Krugman: Idiot-Proofing Financial Regulation

[ProSense]

Idiot-Proofing Financial Regulation

Ezra Klein expresses some skepticism about my skepticism. I worried that no financial reform will work if the government is dominated by people who don’t believe in regulation; Ezra counters that the FDIC has been pretty robust to idiots in power.

Actually, we’re both right.

The New Deal system of financial regulation really had two main parts: deposit insurance and bank capital requirements. The first ruled out bank runs; the second reduced the incentive for banks to take advantage of guarantees to gamble with other peoples’ money. The capital requirements actually worked better than they really should have, because of a third factor: limited competition meant that banks had a large franchise value, which they were reluctant to endanger.

This whole system was fairly idiot-proof. Not totally: when Reagan-era legislators decided to avoid covering losses at S&Ls by deregulating their investments, hoping that they would earn their way out of the hole, the result was a disaster. But all in all the system didn’t require smart or even especially competent leadership.

But the old system faced a relatively simple task: regulating and insuring depository institutions. We knew what banks were, and we knew what undue risks looked like.

Now the problem is regulating shadow banking — non-depository banking. So right from the beginning we have the problem of deciding what is a bank, and what liabilities need deposit-type guarantees. All short-term debt? Only some kinds of repo? Who do we need to be worried about?

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[asphalt.jungle]

1. i love the quotes in post #4

These words of wisdom seem pertinent (from http://c2.com/cgi/wiki?IdiotProofProcess):

"It is impossible to make anything foolproof, because fools are so ingenious." -- Robert Heinlein

"Those who try to build idiot-proof systems always underestimate the persistence and ingenuity of idiots." -- anon

"If you make your system more idiot-proof, the idiots will build a bigger/better idiot." -- anon

"You can make something foolproof, but not damnfoolproof." -- anon

"Campaigns to bearproof all garbage containers in wild areas have been difficult because, as one biologist put it, 'There is a considerable overlap between the intelligence levels of the smartest bears and the dumbest tourists'."