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.
Herbert
Grubel
Professor
of Economics (Emeritus), Simon Fraser University and Senior Fellow, The Fraser
Institute