Insanity and regulation

Last week two new financial regulatory bodies were launched, the Prudential Regulation Authority and the Financial Conduct Authority, to replace the last (failed) one – the Financial Services Authority. Einstein famously defined insanity as ‘doing the same thing over and over again and expecting different results’. In this brief blog post I shall therefore speculate on the reasons for the decision.

The proximate cause can be understood by describing two views of the economy. The first I shall call the Benthamite view. Jeremy Bentham designed a prison, which he called a panopticon, where the watchman observed inmates without them being able to tell whether or not they were being watched. In this model the economy is like a machine: when any of the economic actors do something wrong, the all-powerful watchman can step in and set the offending actor/prisoner right.

A more fruitful way of thinking about the economy, however, is from a Darwinian/Hayekian perspective. The economy is a complex adaptive system, which develops through a process of evolution, where the strongest, most resilient actors survive and grow, whilst the weaker agents fail. This process ensures system resilience through diversity and evolution. In this world view, the panopticon system of regulation is not only futile but actually increases the fragility of the system. The economic actors should not be put right but actually need to fail. If this does not occur, the system ossifies and becomes less resilient as the economic environment in which the financial system operates changes. A mono-culture ecosystem is the least resilient and this is what the regulatory system ensures. The role of government should be to support the evolutionary process, for example by ensuring that collateral damage from the failure of an agent is minimised, and that the participants do not engage in criminal activity, such as fixing interest rates.

So why has the Benthamite view prevailed? The main reason is probably that it suits the incumbent political and economic elites. Politicians of all persuasions like to be seen to be ‘doing something’; it doesn’t suit them to sit back and let evolution take place. The economic elites therefore have their position protected by the state, which effectively underwrites their liabilities, while regulation acts as a barrier to new entrants and hence competition.

This line of reasoning suffers from a severe internal contradiction in its logic. You write - ''A more fruitful way of thinking about the economy, however, is from a Darwinian/Hayekian perspective. The economy is a complex adaptive system, which develops through a process of evolution, where the strongest, most resilient actors survive and grow, whilst the weaker agents fail.'' Implicit in the above is that the big, strong players would do all that it takes to ensure their survival and longevity. Well, they have done that by compromising the political process and institutions as you yourself suggest in the closing para. ''The main reason is probably that it suits the incumbent political and economic elites.'' The large financial conglomerates have tremendous clout in the legislation and regulation making process and the lobbying that surrounds it. They also have inordinate influence on overall polity. Hence, they managed to socialise losses. At that point, they did not seem to be too wedded to free market idealism. They were quite happy with government shareholding, government liqudity support and other guarantees they got. What it demonstrates is that it is quite possible for a so called 'Hayekian' winner to grow in size and then abandon Hayek, tossing him in the nearest aavailable ditch with all his strength all the while holding his book in his hand like a corrupt priest of a religious order. You seem quite tentative in the last para with your use of 'probably'. Why? I don't think less or more Hayek is the problem here (sounds similar to Marxists whining and making excuses that USSR was not truly and enough Marxist which is why...etc etc. Of course, it was enough Marxist and that's why it failed.) Aren't there bigger issues at play here? 1. No Hayekian seemed to have problems when the USA went overboard in the 90s and up until the crash with using state institutions to promote house ownership! Every free market financier ranted how good free market was while making a killing on the back of this perverse home-ownership policy. 2. I didnt see too many Hayekians cry blue murder when you could get a home loan in the UK without putting a decent amount of cash towards the cosideration in yourself (100%, interest only mortgage products) 3. Credit rating agencies failed big time. One could go on. These are wide-spread institutional failures which are not explained by easy causalities linked to very specific idelogies of a time. That would be too easy to fix. Let's get a bureaucracy steeped in Hayek / Darwin. It won't work.
@Abbay - I am afraid that what you say is simply not true. This is Cato in 2003, for example: http://www.cato.org/sites/cato.org/files/serials/files/cato-handbook-pol... . And you make Nicks point precisely in the middle of your paragraph. We had a very tightly supervised financial system but one where the participants knew they would be bailed out (especially in the US, but also here). This tight, rules-based supervision failed completely. I know of no IEA support for the introduction of deposit insurance in the UK in 1979 or for tax relief on mortgages (quite the reverse - though that did go of course, before the crash) and, I am afraid, ratings agencies had their incentives very much skewed by their use for setting regulatory capital. Even the Vickers' report argues that the implicit state guarantee itself encourages the growth in size that makes it inevitable that a bank will become too big to fail. This is not like Marxists arguing that the Soviet Union was not Marxist enough, a banking system underwritten by the state and home loans underwritten by the state is not a market economy full stop, any more than a car company underwritten by the state is part of the market economy.
Thank you Philip. My position is - (1) am personally highly sceptical of new regulations including Basel III, many of these will fail (2) banks should be allowed to fail albeit orderly demise ensured; (3) no holy cows in the broader economy; (4) shareholders should be sovereign and not some quango-regulator. Now coming to Nick Silver's post - its annoying. All this wordsmithing on 'Hayekian / Darwinian' and 'mono-culture eco-system' is little more than sounding esoteric and needless ideology. When real conservative instincts and tendencies fail, people take to the holy totem poles (Hayek is one such). The failures were broader (banks, rating agencies, regulators and governments) and they occurred in large institutions which were growing over the decades but in the process corrupting fundamental values that created them in the first place. For instance, when the 'free market' worshiping state sets the interest rate at near zero for years, then its not the 'large number of buyers and sellers' that benefit but its the financial trader who borrows at near zero (you and I cannot) and trades multiple asset classes. The saver and surplus capital creator (e.g. saver) gets nothing. Similarly, these so called 'free market' guys are have benefitted from enormity of government spending on healthcare, infrastructure and other contracts. These forces, on one hand preach Hayek, and on the other are very thrilled about statism. Its a baffling situation and utterly perverse incentives are at play. Now in such a complex environment, to bring up simplistic solutions bordering on empty ideology-peddling (like petty hawkers selling wares by the roadside) is highly troubling. I was just disappointed to see this blog post at IEA. That's all. And sorry about this long rant.
I've always like Terry Pratchett's economic model as described in the Discworl novel Making Money. The only economic system that works is chaos and any attempt to impose order is doomed. Nobody understands ALL the interdependent factors involved in the economy so nobody can write the algorithms that make mathematical modelling or even reasonably accurate guesswork possible
@Abhay - and this time I will spell your name correctly (sorry about previously). Fair points, though I do agree with the poster. I think he has written before about the banking system in similar terms to your points and we all agree on the crony corporatism of a lot of the semi-privatisations. Which is partly the point. Sometimes you get the worst of all worlds from such arrangements.

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