Posted by Ilya Somin:
A Flaw in George Soros' Case for Increased Government Regulation of the
Financial System:
http://volokh.com/archives/archive_2009_06_14-2009_06_20.shtml#1245343164
I am no expert on finance. Therefore, I cannot tell whether[1] George
Soros' proposals for increased regulation of the financial system have
merit or not. Soros has probably forgotten more about finance than I
ever knew to begin with. However, Soros' position has at least one
serious weaknesses that are common to many arguments for increased
government intervention in society: it fails to give adequate
consideration to the shortcomings of the political process. Strangely,
Soros admits that government is likely to do an even worse job in this
area than he believes the private sector has; yet he still ends up
supporting increased regulation.
Soros argues that speculative bubbles are a form of market failure
that can cause great harm to the economy when the bubbles pop. He
therefore concludes that we need government intervention to prevent
bubbles from forming. However, he concedes that government regulators
are unlikely to do any better at predicting dangerous bubbles than the
market does:
[S]ince markets are bubble-prone, regulators must accept
responsibility for preventing bubbles from growing too big. Alan
Greenspan, the former chairman of the Federal Reserve, and others
have expressly refused that responsibility. If markets cannot
recognise bubbles, they argued, neither can regulators. They were
right and yet the authorities must accept the assignment, even
knowing that they are bound to be wrong. They will, however, have
the benefit of feedback from the markets so they can and must
continually re-calibrate to correct their mistakes. [Emphasis
added]
If, as Soros believes, government regulators will be just as bad or
worse at predicting bubbles than market participants, it's not clear
why he expects government intervention in this area to improve things.
His argument could still work if government regulation in this field
were costless. If that were so, the regulators might occasionally
prevent a dangerous bubble from forming, while not causing any harm in
the vast majority of cases where they are "bound to be wrong."
However, as Soros himself points out, government financial regulation
isn't costless because "While markets are imperfect, regulators are
even more so. Not only are they human, they are also bureaucratic and
subject to political influences." But he doesn't do enough to consider
the likely impact of these "political influences." The rest of his
argument for increased regulation proceeds as if government were a
"benevolent despot," willing and able to implement the right kind of
regulation so long as he gets the right advice from experts like
Soros.
Unfortunately, common systematic shortcomings of government suggest
that Soros' "political influences" might cause even more harm in the
field of financial regulation than elsewhere. As I discussed in
[2]this post, government intervention typically suffers from three
major shortcomings: inadequate knowledge on the part of government
officials, [3]widespread political ignorance among the electorate, and
the power of interest groups who can "capture" the political process
and use it to benefit themselves at the expense of the general public.
All three of these problems are likely to be especially severe in the
field of financial regulation. Even those who worry less about
political ignorance than I do would be hard-pressed to argue that the
voters have a good understanding of complex finance policy issues.
It's telling that [4]some 25% of the public is so ignorant that they
blame "the Jews" for the financial crisis. Such widespread ignorance
suggests that voters will do a poor job of monitoring the performance
of regulators, and also creates the danger that public ignorance will
push the government to adopt severely flawed policies that seem
attractive to voters with little understanding of the financial
system.
It is also obvious that there are powerful interest groups in the
finance industry who will lobby regulators to try to "capture" them
and use government power to benefit themselves at the expense of the
general public. Banks and large institutional investors are obvious
examples. The danger of special interest lobbying is, of course,
exacerbated by widespread political ignorance. Ignorant voters can
easily be fooled into believing that policies pushed by special
interests will actually benefit the general public.
Finally, as Soros himself points out, government financial regulators
suffer from inadequate knowledge and are likely to make mistakes as a
result. The same complex nature of the financial system that ensures
widespread public ignorance also makes it difficult for regulators to
gather sufficient information to know when they should act. If
regulators act on poor information, they might engage in interventions
that create serious harm - as the Federal Reserve discovered on
several occasions in its history, including the Great Depression.
Does all this definitively prove that increased regulation of the
financial system is undesirable? No, it doesn't. But it does suggest
that justifying increased regulation requires a much stronger argument
than that given by Soros. It isn't enough to prove that a market
failure exists. We also need proof that government regulators will
have the knowledge and incentives needed to improve on market outcomes
without causing harm that outweighs any benefits they might create.
Even if Soros is right about the alleged failures of the market, he
hasn't shown that government intervention will be better. Indeed, for
reasons he himself hints at, it might be much worse.
References
1. http://volokh.com/archives/archive_2009_06_14-2009_06_20.shtml#1245258297
2. http://volokh.com/archives/archive_2009_06_14-2009_06_20.shtml#1245258297
3. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=916963
4. http://volokh.com/archives/archive_2009_05_17-2009_05_23.shtml#1242876352
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