Monday, May 14, 2012

The Regulation Debate

Take a look at the May 11, 2012 Associate Press article entitled “Calls to toughen regulation follow JPMorgan loss.” []  I do not expect you to completely understand the article and that is part of my point.  The banking industry has become so tremendously complex that it is difficult for people, including bankers, to understand it.  In their pursuit of profits, banks use intricate financial instruments with exorbitant risks (such as derivatives and credit default swaps) and they use savvy legal techniques to disguise those risks.  Most analysts put much of the blame for the economic decline of 2007-2009 (from which we have not yet fully recovered) on excessively risky lending practices by banks due in part to insufficient regulation of financial markets and the use of complex financial instruments that are not completely understood.

Banks have spent vast sums of money lobbying politicians to reduce regulations of financial markets or to create loopholes that make regulations less effective.  JPMorgan Chase, the largest U.S. bank, is widely considered to have one of the most knowledgeable and effective management teams with a chief executive officer, Jamie Dimon, who boasts of the bank’s exceptional understanding of risk management.  So the report that JPMorgan Chase recently lost $2 billion in six weeks pursuing an aggressive investment strategy has reignited concerns that bank actions could lead to another financial crisis that might have a devastating effect on the global economy and potentially require another hefty bailout by U.S. taxpayers.   The rationale for the taxpayer-funded bank bailouts begun under President George W. Bush and continued under President Barack Obama is that financial markets have become dominated by a few giant banks that are “too big to fail.”  Mainstream economists are in general agreement that there were mistakes in the design and implementation of the recent bank bailout packages, but the global economy would be in significantly worse condition if the U.S. government had not taken action to prevent a larger financial collapse.

Many analysts suggest that the problem of banks being “too big to fail” is a direct result of the removal of government restrictions that previously limited the scope of an individual bank’s activities (e.g., by not allowing a typical commerical bank that lends money to households and small businesses also to be an investment bank that engages in risky, speculative behavior) and the removal of laws that limited the size of banks by not allowing them to operate across state lines.  In essence, if laws and regulations prevented banks from becoming “too big to fail,” then we could allow the ones that engage in risky behaviors to go out of business without having a huge negative impact on the global financial system.

The new suggestions that financial markets need increased supervision are part of a much larger debate about government regulation.  This is another area is which the perspectives of mainstream economists differ significantly from many politicians, business leaders, and voters.

Many people talk about free markets as if they are intrinsically  superior to the alternatives.  Politicians profess support of free markets as a moral virtue and they imply that government intervention or interference with business activities is unquestionably detrimental to society.  U.S. politicians who advocate regulation are ridiculed as un-American.  The fundamental flaw with this reasoning, however, is that despite claims to the contrary, almost nobody believes in free markets.  In a truly free market, laws, rules, and regulations do not inhibit, restrict, or prevent any transactions for which there are willing buyers and sellers.  The phrase “free market” refers to a market that is free of government regulation and intervention.  But most people, including libertarians, readily agree that it is appropriate for society to have laws and rules that restrict many market activities.  For example, most people support laws that prevent children from purchasing alcohol, tobacco, and firearms.  We do not think parents should be allowed to use their children as prostitutes.  We want there to be restrictions on the sale and distribution of (at least some) drugs.  Most people agree that slavery should be illegal and humans should not be allowed to sell body parts.  All of these are government interventions in markets. Since almost everyone agrees with these policies, it is reasonable to conclude that almost everyone thinks the regulation of markets is appropriate.

Society needs to discuss market regulation.  But the debate needs to be about which types of regulation are appropriate for different markets, not whether regulation is intrinsically evil.  It is fair for people to disagree about the extent to which certain market activities should be allowed. However, it is hypocritical to cite individual liberty as the basis for less gun control, but then to argue against a woman’s freedom to terminate an unwanted pregnancy.  I am not taking sides on these controversial issues.  Instead, I am suggesting that whichever side you prefer, you need to make better and more persuasive arguments for your position.  It is not sufficient to use liberty and freedom as the only justification for less gun control or the right to choose an abortion.  Everybody believes in liberty to a certain extent and we all believe in the restriction of freedoms in some situations.  We agree that individuals should have the freedom to choose where they live and they should be allowed to apply for whatever jobs they want.  And we agree that people should not have the liberty to kill each other or to steal another person’s property.  However, there are numerous situations in which people disagree about the relative importance of individual freedom versus potential effects on others in society.  For example, opponents of gay marriage suggest that redefining marriage to include homosexuals has negative societal effects that outweigh the freedom of those individuals to choose a marriage partner.  Supporters of gay marriage weigh those effects differently, thinking the freedom to choose one’s legal partner is more important.

There are some market outcomes that can be improved by government regulation.  For example, regulations implemented since the 1960s have reduced the degree and scope of pollution in the United States.  And although regulations are not intrinsically evil, they also are not instrinsically good.  Some regulations make markets less competitive, protect special interests, or have other negative results.  Society should not vilify the regulation of markets, but instead seek to improve rules and restrictions (increasing some and decreasing others) to obtain the desired results.

Mainstream economists believe markets should be competitive, but it is not important that they be free of regulation.  Instead, economists believe better social outcomes occur when markets have a sufficient number of buyers and sellers so that nobody is able to exert undue control or influence over the market.  In many cases, government regulation is the key to keeping markets competitive.  For example, the U.S. typically does not allow one company to buy all of its competitors so that there is only one producer of a product.  These restrictions against monopolies are designed to protect consumers because monopolies tend to charge significantly higher prices than similar markets with competition.

As always, I welcome your questions and comments.