The Corner

Thinking About Regulation

Paul Singer has an op-ed in today’s Wall Street Journal arguing that free-market conservatives need to re-think their approach to financial regulation:

President Barack Obama took his proposed financial regulatory reforms to London this week for the G-20 meeting, while free-market advocates objected. While many of Mr. Obama’s ideas warrant skepticism, conservative opposition to any expanded role for government is a mistake. There is an urgent need for a new global regulatory initiative that addresses the primary cause of the financial collapse: highly leveraged and concentrated positions.

In the latest issue of NR, Kevin Williamson and I reach the same conclusion, but for different reasons. We argue that tighter regulations are needed, not because regulation works better than market discipline at curbing excessive risk-taking, but because government bailouts have impaired the market’s ability to function properly; that without new regulations, firms will continue to gamble on the prospect that the government will always bail them out. Mortgage giants Fannie Mae and Freddie Mac provided the rocket fuel for this crisis, and what happened there? Excessive risk-taking as a function of implicit government backing. And now the government has extended that backing to the entire financial system:

Here’s the problem… the government has already created the perception — and the reality — that systemically significant companies will not be allowed to fail. A year’s worth of bailouts have allowed moral hazard to spread throughout the financial system. Restoring market discipline, if possible, could be a decades-long process. If you accept the depressing but increasingly inescapable conclusion that we have already created a nation of Fannies and Freddies, then the question becomes: How do we best protect taxpayers from the prospect of endless bailouts? Conservatives answered this question with regard to the original Fannie and Freddie by calling for a powerful regulator with the authority to seize the companies if necessary.

The ideal solution would be to restore market discipline by allowing firms, even large ones, to fail, but that might not be possible at this point. The more realistic solution would entail a new regulatory framework to substitute for the market discipline that the bailouts have destroyed.

Update: I should clarify that I don’t necessarily endorse all of Singer’s recommendations, but I share his view that we need an updated regulatory infrastructure. Kevin and I laid out our own recommendations in the article.

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