Regulation Does Not Prevent Crises. Here Is Why
If you read articles and books about the crisis, I am sure you will find a common denominator about the main cause, at least in mainstream press “Taking an excessive risk”. And it is partially correct. But, on many occasions, commentators fail to explain why this happens. Why changes in our brain that takes us from a natural cautious attitude to diving into excess?
The widespread perception that risk does not exist.
And how can this absurd idea be generated in the collective subconscious? It cannot come from any other source than from the government’s monetary and fiscal policy. A “take more risk, I will limit it” message. And that’s just the spark. All economic agents feed the fire and participate in the creation of a bubble, while the accumulation of risk is multiplied by the confirmation bias. “Everyone says so.”
Mainstream studies will devote entire books to explaining why manipulating the cost and amount of money is not a problem. Families, businesses, banks, governments, and agencies will mutually convince each other that nothing can fail, because “everyone” accepts that “this is a new paradigm”, endless explanations to deny evidence and logic.
Rates are artificially reduced from five percent to one percent and a global crisis is generated? Let’s lower them from one to zero, or better, negative. It will surely work. Does the credit and money supply expand disproportionately? Obviously, the solution should be to “flow credit” and increase the money supply, of course.
Do credit and money supply expand disproportionately? Obviously, the solution should be to “ease access to credit” and increase the money supply, of course.
If tens of thousands of pages of regulation could prevent crises, these would not exist.
The publication Ten Thousand Commandments analyzed, for twenty-five years, the accumulation of regulation. According to their analysis, there has been a new federal regulatory measure every two hours and nine minutes-24 hours a day, 365 days a year, for the past twenty years. About 81,000 pages per year, only in the US.
It is estimated that before the crisis the European Union generated an average of 4,500 rules and regulations for the financial sector each year. Only the Fédération Européenne des Conseils et Intermédiaires Financiers (FECIF) received 500 pages a month.
Regulators tried to compensate basic imbalances with tons of paper without addressing the root of the problem.
There is no way to avoid a crisis by adding rules and regulations while at the same time manipulating the quantity and price of money by injecting huge amounts of liquidity and lowering rates more than six hundred times.
A crisis is not avoided by setting maximum bankers’ salaries if perverse incentives are imposed by others that benefit from a system of privilege in credit and access to liquidity. Governments.
Regulators and legislators, by definition, are magnificently equipped to avoid the crisis that just happened, not the next. And we find ourselves in that same situation today. Because regulation, unfortunately, does not attack the origin of the problem. Financial repression as an instrument to artificially “force growth.”
Interest rates have been cut more than six hundred times in recent years. Zero or negative rates do not reduce risk, they increase it. If you really think that Alan Greenspan was evil for lowering rates to one percent, yet Bernanke or Yellen are saviors lowering them to zero, you have a diagnosis problem.
If you think that with Greenspan there was no regulation and that today everything is under control, you are seriously uninformed.
If you believe the fallacy that Trichet “created” the European crisis by raising interest rates to -oh, the calamity- 1.5%, you have a case of bubble behavior.
If you believe that there is a crisis because the financial system creates money artificially and that the solution is that money continues to be artificially created, but only by the government, allow me to sell you the New York Statue of Liberty at an exceptional price, just for you.
But there are more important risks.
There are no laws or regulations that control the risk generated by the institutionalized fallacy that “public debt is not at risk.” And that ridiculousness is, for example, the pillar of the European Union. This affects bank balance sheets, the composition of pension plans and the perception of all economic agents.
Preparing to avoid the previous crisis does not solve the next. Crises are always generated in assets that we consider of extremely low risk.
It is impossible to accumulate disproportionate risk unless economic agents, governments, and central banks think that such risk does not exist. Hence real estate bubbles, allegedly low-risk bonds, “guaranteed” technologies, “bullet-proof” infrastructures, “risk-free” subsidized public companies …
Of course, you can say that the financial system creates complex products that can be very risky. But the root of those time bombs is always found in ideas like “house prices never go down,” “the government guarantees it” or “long-term, everything goes up.”
Regulation never supplements financial culture. And even financial culture does not prevent some mistakes.
Financial repression is creating the basis for the next crisis. Are you not terrified to see that governments, companies, and families accept negative rates? Are you not scared to see money supply grow twice as much as nominal growth?
Thousands of pages with thousands of rules will not prevent the creation of an excessive risk accumulation… when rates are NEGATIVE!
Does that mean there should be no regulation? Not at all. Regulation should be effective, simple, easy to implement, understandable, direct and, above all, to facilitate economic activity without trying to cover every aspect and prevent any risk, because it ends up achieving nothing and preventing less.
In the US the Republican party is already in the process of forcing the Federal Reserve to follow a Taylor Rule to avoid continuing to perpetuate bubbles , but much more is needed.
I’m going to break a spear in favor of the regulators. They work with what is in front of them and do what is required of them. It is not they who dictate monetary or fiscal policy. I remember a conversation with a good friend of a regulatory body who, before the launch of the last mega stimulus, told me “let us see now how we contain this tidal wave.” “You cannot,” I said. And they could not.
When the imbalance generated by the madness of monetary laughing gas, they will tell us again that it was a problem of “lack of regulation”. And that the solution is to repeat the same imbalances with ten thousand more pages of rules.
The best regulation is to stop believing that two plus two equals twenty-two.
Daniel Lacalle. PhD in Economics and author of “Life in the Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.
Image courtesy Google.