Much of the new breed of regulation that appears to have failed has relied on institutions using highly quantitative models and lots of market information. Uniform accountancy standards have been implemented by law in much of the world, based on market values. Data-driven risk models based on patterns repeating themselves in financial markets in predictable ways were encouraged by regulation. These models were adopted widely throughout the world. So, what happens when they fail? The whole financial world – encouraged by regulation to take the same approach to risk management and capital setting – goes pop at the same time.
Markets, in fact, are a discovery process. It cannot be assumed that market prices are a perfect reflection of economic value at any particular time. Market participants continually discover new information, make errors and respond to errors. It is important that financial institutions are allowed to do things differently so that some (who use better and more efficient methods) succeed and others fail (indeed, it is important that institutions are allowed to fail). When we use data to take financial decisions, decide how much capital to keep and so on, we should be aware that the data we use contains some information but that relationships that hold one day will not hold precisely the next day. We should stand back and think conceptually about the risks that financial institutions are taking.
The crash gives many more indications that Hayek was right. Hayek argues that unregulated markets develop institutions that ensure that trust and reputation become valuable commodities. But who cares about trust and reputation when we believe that everything will be looked after by the regulators or by deposit insurance? As far as a company is concerned, compliance with regulation has become more important than trust. The market has been allowed to generate crude economic efficiency, but trust has been crowded out by regulation.
Hayek suggests too that booms and busts are the product of poor monetary policy. Central banks hold interest rates too low. People consume too much and invest in business projects that would not be profitable at higher levels of interest rates. Resources then get misallocated. And then the whole thing goes bang and we get a recession (in this case accompanied by a banking crisis).
The socialists can carry on arguing – though they are wrong. But the equation-driven, data-driven neo-classical economists should stand back a bit and admire Hayek. They have a lot to answer for too. They should not lose confidence in the free-market cause, but look for better arguments.
First published on the Daily Telegraph’s Ways and Means blog.