We set out five principles on which to base sound economic governance and add a more practical rule of thumb
One of the most important lessons of the global financial crisis is that we got – and indeed continue to get – regulation spectacularly wrong. For far too long it was thought of simply as ‘red tape’ – an unnecessary imposition and an unwelcome and unwarranted interference leading, invariably, to tiresome, overbearing, cumbersome and inefficient bureaucracy. We inclined accordingly to as little of it as we could credibly get away with (the appropriate euphemism was ‘light touch’). And, even if we carried a lingering doubt at the back of our minds about the probity of all of this, we comforted ourselves with the thought that this market-conforming regulatory disposition was at least growth-enhancing – in that the blind eye it invariably cast on potentially rather shady practices almost certainly contributed to higher economic output and, in turn, higher taxation receipts.
Shamed perhaps by their popular depiction as interfering meddlers pathologically predisposed to intrude into arenas they seldom understood, the disposition of the regulators themselves was, far too often, also that of benign neglect. They, too, comforted themselves, this time with a slightly different thought – that markets, for the most part, were their own best regulators and market actors were in general better placed to assess the risks to which they exposed themselves than those seeking to second-guess their behaviour. If that resulted in an historically high ratio of private debt to GDP, then so be it: the markets, and the actors who breathed life into them on a daily basis, surely knew what they were doing – and, above all, they were making money … lots and lots of money.
This was always wrong and it is an attitude and a disposition we can no longer afford as we seek to build a new model of capitalism out of the ruins of the Anglo-liberal growth model. Interestingly, amongst the first to accept this and call for a more precautionary regulatory disposition were many of the regulators themselves (or, at least, many of those on whose watch, as regulators, the crisis had unfolded). Chastened, presumably, by their experience and their incapacity at the time to prevent a slow-motion car crash unfolding before their eyes, many of them seem now to be of the view that the same cannot be allowed to happen again – and that, having in effect fallen asleep at the wheel once, it is their responsibility to ensure that those who replace them stay awake rather longer.
Tragically, to date at least, they have not found a terribly receptive audience amongst those in the advanced political economies who appointed them as regulators in the first place. It is not difficult to understand why. The truth is that there was always something in the argument that regulation has a certain propensity to suppress growth – or, at least, some forms of growth. And growth is, of course, what incumbent administrations (particularly those seeking re-election) crave above all else. High loan to value ratios, low capital adequacy requirements, high levels of consumer debt, cheap credit, sub-prime lending and mortgage-backed securities all look like prime targets for a more precautionary regulatory regime. Yet, as long as the bubble lasted, each was a real source of growth – or, perhaps more accurately, a multiplier of potential growth.
Indeed, whether we like it or not, each has played a part in the putative ‘recovery’ of the British economy since the second quarter of 2013. That is precisely why such a recovery is spurious; it is not based on stable growth, but rather the re-inflation of the bubble whose bursting precipitated the crisis in the first place. This is why we need appropriate regulation – market-steering or market-limiting regulation capable of precluding the re-inflation of asset-price bubbles such as we have seen in the housing market. It comes, though, with a short-term price. For we have to accept that such regulation is not consistent with the consumer debt-fuelled recovery prompted by the British Coalition government since 2013; instead it entails, and must indeed be an integral part of, a transition to a new mode of development or growth for the British economy.
So what might such regulation entail? Consistent with the model of Civic Capitalism we are seeking to outline in these posts, we propose five principles for sound economic governance and a more practical rule of thumb. The five principles are simply stated:
- First, and perhaps above all else, we argue that regulation should not just be about tempering market excess; it needs to serve, and be seen to serve, a wider societal purpose – to help markets contribute to the growth model of the economy as a whole.
- Second, following Nobel Laureate Paul Krugman, we suggest that regulation should be in proportion to the potential risk posed by the object of regulation. Krugman’s focus here is the banking sector, but the principle is more widely applicable. He argues that banks should be regulated not against universal and rigid rules, but in proportion to their systemic significance to the financial sector as a whole. Thus, we don’t so much need a rule that precludes banks from becoming ‘too big to fail’ (or too big to be allowed to fail), so much as a regulatory regime which ensures both that banks too big to fail don’t fail and that the burden of regulation they would endure is a strong disincentive to them ever attaining such a systemic significance in the first place.
- Following almost directly from this, we suggest the need to adopt a principle of discretionary precaution in economic regulation. Effective regulation, whether of the energy market or the market for financial innovation, is most effective, not when it is rules-bound but when it is flexible, adaptive, intelligent and transparent. Regulators, as the crisis shows so effectively, need to be risk-averse – even if at times that has the effect of closing off potentially lucrative investment or growth opportunities. They need, in other words, to adopt a strong and consistent precautionary principle. But they also need the authority to demand full and complete information disclosure from the institutions they regulate and a flexible capacity to respond dynamically to the risk assessments they generate on the basis of that information.
- A further principle follows, with particular significance for complex and dynamic markets such as those for instruments of financial innovation. It is that, in the name of precautionary discretion, we should adopt a presupposition against financial innovation in the absence of a strong counter-veiling case. It is often argued that it is impossible to regulate financial markets effectively since financial market actors themselves are typically at least one step ahead of the regulators. There are usually two elements to the argument: first, that the almost constant innovation in financial instruments allows market actors to side-step any regulatory rule or regime designed to hold them in check; second, and rather unkindly, that those who regulate financial markets have typically failed to make money in them and, as a consequence, are not well placed to anticipate the creativity by which rules are negotiated. Although there may be an element of truth in both propositions, this only becomes an impediment to effective regulation of financial markets if we have a presupposition of tolerance to financial innovation. This can and should be overturned.
- Finally, we suggest that regulation (whether domestic, international or global) is best seen as a collective public good. As such, it needs to be delivered through a system that is both public and publicly accountable. Credit rating provides an excellent example and should be seen as part of the system of global regulation of markets and market risk. For credible and effective credit rating is categorically a public good – insofar as it serves either to reduce the risk to which financial investors expose themselves or help them better to assess and hence hedge against that risk. But, as the dynamics of the crisis showed so clearly, we cannot entrust such an important task to private ratings agencies with a clear financial stake in the assets they rate and with little or no retrospective responsibility and accountability for the public good they ostensibly provide. The reality is that there are a range of public or quasi-public bodies which could take on such a role. For example, with respect to the credit rating of sovereign debt, the IMF in its periodic reporting in effect already provides credit ratings (just ones not expressed in the standard metric form). It is surely time to dispense altogether with private credit rating as we strive to build more appropriate public structures for the regulation of the global economy.
This brings us, by way of conclusion, to a more practical consideration. Regulators need to be trained in disequilibrium thinking. As we have argued before in this series of posts, mainstream economic theory today is, almost exclusively, equilibrium theory. In other words, whatever its value and whatever its influence, it has virtually no capacity to prepare us for disequilibrium outcomes – like crises. Most of the time that is fine; but regulation is there to prepare us for, and thus guard us against, the possibility of catastrophic events. Regulators, in short, need to assume the worst; they cannot afford to presume the best.