The regulatory cycle or why new rules aren't the answer.

Deregulation has taken a lot of the blame for the current crisis. Most of the people saying that conclude that if deregulation caused the problem, regulation can solve it. They are wrong.

To understand why you must abandon the common, if largely unconscious assumptions about regulatiors and how they produce regulation. Generally people assume that wise, impartial regulators sit down, look objectively at the facts and, unswayed by intellectual fashion and the irrational exuberance or depression of the market and society, make wise, impartial, objectively based decisions. If that were true then why is it that such decisions are only made exactly when they are not needed, as is presently happening. Currently the US government is writing rules about overextending your company, investing too much in doubtful financial assets and everything nobody wants to do any more because it loses money. No doubt other governments are too. It's like making sure everyone has cleaned the leaves out of their gutters after a bushfire has demolished half the town. To understand why they're passing such laws and regulations now, you must understand the financial regulatory cycle and how it trails the monetary cycle.

Stage one of the regulatory cycle is Crisis, caused by the excesses of monetary expansion. Crisis creates a demand for immediate action to combat the cause of the present catastrophe. The cause is however the state of the regulatory cycle some time in the past so correcting it has no immediate effect.

Nevertheless the second stage, Action occurs. Regardless of the immediate effects of Action the monetary cycle moves on and things correct themselves. The Action may speed this up, slow it down, make it easier or harder, more expensive or cheaper.

This leads to the third stage, Inefficency. During Inefficency actions taken during more frantic times are observed to be hampering the markets efforts to create wealth. Since the market is still in recovering from a bust there is little chance they are actually preventing bad behaviour anyway, since that only happens in the boom phase. Thus their effect is to impose large present costs for very small or nonexistant present gains.

This leads to the fourth stage, Circumvention. Firms in the financial market do two things. Lobbying to remove the restrictions placed in stage 2 occurs to the general appathy of the population. Few if any voters and political masters understand the present rules and why or even if they're important. Resistance to selective deregulation is low as the circumstances that led to the need for the regulation are gone. Firms also develop practices that go around the current rules while having largely the same effects as the practices forbidden. This makes the original regulations even less important, even counterproductive if they simply shift activity to less transparent or accountable sections of the economy. Circumvention accelerates when during times of monetary expansion because during those time the need for caution and restraint is weakest.

The combination of the monetary boom and Circumvention above leads back to Crisis.

You might ask, "Is this cycle inevitable?". Might we act appropriately and promptly to prevent such a destructive turn of events. The answer is "Why would we?". During the times when such action is neccesary by it's nature few people think it's warrented. If people were in general worried about the negative effects of asset price bubble then we would not have one, since a precondition of such a boom is that people don't think it's either happening or going to happen. To impose or keep regulations to prevent it happening regulators must go against the wishes of pretty much everyone who's paying attention to their activities. They must do this despite not being able to offer any evidence that their actions are warranted, predictions being notoriously difficult in economics. Those wanting to remove restrictions can point to solid evidence of costs in the here and now. In any case in many or even most cases they're right about the high costs and low benefits of regulation, because much of the regulation was passed in panic during stage 2 (Action) when it was felt there was little time to think through the costs and problems. A case could and will be made that the actions in the Action stage were hasty and ill-considered and possibly now out of date. A general mood of caution and pessimism will defeat this case, which is another way of saying regulation won't be abandoned until shortly before it's needed.

And yes, my blogposts are like buses, none for yonks then three come at once.