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Investing and Economics Blog

Failure to Regulate Financial Markets Leads to Predictable Consequences

It seems to me the situation that lead to the current economic problems are due to the overthrown of the Glass-Steagal and other long time sensible regulation put in place to restrict economy wide destruction caused by a few large financial firms (well, that plus incredibly poor management by people that paid themselves many times more than anyone else and other factors – huge consumer debt…). But the most significant systemic problem was failure to regulate even close to sensibly. I have several posts on this topic on previously: Congress Eases Bank Laws, 1999 – Treasury Now (1987) Favors Creation of Huge Banks – Canadian Banks Avoid Failures Common Elsewhere and Greenspan Says He Was Wrong On Regulation.

Capitalism requires sensible regulation. Regulation is not a friction on capitalism it is a necessary component. Poor regulation is a friction that is waste that should be excised. Unfortunately that is a very challenging task and when you allow those with the most gold to set the rules it is no surprise you have them saying they should not be regulated but should be protected. The failure of financial regulations do show the very obvious problem we have currently of those that donate huge amounts to politicians are granted favors that are paid for by the economy overall.

The widespread failure to regulate financial markets recently is almost certain to lead to this exact type of situation every time. Companies will over-leverage, take huge risks, take huge pay while times are good and just go bankrupt when times are bad. Think about how a bank makes money. They charge fees for things like: writing a loan, overdraft charges on your account, arranging financing (loan or stock sale)… They charge more for in interest than they pay. Some money there but really they are doing nothing special so they should not be able to charge too much. Even the ridicules fees companies pay (often those in the companies have arrangements to get personal special deals – allocations of IPO’s, jobs later…) for arranging stock sales do not have a systemic risk. Those risks should be very easy to manage sensible.

They speculate in currency markets, commodities markets, futures, derivatives… If you want a stable economy if you allow huge speculative investments to be assumed to such an extent they risk the economy you are in trouble. If you refused those risks to limited liability companies perhaps your limited regulation model might work. Where those profiting on products with negative economic externalities would personally go bankrupt prior to the losses becoming economically crippling. But I doubt even that would work. And we don’t have that now. We allow people to setup limited liability corporations, drain them of capital on speculation of potential value and then walk about with hundreds of millions of dollars if the company fails. And the negative externalities (due to huge leverage) are huge.

Regulation seems the obvious solution. And it works when applied. It wasn’t until the USA decided to abandon the financial system regulation and enforcement that the problems became systemic. And see the current Canadian banking system for what happens, even while the world economy is collapsing if you required banks to remain banks instead of massively leveraged speculators paying huge bonus to the executives based on their claims of profitability.

I agree trying to control risk is dangerous. There are however, very sensible measures to take. Do not allow huge financial companies to exist (we have laws on anti-trust, anti-competitive behavior…). Do not allow banks to speculate (more than a careful controlled regulated amount). Do not allow massive leverage of massive amounts of money. Do require audited financial records. Do require companies that want to speculate to be much smaller than regulated bank, and bank-like companies. Do elect politicians that will appose allowing companies to undertake systemic risks to the economy for short term financial gains.

We continue to elect politicians that provide large favors to those giving them money at the expense and risk to the rest of us. Therefore we are bringing this upon ourselves. When we chose to stop supporting politicians that behave in that way then we will get different behavior. Until that point it will continue. We don’t seems to be in any mood to change what we have been doing.

Comments on Note to Regulators: Beware the Montana Paradox

Related: More on Failed Banking Executives – more posts on regulation in capitalist economies – Credit Crisis the Result of Planned Looting of the World Economy – Bad Behavior

April 26th, 2009 John Hunter | 6 Comments | Tags: Economics, Financial Literacy

Comments

6 Comments so far

  1. Curious Cat Management Improvement Blog » Why Congress Won’t Investigate Wall Street on April 30, 2009 10:23 pm

    The failure of the political leaders, putting economic policies favoring their donors instead of the economy as a whole, is something that should be investigated.

  2. Canada's Sound Regulation Resulted in a Sound Banking System Even During the Credit Crisis at Curious Cat Economics Blog on June 22, 2009 12:05 pm

    “Canada’s banking system has so far displayed remarkable stability amid the global turbulence, thanks in good part to strong supervision and regulation…”

  3. Volcker on the Great Recession and Need for Reform at Curious Cat Investing and Economics Blog on December 13, 2009 8:07 am

    […] He is right that we need serious reform to the deregulation that allowed the credit crisis to explode the economy. […]

  4. Making Debt Holders into Unpaid Regulators at Curious Cat Investing and Economics Blog on April 7, 2010 9:18 pm

    […] ethics and character that the USA has now. The solutions are not simple. Some are obvious, like limiting leverage, not providing huge favors to those that pay politicians huge amounts of cash… While Canadian […]

  5. Anti-Market Policies from Our Talking Head and Political Class at Curious Cat Investing and Economics Blog on October 13, 2011 7:52 am

    […] is exactly the type of behavior supported by the actions of the politicians you elect (if you live in the […]

  6. Simple Explanation of the Fractional Reserve Banking System at Curious Cat Investing and Economics Blog on December 23, 2011 7:53 pm

    […] The webcast is by the great Kahn Academy which produces simple educational content (like the above) on all sorts of topics. I find this too slow but I think it might be good for people that are not really sure how the banking system works. There is a group of people that are very apposed to fractional reserved banking, as a principle. I actually am fine with it, but it needs to be regulated much better than we have done. […]

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