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The Paucity of Good Reform Proposals

June 2, 2009

In the wave of the popping of the housing bubble and and resulting damage to financial institutions, I have heard many calls for “more regulation.”

First the standard point from government skeptics: why more regulation and not better regulation? I have seen surprisingly little evidence or arguments that a lack of certain regulations resulted in the runup in housing prices or the sensitivity of financial institutions to weakness in the secondary mortgage market. Most of the calls for more regulation appear to be 20-20 hindsight that “something” should have been done by the government to prevent these problems.

Despite the vacuity of calls for more financial regulations, I am open to the possibility that a better regulatory structure might improve the operation of these markets. It is certainly conceivable that even radical changes might be useful. Unfortunately, most of the specific proposals made seem like really bad ideas, e.g. reinstitute the Glass-Steagal separation of commercial banking and investment banking.

Giving regulators more discretion only seems like a good idea if we believe regulators know more, or are wiser, or have fewer conflicts that affect their judgment than market participants. The insights of the public choice economists suggest regulators are likely to be worse than market participants in all these areas. One possible exception that comes to mind is that there may be suboptimal controls on individuals’ ability to receive extraordinary current compensation while their companies at being set up for future failure. Although this is a classic agency problem that seems better addressed by a robust market for corporate control than increasing regulatory discretion.

I was also struck today by the fact I have heard no real proposals for political reform. Surely some large part of the recent financial problems were caused by a Congress that, for example, created Fannie Mae and Freddie Mac, encouraged lenders to hold their stock as capital, implicitly backed their debt with a government guaranty and encouraged more sub-prime lending. Are there structural reforms we should be considering to make the political system respond more to what is in the long term interest of the entire country rather than those of vocal interest groups? I supposed campaign-finance reform would be such a proposal, but by all accounts it has not succeeded in altering this dynamic and is a remarkably unimaginative proposal.

What about incentive pay for elected representatives based on various measures of national well-being in the future, to the exclusion of other compensation? Perhaps each piece of legislation could have such incentives built into it? Or perhaps taking seriously enumeration of powers in the constitution? I would like to see more ideas for political reform along these lines.

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