Economics know-how about financial regulation/stability before the crisis..

Richmond Fed chief Jeffrey M. Lacker gives a useful speech.

He covers what econs knew before the crisis in financial regulation space.

The thoughts could be divided into two schools:As policymakers entered 2007, the economics literature offered them two broad but fundamentally different views of the world — two theories of financial instability. One tends to view market institutions and contracts as relatively fixed and the resulting financial system as inherently prone to the type of instability depicted by the simple model of bank runs. Under this theory, an expectation of government support may be necessary to make crises less likely, although that support necessitates regulatory oversight and constraints on banks to replace the market discipline that is lost when counterparties feel protected by government guarantees.

]In the alternative view, private financial arrangements are themselves adaptable and endogenous. Much of the vulnerability observed in financial markets is itself the induced response of market institutions and behaviors to the expectation of government backstop support in the event of distress. In the absence of that expectation, there would be stronger incentives to seek more robust arrangements.

So on the eve of 2007, policymakers were faced with two broad, competing views on the origins of financial market fragility — either it was inherent in the structure of financial arrangements, or it was induced by expectations of government support.

The US policymakers entered the crisis mainly schooled in the first thought. This led to perverse incentives and too big to fail problem. He of course believed in the second school.

He even discusses the broad research which led to development of these two theories starting from Douglas Diamond and Philip Dybvig theories, mechanism design etc.

He hopes we limit these government interventions and let markets function on their own:

There’s no doubt that the crisis will stimulate research for decades to come. Given the magnitude of the interventions we’ve seen, research that improves financial policy could yield enormous social benefits. In this connection I would note that our most recent estimates at the Richmond Fed are that, as of December 31, 2011, 57 percent of financial sector liabilities benefit from perceived government support. This is up from 45 percent over a decade ago and reflects in part an expansion of implied commitments based on new precedents set during this crisis. In my view, this growth in government support for the financial sector is not sustainable. As economic policy challenges go, I would rate this as second only to the looming federal fiscal imbalance. I sincerely hope we can make progress in the years ahead. 

Nice coverage on financial sector policy research..


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