The financial crisis and the economics of institutions

The present financial crisis illustrates clearly the fundamental importance of institutional structure to the satisfactory operation of a market economy. Looking at the present carnage it is hard not to conclude that institutional failure has occurred on a massive scale.

To blame the actions of ‘greedy bankers’ or to deduce that such events prove the hopeless inadequacy of ‘unregulated Anglo-American financial capitalism’ is to miss two fundamental points. Bankers have always been greedy – or at least self regarding – along with everyone else. And Anglo-American Capitalism even in its most recent manifestation is certainly not unregulated. Most people who actually have the responsibility of making things work in practice know that we have lived for several decades in an age not of ‘deregulation’ but of increasing regulation.

Institutions evolve to regulate our dealings with each other. The temptations to which all market participants are subject – to deceive others, not to deliver on promises, to shade on quality – are obvious enough. Because people cannot know everything and will always possess only partial information about the actions and reliability of their business associates they look for protection. They do this by building institutions.

The Rochdale pioneers sought protection from local monopolists and adulterated food by forming retail cooperatives. People trying to provide for old age spontaneously formed ‘mutual’ life assurance societies – governed by their members – because trust in investor-owned institutions was an obvious problem. Mutual fire insurance societies emerged for much the same reasons though here the problem was the potential moral hazard of the insured as much as that of managers or outside owners. Health insurance and other benefits were provided by ‘Friendly Societies’. The early savings banks were often structured as non-profit or charitable institutions. These institutions were the outcome of evolutionary market processes and they have been effectively swept away by competition from the state in the provision of regulatory services.

The present crisis does not show up the weaknesses of unregulated financial capitalism. It throws into relief the weaknesses of financial markets when regulated predominantly by centralised state agencies.

Depositors seem at present genuinely surprised to learn that to place funds in a depository institution is to incur a risk of loss. Such naivety would have been rare fifty years ago. It has come about as consumer protection legislation has proliferated. In the case of banks, their governance arrangements have ceased to influence the users of their services. When lenders fail to notice the type of institution to which they are committing their savings, and pay attention only to promised returns, one of the main buttresses supporting conservative banking practice is removed.

If all institutions ‘look’ equally good to consumers and there is an apparently powerful regulator to guarantee this result, then Gresham’s Law will apply, and competition will tend to undermine quality – in this case financial safety. As the demand for yet more powerful and ever more centralised regulation grows, this essential intellectual dilemma is ignored. When institutions can find the means reliably to ‘signal’ their quality to consumers, competition will increase quality. When common ‘standards’ are centrally imposed, however, they have to be ‘cast iron’ (enforceable at low cost) or competition will perversely be directed into hidden (costly to detect) efforts to circumvent or to debase the standards.

Government interference which tends to crowd out possibly superior voluntary forms of ‘regulation’ incurs an ‘opportunity cost’. For a time people remember what used to be, and maybe regret its passing, but subsequently the ‘cost’ becomes hypothetical and is all too easily ignored. This kind of government or regulatory failure is not usually recognised as such. I speak with some feeling, as we are currently suffering from exactly such a phenomenon in accounting.

Government interference which tends to crowd out possibly superior voluntary forms of ‘regulation’ incurs an ‘opportunity cost’. For a time people remember what used to be, and maybe regret its passing, but subsequently the ‘cost’ becomes hypothetical and is all too easily ignored. This kind of government or regulatory failure is not usually recognised as such. I speak with some feeling, as we are currently suffering from exactly such a phenomenon in accounting.

Post new comment

The content of this field is kept private and will not be shown publicly.
Type the characters you see in this picture. (verify using audio)
Type the characters you see in the picture above; if you can't read them, submit the form and a new image will be generated. Not case sensitive.