Saturday, April 24, 2010

The Oversight of Regulation

The lights go out and I can't be saved
Tides that I tried to swim against
Have brought me down upon my knees
Oh I beg, I beg and plead
--Coldplay

In his weekly radio address, President Obama claims that increased financial regulation will end tax payer funded bailouts and 'put an end to the cycles of boom and bust that we've seen.'

Not likely. Such claims ignore the root causes of boom/bust cycles to begin with, and the role that government has in exacerbating them.

Underlying business cycles are patterns of inflation followed by deflation. Classically defined, inflation is an increase in the quantity of money and credit. In today's monetary systems, the majority of money is in the form of credit, meaning that during inflationary periods, there must be both supply of credit and folks who want to borrow. In free markets there is likely to be a natural ebb and flow to this cycle. This is because there is a group component, or herding impulse, to economic behavior--i.e., collective optimism followed by collective pessimism.

In free markets, there are 'natural regulators' that reign in optimism during expansionary times. One is the price of money, or interest rates. For example, as folks borrow more to fund expansionary and speculative projects, interest rates that creditors charge rise to offset the risk of increased leverage in the system, making further borrowing less likely and slowing down expansion.

Another natural regulator is outright failure. In free markets, poor decisions are penalized by loss of economic resources. Fear of loss tempers feelings of greed, thus reducing potential for exorbitant booms.

But today's markets are not free. Interest rates, for example, are no longer under pure market control. The Federal Reserve and other central banks manipulate interest rates to fix the price of money at non-market levels. Central banks also have power to create money and credit out of thin air, which greatly increases capacity for systemic inflation during boom periods. It didn't take long after the Fed's founding in 1913 before financial system leverage began increasing dramatically.

Increased regulation and oversight can also distort signals of value and risk. For example, FDIC insurance 'guarantees' deposits at participating financial institutions, thus reducing propensity among buyers to kick the tires of financial instituations where they park their money and investments. Conditions of moral hazard develop as folks are prone take more risk, thinking that government has their back if things go bad.

The consequences of this? Potential for much more leverage during expansionary periods than was ever possible in free market situations. Cheap credit, unlimited money creation capacity, and no fear of loss fuels a 'crack up boom' that inevitably spawns a deflationary bust as projects that should never have seen the light of day go to zero value.

Appropriate solutions to this situation are not grounded in more government control, but less. Remove price fixing central banks and their monetary printing presses, and regulations that atrophy buyers' motivation for managing risk, and watch big financial meltdowns disappear.

Like bureaucrats that have preceded him, however, Mr Obama will likely add more fuel that will ignite an even bigger fire down the road.

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