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Why We Need An Incoherent Financial Policy

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You don't have to look very hard to discover someone lamenting the lack of a coherent blueprint for dealing with financial crises. Hank Paulson has publicly called for a legible road map that would allow policy makers to systematically and individually interpret all sorts of diverse financial troubles to assess the appropriate policy response. It's become almost the mantra of pundits discussing the difficult negotiations and diverse outcomes of the failures of Bear Stearns, the government sponsored mortgage companies and Lehman Brothers. But it's dead wrong.

Today the folks who brought us Slate launched a new business website, The Big Money, that quite naturally leads with a story about Lehman Brothers. It takes a refreshingly contrarian view that the government should have bailed out Lehman. (Felix Salmon does a nice job of refuting their substantive arguments over at Market Movers.) But their conclusion ends up with the all too stale call for consistent policy responses to financial meltdowns.
"But at some point--it might have to wait for a new administration--the federal government is going to have to spell out with consistency what it is trying to accomplish with its financial regulation so that the rest of the world can gauge whether it's doing it effectively," Chadwick Matlin and James Ledbetter conclude.
The Disaster of Coherence
It's easy to see the attraction of a coherent policy. In many ways, the world would be much more comfortable if a simple set of rules would allow us to know how to react to financial distress. Market might be less uneasy if they could predict in advance the response of policy makers. Many people in Washington DC and on Wall Street crave a world that is more legible and transparent than the chaotic, dark place we're currently muddling through.
Unfortunately, any coherent financial policy would likely be a disaster, making our markets less efficient, encouraging regulatory arbitrage and rent-seeking and, ultimately, creating more risk rather than less. We're better off with a pragmatic, one-thing-at-a-time, narrow case approach.
Let's consider the timely example of this year's financial bailouts, which have been criticized as a source of market uncertainty and almost unanimously for the lack of any coherent scheme in the overall conduct of financial regulators. The Federal Reserve, the Securities & Exchange Commission and the Treasury Department have all been accused of sending mixed signals, relying on obscure legal loopholes to perform unprecedented actions and, more or less, making things up as they go.
In some sense, this is a bit overstated. The form of the policy response to the crises have become surprisingly consistent. Policy makers gather together regulators from various agencies and executives from financial firms to hash out a response to a crisis. What seems unpredictable is when one of these meetings will occur, what triggers them and what the response will be. Sometimes the systemic crisis is viewed as bad enough to outweigh concerns about moral hazard; sometimes vice versa. There doesn't appear to be any publicly available metric for deciding which conclusion will be reached, and many doubt that there is a private one employed. As one wag put it, "If you're bank is in trouble, you better hope Hank Paulson liked his breakfast that morning."
A more coherent policy would employ publicly available measurements of systemic risk, assess 'moral hazard' according to a methodology that involved more than the political will or readings of editorial pages, and allow for a more orderly resolution to the meltdown of a financial firm. Instead of all night meetings involving the heads of every Wall Street firm and national bank, the assessment could be reached by bureaucrats employing a technical reading of the costs and benefits of failure or rescue.

Free Market And Socialized Security Coherence

The clearest way to coherence would be the free market approach, which would simply rule out bailouts from the start. Firms would be permitted to fail, counterparties would bear the risk in full, regulators would be prohibited from providing assistance and market processes would proceed uninhibited. Unfortunately, the vast apparatus of the state make the free market approach unlikely to prevail. Special interests will always have more at stake than the general public, state actors will seek to amalgamate power, public ignorance will guarantee the free market rule goes unmonitored and the costs of collective action will ensure it goes unenforced. These dynamics mean we would very quickly find that the policy response would be to abandon the free market approach on an ad-hoc basis. In short, absent a striking reduction of state power, free market coherence will remain unavailable.
Conversely, we could develop an approach in which we would bailout every important financial institution, guarding the markets against failure and loss. Such a system would necessarily have to be coupled with stringent market regulations and supervision that would prevent firms from engaging in reckless activity due to the moral hazard provided by this government insurance. The problem with this program is that there is little evidence that regulators understand the regulations that would need to be put in place to guard against the hazard created by socializing losses. Indeed, such regulations are probably unavailable since financial crises often arise from unforeseen or highly unlikely sources of risk. Since failure could not be avoided, we would have in place a policy of privatized gain and socialized loss that would be politically unsustainable. The randomness of the markets would undermine the bailouts for all approach.

A Middle Way?

A middle way, which is what most market watchers and policy makers seem to prefer, would include vigilant regulatory oversight coupled with a technocratic recipe for bailing out only those firms that played by the rule and yet still fell afoul of the markets. In a sense, failure while rule-following would be looked at as a kind of market failure that the government would repair. (We'll note that it's a strange thing to call a mismatch between the desired policy outcome and market processes a 'market failure' rather than a regulatory failure.) This solution, however, is perhaps the worst we've considered so far. Sophisticated financial firms would quickly adapt themselves to maximize profit and risk by exploiting the rules, and no set of rules is likely to be comprehensive enough to prevent this regulatory arbitrage. Indeed, this approach provides a road map for financial firms to guarantee investors and creditors against losses, on the one hand, while giving them a map of the sewers--the less regulated nooks and crannies--where they can seek outsized profits. You can get a taste for how this would work in an article by Dan Gross in Big Money, in which he uses the collapse of Lehman to explain how to tell who gets bailed out. A coherent, transparent plan would make this even worse.
Incoherent, ad-hoc policy responses to financial crises avoid these problems. Investors and creditors would have to remain vigilant about the likelihood of losses and failure because they would bear the risks associated with the uncertainty of whether a bailout would be available. Indeed, the likelihood of a bailout would become just another uncertainty which would have to be priced by market processes. Moral hazard is best countered, that is, not by coherent regulation but by the uncertainty of markets and inconsistency of policy response. At the very least, you have to conclude that an incoherent financial policy has much to offer and avoids the flaws of the coherent policies.

We Vote For Incoherence

Of course, this does not mean that the incoherent financial crisis response we've undertaken this year are the best possible responses, implemented in the best possible manner for the best possible reasons. Perhaps Bear Stearns should have been allowed to fall into bankruptcy. Perhaps the Fannie Mae and Freddie Mac shareholders should have been entirely wiped out. It does mean that our impulse for coherency, however widespread, is not all that well thought out. To overshoot in favor of coherency risks deepening our financial crisis or making future crises worse. We're a nation of tinkerers and practical problem solvers. Maybe that's not so bad.