How should we design our financial and regulatory institutions? The lesson from the 1970s was that rampant inflation and unchecked inflation expectations would eventually create obstacles to proper resource allocation and growth. So we established the Fed’s mandate to promote maximum growth while delivering price stability. The current episode suggests that the Fed’s current policy goals and instruments are not sufficient to prevent “inflationary” asset prices and price expectations.
The knee‐jerk response by some observers has been to blame the Fed’s conduct of monetary policy. Some observers suggest that the Fed should regulate financial companies more tightly, others that it should broaden the definition of price stability to include asset prices, and yet others that the Fed’s objectives should be broadened to include prevention of asset price bubbles.
Some observers, especially European policymakers, have called for tighter regulation of financial institutions under a new global financial architecture. And the immediate response of governments all over the world has been to attempt to salvage the existing financial institutions, instruments, and arrangements by injecting massive taxpayer funds into the financial companies that are skirting economic collapse.
When will this process end and where will it lead? Recent government interventions have now almost certainly created expectations of similar future bailouts during the next financial crisis. That means banking institutions will feel more at ease in expending considerable efforts at skirting whatever new regulations are created to prevent a similar financial crisis from recurring.
Thus, the cat‐and‐mouse game of regulatory arbitrage in search of profits may intensify, rather than disappear, as a result of adopting stricter financial regulations. But, for a time, stronger capital and risk regulations may stifle financial intermediation and slow the pace of recovery from the current recession.
Some analysts are proposing the adoption of smart regulations that are sequenced and modulated according to movements in macroeconomic variables such as the capital standards that vary with the business cycle. One could call such regulatory measures “financial automatic stabilizers.” However, as recent experience with fiscal stimulus packages shows, political pressures prevent politicians from leaving such systems well enough alone.
Any whiff of financial‐sector problems will incite Congress and Treasury bureaucrats to tinker with the rules. Which institutions and officials are likely to be sufficiently prescient to correctly calibrate such regulations each time the financial sector hiccups? And would politicians be able to resist calls for regulatory relief when financial sector lobbyists flood their offices as profit opportunities surge? Even more likely, any new regulatory attempt to globally control profit‐driven risk‐taking will spur new attempts to circumvent regulations.
The key lesson from the current financial crisis and recession is that a government‐imposed financial architecture is unlikely to persist for any significant length of time. Global market developments, and the need to channel resources toward opportunities perceived to be the least risky and most profitable, will continue to modify institutional financial arrangements. Imposing onerous financial regulations will only impede the reconstitution of financial institutions, delay the recovery, and dampen the pace of long‐term economic growth.