Regulating Systemic Risks

I would agree with the use of the word 'only' because monopoly, centralization, and involuntary socialized 'sharing' require the use of force, and force is a power given to just one institution: government.

What I was disputing was that that is the "only" thing which can cause systematic risk.

There is a good case to be made AGAINST using the government to regulate systematic risk, and Don does a good job at making that case.

In my opinion, he does a very poor job at explaining why systematic risk ONLY emerges "when competition is replaced by monopoly power, when decentralization is supplanted by centralized decision-making, and when personal responsibility gives way to socialized 'sharing' of costs and benefits."

Listen guys – I am no finance expert (case in point – it seems I used the word "systematic" instead of "systemic" in my original post). I don't know what else may cause it, but it seems to me that all you need for systemic risk is considerable interdepencies.

I am not the one that used such declarative language – Don used it. The burden is not on me to refute that language because I didn't choose it in the first place.

Don said that (1.) centralized decision making, and (2.) socialized costs and benefits are the "only" causes of systemic risk. If he was the one that said it, he clearly knows why there are absolutely no other causes.

I'm curious about why he's so declarative without producing a shred of evidence for being so declarative – I never claimed to have an answer.

He did a "poor" job because he didn't even attempt it justify it. I'm not saying he's not capable of doing a good job. I'm just saying the job he did was poor.

RickC -
I'm serious as well. I'm not a finance expert. I absolutely cannot provide you with a solid example, and I don't think my question obligated me to. However, my understanding is that systemic risk essentially requires strong interdependencies of financial institutions. If that's what is at the heart of systemic risk I see absolutely zero reason why Don would be so restrictive in listing it's causes. Can I give you a specific example? No. Don seems to know why there is no other way, though – so it might be worth him commenting.

He does make a very good case against government regulation. I want to try to challenge the conventional wisdom in some circles that "Government is always the problem". I don't think it's always the problem. That doesn't mean I believe the converse – that "government is always the solution". I'm very suspicious of state interventions – I think that's our birthright as Americans. And I will say I think Don did a good job explaining why a state intervention could be like throwing gas on the fire.

But I find his unbridled faith in the market grating – and that's what I'm trying to address.

"Monopoly control over the money supply is only the most devious of the countless ways that government dangerously intrudes itself systemically…"

I'm still waiting with bated breath to see what alternative to our current monetary system that Don and Russ would prefer and how they might envision us getting from what we have currently to that alternative. It's hard for me to take such statements seriously until I know what the alternative is.

Kudos Bret!

I think the Ron Paul types frame the whole monetary system debate all wrong. Yes the Fed inflates away the value of the dollar over time. We all know that – it's not that big of an insight.

The question is – do the benefits of central control outweigh the costs of that inflation? Does the benefit of escaping the violent pre-Fed swings between rapid deflation and inflation outweigh the cost of the steady inflation we can expect from the Fed? It is, like so many things, a tradeoff.

I'm not an expert on monetary economics either – I've been fairly happy living under the Fed in my lifetime and I suspect it's worth the cost.

But I do always wonder why Ron Paul and others never seem to frame this as a tradeoff, and always seem to frame it as a decisive answer. If you don't frame it as a tradeoff, I suspect you really don't understand the issue at hand.

For those really interested in theories of systemic risk that don't involve government intervention, here is a paper you might be interested in.

Agency Costs, Collateral, and Business Fluctuations by Bernanke and Gertler

Abstract:
"Bad economic times are typically associated with a high incidence of financial distress, e.g., insolvency and bankruptcy. This paper studies the role of changes in borrower solvency in the initiation and propagation of the business cycle. We first develop a model of the process of financing real investment projects under asymmetric information, extending work by Robert Townsend. A major conclusion here is that when the entrepreneurs who borrow to finance projects are more solvent (have more "collateral"), the deadweight agency costs of investment finance are lower. This model of investment finance is then embedded in a dynamic macroeconomic setting. We show that, first, since reductions in collateral in bad times increase the agency costs of borrowing, which in turn depress the demand for investment, the presence of these financial factors will tend to amplify swings in real output. Second, we find that autonomous factors which affect the collateral of borrowers (as in a "debt-deflation") can actually initiate cycles in output."

It was published in the AER under a slightly different title, but I remember the NBER version being better bc it has a section on policy implications.

There are more such papers you could find on google scholar. The bottom line is that if you write a model with a non-trivial financial sector with asymetric information in financing projects and acquiring capital, you can get heavy systemic risk.

Daniel,

Okay, then you'll have to make a case for how competition is replaced by monopoly power, risks are socialized and centralized decision making supplants competition in the absence of government power.

Don never claimed there is no systemic risk without government intervention. He merely stated that the natural consequences inherent in the market do a better job of regulating systemic risk than top-down government intervention. Since you don't deny that government intervention causes the aforementioned problems, I don't understand your disagreement.

Methinks –
I never claimed he said that government intervention is the only cause of systemic risk. I specifically listed the two conditions that he listed:

(1.) centralized decision making, and
(2.) socialized costs and benefits are the "only" causes of systemic risk.

And my criticism was – how do you justify that those are the ONLY two causes of systemic risk.

We did talk about government and markets – and I said that his use of the word "only" seemed to be symptomatic of a naive trust in markets and a naive distrust in government. If I overanalyzed his position, I may be wrong about that.

But I was very specific about the conditions that he listed and I still don't know why he justifies it.

By the way – random thought on "regulations centralize and consolidate markets"… what about antitrust? If the state can inefficiently concentrate markets by fiat, why can't it in inefficiently disperse markets by fiat?

Methinks -
"Strawman slayer" I like that

I actually wish I had rephrased that before I posted it. I wanted to retract "individual" and insert "market". I think it is probably more accurate to say that a large majority here think that "the market" can do no wrong. And as you point out, obviously that's a straw man too. I probably should have said that a "majority on this blog think that the market is a guaranteed way of obtaining an optimal solution, given the set of feasible courses of action". That last one is probably closer to the truth. Is that still too accusatory? If it is let me know – I think it's fine and I'll assert it.

I'm not saying that those two conditions can arise without government power. I wouldn't be surprised if they can – but that's not what I claimed. What I claimed was that those two things are not the ONLY cause of systemic risk.

Take a look at Charlie's post of Bernanke's NBER working paper. Asymmetric information in a free market. The government didn't do that. Centralized decision making and socialized costs and benefits didn't do that either – and that's a cause of systemic risk.

Thanks for keeping me honest on what I said about people on this blog – feel free to point out other straw men I set up.

And as I said before – I feel zero obligation to present evidence or arguments. Don is the one making the unfounded statements. All I'm asking for is a little foundation. I don't have to prove myself as a precursor to questioning his declaration.

OK wait a minute – when I extrapolated from Don's use of the word "only" I was making a statement just about Don. Then I made an additional observation about people on this blog. Those two statements are not the same thing – but I didn't deny anything. In fact I accepted what I said about people on this blog, and revised it when you pointed out I was wrong. I didn't mean to insult anybody's intelligence – if you took it as an insult then maybe I'll phrase it more delicately next time.

On your #2 point – I agree that generally speaking, bottom up markets produce better results than top down government. Why would you assume that I would believe anything other than that?

On "large" vs. other systemic risks… First, if a systemic risk isn't large, it probably doesn't really count as a systemic risk, right? Second – how in the world does that change things? He is still narrowly defining what could cause a systemic risk – large or small – and he's still doing it without evidence.

And let me say one more thing – I know it was just a letter to the editor. I know it was not a format conducive to providing evidence. But in that case, I think he ought to have just left off the word "only" like Sam suggested and I would have been fine with it!

Thanks again Charlie.

Don – we have yet to hear from you. Was "only" an overreach or do you stand by it?

I like to think his monetarist, life-time consumption, natural rate years were his better years – but perhaps he would have challenged me on that

Another disclaimer – haven't really read any of what Friedman actually wrote at this point, but his Monetary History is next on my reading list after I finish off what I'm currently reading. My lack of direct experience with that work has been eating away at me since everything went to hell this past Fall.

Daniel,

our posts are out of order a bit, causing some confusion.

You don't have to phrase things delicately, just accurately to avoid confusion. Glad you like "straw man slayer". You'd like it even better if you could see my mental image of a straw man slayer

"a majority on this blog think that the market is a guaranteed way of obtaining an optimal solution, given the set of feasible courses of action"

I don't think you were being accusatory, just inaccurate. I'm not sure this statement is accurate either. I can't speak for everyone, but I would reject it for myself because I don't believe that we can 'guarantee' anything. I would say that a bottoms up approach gives us the highest probability of obtaining an optimal result in most cases.

I also think government is more efficient for certain things like providing for the common defense, redistributing some wealth (negative income tax is my preference), running the court system, maintaining rule of law and protecting the interests of the mentally insane, incompetent and minors. Although, I've had sufficient experience with the last function to know exactly how poorly the government acts in that capacity. I just haven't thought enough about it to come up with a better solution.

WRT systemic risk: Actually, now that I'm not posting between actual work activity and I've thought about it some more…we might be misusing terms.

Isn't "systemic risk" the risk we end with after diversification? That is "systemic risk" = "undiversifiable risk". If that's true then government can't reduce systemic risk. Regulation arbitrage simply moves the risk from more regulated industries to less regulated industries or segments of industries, but it remains in the economy. If government regulation engulfs the entire economy, then the systemic risks moves to the black market, no? Meanwhile, the economy stagnates. The cost of reducing and undiversifiable risk is greater than the benefit.

If government can't reduce systemic risk by definition, then it can only impose unnecessary costs to maintain systemic risk with the large potential for introducing new risks – diversifiable risk.

I don't think about these things regularly. Feedback would be appreciated.

Jl,

Thank you for your response. It was also believed that hedge funds posed systemic risk, yet they have been blowing up every day without blowing up the system.

Systemic risk results from interdependence. Without interdependence, there can be no cascade effect or "systemic risk". With or without a Fed, an SEC, a FINRA, an FDIC the institutions trade with each other and overlapping credit exposures will always exist. Thus, I'm wondering just how controllable that risk is. In other words, is systemic risk in this sense very different from undiversifiable risk in securities?

"Isn't "systemic risk" the risk we end with after diversification? That is "systemic risk" = "undiversifiable risk"."

I think you are still confounding two types of risk. I would analogize it to driving through a city, where traffic is coordinated by a series of traffic lights. Obviously, the cars will always face some undiversifiable risk, no matter what some cars will get in wrecks. But suppose all of the traffic lights were connected, so that one wreck in the intersection that destroyed a light took all of the others off-line. The wreck has a cost to the people involved, but the damage of the light caused a huge amount of additional damage as the coordination of the whole city was compromised.

It is possible that such an arragement could arise even from private provision of the lights. Perhaps, the first entepreneurs intersection reached such a mass of traffic that he built light, the next wanted his light coordinated with the first for convenience…etc. Even if there is a strong incentive to keep your traffic light working, one obviously wouldn't bear all of the cost for the discoordination that would be caused by the rest of the system going down.

I think this is the problem with systemic risk. There are two functions of the financial system the first you mention is diversifying rent, but the second is possibly more important providing a mechanism for borrowers and lenders, risk-takers and risk-averters to be brought together. It is this coordination effort that could be taken down by systemic risk.

Daniel, I think many people assume that statements along the lines of "Government does extremely little right" implies "Markets can do no wrong." That is of course false, and Don (and others here) have noted that markets are not perfect. Don makes a point to say so in many EconTalks as well, I have noticed.

I think most people that you refer to here in the Cafe would agree that the Market is not perfect, but is in fact vastly superior to the government in nearly all endeavours. It is not a question of which is perfect, but which produces the better results.

"a huge majority on this blog operate on the assumption that a forced collective can do little right"

There is a reason for the coercion, to induce people to go against their own judgment in favor of the judgment of some other party.

This may be justified in aid of people of poor judgment, but then the justification holds as well in the case of people with
very good judgment.

As coercion is substituted for persuasion, it is often the case that those with poor judgment override those with good judgment, otherwise persuasion would more likely be used.

"I take issue with the use of terms such as "market failure" or "the market is imperfect".

The market is not a creature of design or agency, or even of purpose. As such, the market cannot fail or succeed. The market is a feedback system."

I think of the goal of a market as organizing goods efficently or Pareto Optimally. That is a market is failing when there is some other allocation that can make everyone better off (or more correctly make at least one person better off without making anyone else worse off).

In that light, I think market failure is a useful term that belongs in the vernacular. Certainly, it is a useful concept.

I think a more useful term would be "intervention failure".

It is this coordination effort that could be taken down by systemic risk.

Charlie, unless I misunderstand you, there is no coordinated effort on the part of the industry apart from the coordinated effort effected by the regulator. There is a lot of interdependence. That interdependence causes systemic risk (potential cascade effect). There is nothing the regulator can do to prevent that risk except to loosen regulations to allow companies to become more diversified.

The only thing I can think of that the regulator can potentially do is to limit leverage so that losses aren't as magnified. But, regulators were already closely regulating leverage. All the banks were compliant with Basil II.

"There is nothing the regulator can do to prevent that risk except to loosen regulations to allow companies to become more diversified."

Not necessarily, suppose due to scale effects it is good for a financial company to become larger, but suppose when a large company fails it inflicts a much larger coordination cost than when a small company fails. In principle, the market actors could make everyone better off by the small companies paying the big companies not to become large, but the market won't exist for this (everyone would pretend to be about to become large). A regulator could potentially fix the problem by taxing size and dispersing it.

The point is that there are things that affect well-being that won't ever be fed back through markets, because private property rights don't exist or because contingent contracts can't be written, so the feedback loop is flawed.

Ever is a long time.

Why don't property rights exist?

An early pollution case involved a orchard framer suing the railroad because the emissions from steam engines were damaging his trees. The court ruled for the railroad proclaiming that "we can let property rights stand in the way of progress."

That's why I think "intervention failure" is a more useful term.

If there are problems because of a lack of property rights, it's likely because intervention has prevented their application.

I don't see these problems as "market failure", I think it's a problem with market actors.