Macro-pru, regulation, rule of law and public choice theory

Another rule of law-related post. It might be the anniversary of the Magna Carta that brought this topic back in fashion. Consider it as a follow-up post to my Hayekian legal principles post of a couple of weeks ago.

John Cochrane has a very long post on the rule of law on his blog (which could have been an academic article as the pdf version is 18-page long) titled The Rule of Law in the Regulatory State.

His vision is a little gloomy, but spot on I believe:

This rule of law always has been in danger. But today, the danger is not the tyranny of kings, which motivated the Magna Carta. It is not the tyranny of the majority, which motivated the bill of rights. The threat to freedom and rule of law today comes from the regulatory state. The power of the regulatory state has grown tremendously, and without many of the checks and balances of actual law. We can await ever greater expansion of its political misuse, or we recognize the danger ahead of time and build those checks and balances now.

He believes the rise of the regulatory state does not fit the standard definitions of socialism, regulatory capture or crony capitalism. He believes that we are

headed for an economic system in which many industries have a handful of large, cartelized businesses— think 6 big banks, 5 big health insurance companies, 4 big energy companies, and so on. Sure, they are protected from competition. But the price of protection is that the businesses support the regulator and administration politically, and does their bidding. If the government wants them to hire, or build factory in unprofitable place, they do it. The benefit of cooperation is a good living and a quiet life. The cost of stepping out of line is personal and business ruin, meted out frequently. That’s neither capture nor cronyism.

He thinks the term ‘bureaucratic tyranny’ could be appropriate to describe the situation, and that it is the ‘greatest danger’ to our political freedom. That is, opposing or speaking out against a regulatory agency, a politician or a bureaucrat might prevent you from obtaining the required regulatory approval to run your business.

He takes what seems to be a Public Choice view when he states that “the regulatory state is an ideal tool for the entrenchment of political power was surely not missed by its architects.”

While his post covers all sorts of industries, and while his definition of the rule of law (and its difference with mere legality) isn’t as comprehensive as Hayek’s, it remains pretty interesting. He actually has a lot to say on the current state of banking and financial regulation:

The result [of Dodd-Frank] is immense discretion, both by accident and by design. There is no way one can just read the regulations and know which activities are allowed. Each big bank now has dozens to hundreds of regulators permanently embedded at that bank. The regulators must give their ok on every major decision of the banks.

While he says that, for now, Fed staff involved in bank stress tests are mostly honest people, he is wondering how long it will take before the Fed (pushed by politicians or not) stop resisting the temptation to punish particular banks by designing stress tests (whose methodology is undisclosed) to exploit their weaknesses.

While Cochrane laments the rise of discretionary ruling and its consequences on freedom, The Economist also just published a warning, albeit a less-than-passionate one. Since the crisis, The Economist has always taken a somewhat ambivalent, if not completely contradictory double-stance (for instance, it takes position against rules in monetary policy in the same weekly issue). Here again, the newspaper believes that the crisis made new rules ‘inevitable’, because taxpayers ‘need protection from the risks of failure’. And that, as a result, regulators needed ‘flexible’ rules (MC Klein made a similar point some time ago – see my rebuttal here).

By and large, The Economist has approved that sort of rulemaking, as well as the use of macro-prudential policies (something I have regularly criticised on this blog). Nevertheless, the newspaper also complains about abuse of discretionary decision-making and the effect of regulatory regime uncertainty (a term originally coined by Robert Higgs). It doesn’t seem to have realised that the nature of what it was requesting (i.e. respect of the rule of law and control of the industry and of the monetary system by regulatory agencies) was by nature antithetical. Cochrane’s fears (as well as mine) thus seem justified if such a classical liberal newspaper cannot even realise this simple fact.

Public Choice theory could be used as a strong rebuttal to the regulatory discretion rationale. As Salter points out in a remarkable paper titled The Imprudence of Macroprudential Policy, the economic and political science behind discretionary macro-pru policies taken by bureaucratic agencies suffers from major flaws that regulators or academics haven’t even tried to address.

Buchanan Quote

He highlights the fact that, as Mises and Hayek had already mentioned decades ago during the socialist calculation debate, regulatory agencies lack the information signalling system to figure out what the ‘right’ market price should be and hence act in the dark, possibly making the situation even worse* (and empirical evidences do show that it doesn’t work), and that the assumption of the macro-pru literature that capitalist (and financial) systems are inherently unstable is at best unproven. A typical example is Basel’s capital requirements: as I have long argued on this blog, RWAs incentivise the allocation of credit towards asset classes that regulators deem safe. The fact that they are aware of the allocative power that they have is clearly illustrated by the recent news that EU regulators would lower capital requirements on asset-backed securities to persuade insurance firms to invest in them! Yet they continue to blame banks for over-lending for real estate purposes and not enough ‘to the real economy’. Go figure.

Worse, Salter continues, macro-pru regulation (and his critique also applies to all other regulatory agencies) assumes away all Public Choice-related issues, taking for granted omniscient regulators always acting in the ‘public interest’. Yet proponents of strong regulatory agencies seem to ignore (voluntarily or not – rather voluntarily if we believe Cochrane) that regulatory agencies themselves can fall prey to the private interests of regulators, whether those are power, money, job… If not directly to the regulators, regulatory agencies can fall prey to voters’ irrationality, as Caplan would argue (but also Mises and Bastiat), leading elected politicians to put in place regulators executing the irrational wishes of the voters. The resulting naïve line of thought of the macro-pru and regulatory oversight school is dangerous and goes against the body of knowledge that Western civilization has accumulated since the Enlightenment period.

And such occurrences are not only present in the minds of Public Choice theorists. They are happening now. The case of the head of the British Financial Conduct Authority directly comes to mind: whether or not one agreed with his “shoot first, ask questions later” method (and many didn’t), he was removed from office by the new UK government as he didn’t fit in the new political ‘strategy’.

What can we do? Cochrane proposes a Magna Carta for the regulatory state, in order to introduce the checks and balances that are currently lacking in our system (for instance, appeals are often made with the same regulatory agency that took the decision in the first place). Buchanan would certainly argue for a similar constitutional solution that would attempt a return to the ‘meta-legal’ principles of the rule of law described by Hayek, with an independent judiciary as the main arbitrator.

The wider public certainly isn’t ready to accept such changes given its negative opinion of particular industries (they’d rather see more regulatory oversight). Consequently, the only way to convince them that constitutional constraints on regulatory agencies are necessary seems to me to remind them that regulatory discretion negatively affects them as well (and day-to-day examples of incomprehensible regulatory decisions abound). If broad principles can be agreed upon from the day-to-day experience of millions of people, they should apply more broadly to all types of sectors. As Salter concludes for macro-prudential policies (although it applies to any regulatory agency):

Market stability is ultimately to be found in institutions, not interventions. Institutions that are robust to information and incentive imperfections must be at the heart of the search for stable and well-functioning markets. Robust monetary institutions themselves depend on adherence to the rule of law and the protection of private property rights, which are the cornerstone of any well-functioning market order. Since macroprudential policy relies on unjustifiably heroic assumptions concerning the information and incentives facing private and public agents, its solutions are fragile by construction.

*Cowen and Tabarrok take another angle here by arguing that the problem of ‘asymmetric information’, which underlies most regulatory thinking, almost no longer exists in the information/internet age.

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