Monday, December 1, 2008

The Case of the Omniscient Regulator

Exception noted:

I see little hope of creating any kind of "early warning" system, if by that Mike means better forecasting. Crises like the current one are inherently unpredictable. If they were predictable, hedge funds and other money managers would not lose so much money during them.
-Greg Mankiw

"Inherently"? I don't think so, completely, even if it means "forecasting", to a degree.

The tools to manage risk are all in plain sight. All that one needed to do, perhaps, is to have looked at the growth charts, for CDS and for RMBS issuance in the asset-backed markets. When you view exponential growth, you worry aloud, quickly and actively.

A glance at a chart does not involve some complex understanding that goes beyond the comprehension of savvy market participants. What's more, those participants weigh a different set of concerns, most commonly, see a different utility in the outcomes. (Put another way, Greenspan was arguably wrong to have let himself get swatted with this argument, by Wall Street, when he caused them some pain by issuing the stupendous phrase that defined an era, "irrational exuberance".)

Indeed, if the 'shocked disbelief' of the current period has instructed anything, it is that an unencumbered embrace of self-regulating, all-seeing "markets" is gravely misplaced. Even on practical grounds, it may have been far less costly to the general welfare to have tried and failed than to have done nothing at all.

It helps to be particular, as well.

The key problems of "systemic risk" to the financial system, which one could argue center on AIG and Lehman, so far, both involved many risks that were certainly knowable a priori. I don't' think there was much "inevitable" about their failures.

The key problems of "economic risk", like the loading on of debt, the decline in national savings and a structural trade deficit, are problems that can be dealt with "systematically", by policy choices.


In another context, Greg argued:

But I continue to believe that there are other choices.
Following that thought, perhaps it is past time to get past old dichotomies and argue, instead, how best to formulate a set of better regulators and regulations.

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