The Myth of Regulating Finance

The Myth of Regulating Finance

There is no reasonable mechanism that can guard against the boom and bust cycle, and certainly not those Washington put in place after the last crisis. Regulation is simply inadequate to the task.

Back then, the rest of world finance ran on gold, yet the newly formed United States had too little of it for its needs. All the gold available in this country flowed overseas to pay interest and principal on the huge debts incurred during the war for independence. Without an acceptable base, the nation lacked a financial system. Additionally, it had no money of its own—Americans depended on a mélange of foreign currencies and paper privately-issued by presumably trustworthy merchants. Without a domestic deposit base, the country also lacked an effective means to advance credit. Business could not even finance the purchase of inventories, much less procure longer-term lending to support expansion and innovation. Hamilton devised an imaginative substitute for gold that, at least theoretically, could work today.

Instead of a gold base, he offered the debt obligations of the federal government. At first, this might seem counterintuitive, but he nonetheless so arranged the governments affairs that the debt served the purpose. He put the government’s finances in order and made it clear that the debt would always pay in full and on time. He reinforced this promise by establishing a sinking fund to earmark a portion of the government’s annual revenues for debt repayment. That secured the first virtue of gold, the confidence people had in its value. To make the government obligations still more like gold, he endeavored to fix their price. He used the sinking fund to act in markets to that end. He also established the First Bank of the United States—a government-private partnership that would effectively serve as the government’s bank, set an example by conducting itself on prudent principles, and also stabilize the price of government debt by buying and selling the bonds in the market. The solution worked. The public looked on the debt as good as gold. And since the guarantees of payment rested on government revenues, they were effectively tied directly to the U.S. economy’s ability to produce. In this way, the debt was actually more realistic than gold.

In some respects, today’s financial system would seem open to a Hamiltonian solution. It is, in many ways, as Hamilton established it some 230 years ago. Though from time to time the United States declared itself to function on a gold base, the financial system has always rested on a base of government obligations. Unfortunately, a return to these arrangements would demand an unlikely move in Washington to tether debt to revenues and, consequently, to the real economy, as Hamilton’s scheme did. At the very least, Washington would have to put debt on a predictable path. In today’s political milieu, such a move seems far less than likely. Policymakers would also have to assure the public that they would tether the liquidity in the financial system to revenue-linked debt, or at the very least put it on a predictable path. Such assurances are antithetical not just to current fiscal practices but also to the nation’s monetary policies, which create liquidity with little reference to government finances.

IF SUCH a return is impossible and regulation, though helpful, remains inadequate, it would seem that boom-bust patterns are inevitable. They are. Ironically, however, recognition of the risks involved, and the inadequacies of regulation could itself help moderate if not actually tame the boom-bust character that so frightens so many people. If the authorities were to admit freely that their ability to control matters is limited and that the system carries inherent dangers, financial people, businesses, and individuals might proceed with greater caution than heretofore and insist that others do the same. Depositors might prefer institutions that have demonstrated more caution. Financial managers might enhance their career prospects instead of injuring them by showing sensitivity to excess. They might have a better chance to explain to boards and shareholders why they want to avoid “the dance,” in Charles Prince’s words.

As long as there is a pretense that regulation can do the job, these decisionmakers have little incentive to embrace prudence or even consider it. One could say that the inflated claims of regulations and regulators have introduced a moral hazard by allowing people to believe that they can neglect reasonable caution. An expectation that this acknowledgement of reality would induce a moderating prudence is admittedly a slender reed on which to base optimism, but it is all the country possesses.

Milton Ezrati is a contributing editor at the National Interest, an affiliate of the Center for the Study of Human Capital at the University at Buffalo (SUNY), and chief economist for Vested, the New York based communications firm. His latest book is Thirty Tomorrows: The Next Three Decades of Globalization, Demographics, and How We Will Live.

Image: Reuters.