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No Alternative to Regulatory Discretion

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"No Alternative to Regulatory Discretion"


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David Brooks’ reason for opposing the financial regulatory reform is that it engages in too much centralization. His alternative?

Both N. Gregory Mankiw of Harvard and Sebastian Mallaby of the Council on Foreign Relations have been promoting a way to do this: Force the big financial institutions to issue bonds that would be converted into equity when a regulator deems them to have insufficient capital. Thousands of traders would buy and sell these bonds as a way to measure and reinforce the stability of the firms.

Ezra Klein spots the flaw:

You see the problem here, right? This proposal says that regulators — who may even be organized into some sort of council or commission — should watch financial firms and bring down the hammer when they get into trouble. Nothing about Brooks’s proposal is less centralized than Dodd’s proposal. In fact, they work in virtually the same way.

But Klein has his own alternative:

Now, there’s some chance that Brooks is simply explaining his proposal poorly and he actually has in mind something like the Zingales/Hart proposal to use the market price for a special class of debt as a way to trigger automatic regulatory action, which would potentially protect against groupthink and inattentive bureaucrats.

If so, that’s great. I’m a fan of this proposal, though no Democrats or Republicans have introduced it in Congress. But so far as what he’s written goes, Brooks has created a centralized system that works at the behest of government regulators even as he’s written a column criticizing Dodd for creating a centralized system that works at the behest of government regulators. It’s a bit weird.

I have the same critique of Klein that Klein has of Brooks—this isn’t as different as it seems. After all, if you read the Hart/Zingales proposal the automatic regulatory action turns out to be nothing more than the commencement of a process for discretionary regulatory action:

If the trigger were to be set off by a too-high CDS price, the regulator would be required to carry out a “stress test” on the financial institution to determine if it is indeed at risk. In a stress test, regulators use sophisticated algorithms to run “what if” scenarios that examine whether a financial institution has sufficient assets to survive serious financial shocks. A stress test should precede any other action, so that extraneous panic is not allowed to bring down financial institutions unnecessarily. If, for instance, a few significant hedge funds or other investors lost confidence in a bank on the basis of a rumor or misperception about its strength, and began to buy credit default swaps as protection against its failure, the CDS price would rise and might trigger regulatory action. It is important that the regulator first test the validity of the concern before acting on it.

All three of these proposals are different ideas. But they’re not that different and none of them avoid centralization or regulatory discretion. There’s just no alternative.

I conclude with a point about decision-making processes. One way to make the law would be to ask “who wants to create a new resolution authority for failed firms.” A majority of Senators would raise their hands. Then the minority who didn’t raise their hands would leave the room. Then, the Senators still in the room would decide whether they preferred the Dodd approach, the Mankiw/Mallaby approach or the Hart/Zingales approach. Whichever approach had the most support would then happen.

But of course that’s not how we make laws. Instead, you’ve got a huge bloc of Senators who don’t want to vote yes on any version of anything and you need sixty votes to pass a bill. Consequently, if the 70 or so Senators who might be open to doing something start squabbling over relatively small differences what winds up happening is nothing at all. Oftentimes in the Obama Era the difference between “reasonable” conservatives (David Brooks and Greg Mankiw often leading the charge) and reasonable liberals has been that reasonable liberals look at flawed legislation that would improve on the status quo and support it while “reasonable” conservatives look at flawed legislation that would improve on the status quo and oppose it, while claiming to support alternative flawed proposals that they don’t actually lift a finger to organize support for within their own ideological faction.

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