Does Bad Economics Explain Bad Regulation?

I don’t mean this in the typical sense of economists providing intellectual justification for deregulation; rather, has neoclassical economics been a source of cognitive dissonance and therefore a form of regulatory capture? Most regulators, politicians and policymakers have training in neoclassical economics and so it is likely to affect their behaviour.

Consider banking. Textbook economics still assumes the money multiplier model, which is patently falsified by empirical evidence. Had they realised the endogenous approach, it would have been far more apparent to them that capital, rather than reserves, is the only thing that limits banks ability to lend except the bank themselves. Thus, it would have been clear that leverage and capital limits were incredibly important, and the afterthought-style approaches of Basel I & II (and III) would have been exposed.

Had they also realised that, as Keen notes in the former link (required reading), the level of private debt has to increase to increase AD, they would have realised how important it was that this credit was channelled towards productive activities that facilitated increased production and income, instead of towards speculation and consumers. In the case of the former, GDP can keep up with private debt increases, but in the case of the latter, we get asset price inflation, then debt-deflation when those prices collapse.

Regulating emergent properties

But the problem isn’t simply false beliefs about the economy – it’s the general approach and framing. In Economyths, David Orrell notes that in order for an economy to be stable, positive feedbacks loops – processes that create a self-perpetuating spiral, like high inflation – would have to be incredibly rare or weak. He then goes on to rattle off about 10 examples of positive feedback loops, and recommends a style of regulation that would identify these and transform them into negative feedback loops, which cancel themselves out.

One of the problems with regulation now is that instead of focusing on flows and emergent properties, the big picture is generally ignored; regulators make each firm conform to whichever  criteria that might seem to make sense on an individual scale, but do not generally. To take an example, VaR is designed to stop banks from taking risk by forcing them to sell assets when the economy is more volatile to reduce their capital. The problem is, it actually creates a positive feedback loop because as the economy gets more volatile, more assets are sold and that increases volatility. Thinking about VaR from a neoclassical perspective blindsides regulators to dynamic processes like this.

This style of thinking would also surely be less vulnerable to regulatory capture. By focusing on flows and  emergent properties, regulators would not be deemed to be intervening in a particular firm’s operations. It would be a less personal approach than the current ‘check up’ one, with goals that did not necessarily vilify the firm in question. ‘We are trying to prevent a positive feedback loop’ is less contentious than ‘we are stopping you doing x’. This may sound airy, but it is similar to a recorded problem with public sector workers – once given targets and told what they should be doing, they lose the motivation to do it. Similarly, if managers/owners feel that they are not being targeted individually, they will probably be more likely to cooperate.

Despite the 2008 crisis, the attitude of many towards financial regulation is still hamstrung by the neoclassical approach. A bit of capital here, some transparency there, maybe let some banks fail – it’s a ‘tinkering’ approach that implicitly assumes the economy is close to equilibrium and just needs a tweak. Systemic problems that are greater than the sum of their parts are ignored, leaving us putting out fires all over the place, but not addressing the source of the problem.



  1. #1 by moiracathleen (@moiracathleen) on December 23, 2011 - 12:28 am

    You make excellent points in the post.

    At one time US banking legislation reflected a congressional determination that banking and nonbanking business must remain distinct so as to restrain undue concentration of control over money and credit. The necessity of maintaining the distinction was challenged and legislative amendments limited its force. Over the years the banking legislation has been amended and the separation between banking and nonbanking gradually lessened in degree. After 2008 that distinction is almost nonexistent.

    It seems to me that recent events lend new urgency to questions relating to banking regulation and the proper relationship between banking and nonbanking business. The question today is whether banking regulation in its present form can restrain the concentration of control over money and credit though it does not require separation between banking and nonbanking business. The answer to this question will shape the ultimate structure of the United States economy for many years to come. Yet we are unable to even reach that question, much less answer the question, because the economists are not talking about how the concentration of control over money and credit impacts the overall economy.

    Why is it this question about the concentration of control over money and credit and the impact on the economy remains largely absent from economic discourse in its present form? I was told that Simon Patten wrote about this issue, but also that he was essentially written out of the study of economics at some point before the 1970s. Have you studied Patten? Was Patten the only one? Surely there were others. Louis Brandeis writes about this in his book the Curse of Bigness and I have to think his ideas on this aspect of law were inspired by economic thought. What do you think about the consequences that arise from the concentration of control over money and credit? If we look study the legislative amendments to the US banking regulation you can definitely see the shift starts during the 1970s. Does this shift in the banking regulation reflect a shift in the study of economics during the same period?

    • #2 by Unlearningecon on December 24, 2011 - 5:08 pm

      I have not actually heard of Patten but I’l look into his work.

      Mainstream macro still models based on the ‘money multiplier’ i.e. CB creates money then banks take it in as a deposit, lend some % out, then take that % as a deposit and lend the same % of that out until the overall amount of money ‘injected’ into the economy reaches 100/that %.

      Of course, this isn’t what happens at all – banks create loans as deposits then look for the reserves later. They are only constrained by regulations and the amount of risk they take on. If economists realised this the importance of regulations would be clear, but as of now the theory says we just need to sweep them away willy-nilly to approach the ideal state of neoclassicism.

      So, to go back to your main question: it’s ignored because economics models it completely wrong. Similar problems would occur in engineering if you modeled steel as a liquid.

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