Baseline Scenario

The Baseline Scenario
Peter Fox-Penner Replies
Posted: 03 Nov 2009 09:22 AM PST
On October 24, we published a guest post, “Patchwork Fixes, Conflicting Motives, And Other Things To Avoid: Some Lessons From the Regulated Non-Financial Sectors,” by Peter Fox-Penner. Below is his response to some of your more than 200 comments.
As a stuck-in-the-last-century guy, I’m remiss in not replying to the many comments to my guest post. As an I-O (industrial organization) economist, I learned a lot more than I contributed reading the many colloquies. Here are just a few general observations stimulated by the discussion:
To start off, there seems to be agreement on the difficulty of measuring risk, either because there is no transparency and/or the instruments are so darn complex. Incidentally, the best short piece I’ve ever read on the emerging science of systemic risk measurement is Andrew Lo’s Senate testimony; perhaps all of you have other good pieces. The one thing I learned from Andrew’s piece is that we are a long way from knowing how to do it.
Many folks agreed that if you can’t measure – it you can’t regulate it. Bond Girl and others worry that regulation will stifle innovation. In my view, there is no question about it. There is no free lunch. Regulation reduces the variance in outcomes in a market – that’s its job. Innovation increases them and even disrupts the distribution. When disruptive events have large economic fallout, or violate our norms for justice, the cost of diminishing these risks via regulation outweighs the costs of reduced innovation.
More practically, however, this is not a question of zero innovation versus zero regulation. All regulation allows for innovation – it just reduces and controls it. New drugs are introduced – lots of them. New electric power pricing approaches are approved. And thank you, James Kwak, for reminding commenters that I don’t say “ban derivatives”, I say “oversee them properly.” Furthermore, it is not just the regulated products that evolve – it is also regulatory processes themselves. There is a steady stream of regulatory decisions that find their way into the courts precisely because the regulator did something different this time around and one party challenges whether this (dare I say it) innovation is consistent with the regulatory agency’s legal charter.
Every regulator allows innovation – some even encourage it. But under prudent regulation, you don’t allow a product to be introduced in widespread ways that might undermine the whole goal of your regulatory scheme. Financial regulators did – though it was partly because their authority was balkanized so that new products had no natural regulator. In the end, that’s Joskow’s point and mine as well. Mind the gap, as they say in the London tube.
Redleg asked a simple, fair question: “Doesn’t simplifying the regulatory system simplify how one might compromise it?” In my own limited experience: “No.” Simpler systems are harder to compromise because many more people understand them and can therefore police them, formally or informally. Regulatory agencies don’t need as high a level of skill. So let’s be clear: regulation should be as complex as is necessary to do a good job, but not more so, and regulators MUST have the resources (educational and otherwise) necessary for their job.
Regulatory capture is unquestionably a huge and generally not solvable issue. It is an unavoidable aspect of regulation that civil society must seek to minimize. There is a century of experience with mechanisms that reduce capture: overlapping terms of regulators, requirements for political balance, revolving door rules, and so on. This is the hugely important day to day work of regulatory practitioners and legislative overseers.
Finally, Uncle Billy makes a number of points about Commissions, including the Pecora Commission. In the current ultra-polarized legislative climate, I think these commissions are extremely important and I have high hopes for what I will now call the Angelides Commission.
As to my background and motivation, my vita is posted on the Brattle website at www.brattle.com and more is at www.smartpowerbook.com. No Brattle client (or anyone else) knew that I was doing this post, much less reviewed it, much less paid for it. (However I do genuinely like Rowe and Joskow). See the disclaimer at the start of the post. And yes, we are proud to consider Simon a senior advisor to our firm. I sought out Simon to contribute to the discussion and he consented, not the reverse.
By Peter Fox-Penner
Peter is a leading expert on regulation at The Brattle Group. The views expressed here are his alone.

Ackermann vs. Hoenig: Take It To The WTO
Posted: 03 Nov 2009 05:31 AM PST
Josef Ackermann, chief executive of Deutsche Bank and chairman of the Institute of International Finance (an influential group, reflecting the interests of global finance in Washington) is opposed to breaking up big banks. According to the FT, he said,
“The idea that we could run modern, sophisticated, prosperous economies with a population of mid-sized savings banks is totally misguided.”
This is clever rhetoric – aiming to portray proponents of reform as populists with no notion of how a modern economy operates. But the problem is that some leading voices for breaking up banks come from people who are far from being populists, such as the UK authorities (in the news today) and the US’s Thomas Hoenig.
Hoenig is an experienced regulator, who has dealt with many bank failures. He is also currently President of the Kansas City Fed and an articulate voice regarding how banks became so big, why that leads to macroeconomic problems, and how consumers get trampled (answer: credit cards, issued by big banks; p.6). He supports a resolution authority that would help deal with some situations, but also says (p.9):
“To those who say that some firms are too big to fail, I wholeheartedly agree that some are too big. However, these firms can be unwound in a manner that does not cause irreparable harm to our economy and financial system but actually strengthens it for the long run.”
Mr. Hoenig is, if anything, a little too polite. There is no evidence that huge banks, at their current scale, provide any social benefit. When these same banks were much smaller, in dollar terms and as a percent of the economy, the global economy functioned no worse than today.
Mr. Ackermann and his colleagues are pursuing a purely self-serving line. Reasonable centrist opinion is turning against them. Either the big banks need to shrink voluntarily or they will potentially face consequences that they cannot control.
Building on ideas from the Kansas City Fed, the Bank of England, the UK Financial Services Authority, and the European Commission, the consensus is moving towards the view that state-supported banking (i.e., operating through implicit guarantees on Too Big To Fail banks) constitutes an unfair form of protectionism. Financial services in this guise do not currently fall within the remit of the World Trade Organization, but it would be a simple matter to extend its mandate in this direction.
In any reasonable judicial-type process, involving relatively transparent weighing of the evidence, Mr. Ackermann would be most unlikely to prevail.
By Simon Johnson