Thursday, June 18, 2009

Why Financial Regulation Reform Is A Red Herring

Obama, and his sidekicks Tim Geithner and Larry Summers has now proposed certain changes in financial regulation, which includes giving the Fed more regulatory powers, raising reserve requirements for some large institutions and unspecified measures against "predatory lending".

Perhaps not all of these measures are useless or harmful, though most probably are. But even those that could do some good, like higher reserve requirements, are essentially red herrings with regard to the cause of this crisis and the prevention of the next. The all-important factor here is monetary policy and its deliberate policy to achieve credit and monetary expansion.

The point is that even if some regulation would have been in place during the last decade that would have held back credit expansion assuming a interest rate policy, credit expansion might still not have been lower. The reason for that is that Greenspan and the Fed wanted to achieve a certain level of credit expansion (the kind of credit expansion needed to increase inflation and growth).

If some regulation would have held back credit expansion, then given the Fed's desired credit expansion they would have pursued an even more aggressive interest rate policy, cutting interest rate even faster and more than they actually did. And if short term rates had fallen to zero then the Fed would have resorted to the kind of quantitative easing that we have seen now.

The end result would have been essentially the same kind of credit and monetary expansion that we saw, and therefore also essentially the same kind of bubble and therefore also the same kind of economic crisis.

In order to prevent all of this from happening again, we then need a monetary reform that takes away or at least limits the Fed's policy of expanding money supply. As long as there is a central bank the will and the power to significantly expand money supply, financial regulation has little or no relevance and is therefore essentially just a red herring.


Blogger Markus Buchart said...

This post is a nice succinct answer to the 'if only there had been more regulation' crowd.

Credit overexpansion had to go somewhere. At best, regulation might have redirected the overexpansion; it would not have prevented it. The trigger for the meltdown might have started in a different part of the economy than it did. Nonetheless the contractionary adjustments we are experiencing would have been necessary and occurred.

Markus Buchart
Winnipeg, Canada

12:30 AM  

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