Academic

Thom Lambert has a thoughtful, provocative post over at Truth on the Market on the financial crisis and financial reform in which he argues that the root of the financial crisis was a bubble and that a systemic risk regulator looks like the wrong solution. I?ve been writing about and having bubbles and financial regulation on the brain for years (and am at this moment procrastinating from finishing my book on the topic) so was glad to read his post.

Here are a few brief reactions. First, if bubbles are the problem, then one of the best ways to prick a bubble ? to answer the question posed by the title of Professor Lambert's post and whether you are looking macroeconomic research or micro, empirical or experimental data -- or to stop one from forming is through controlling the borrowing or leverage used to purchase assets. The most obvious tool for doing so is monetary policy, but monetary policy is a blunt instrument. Ben Bernanke, back when he was a mere mortal economist at Princeton, famously likened using monetary policy to address bubbles to using ?surgery with a sledgehammer.?

There are other regulatory tools that can more narrowly target credit in particular asset markets. For example, we could adjust the capital requirements of financial institutions or margin rules by specific asset class. But the narrowness of these tools means that capital movements and legal arbitrage can undermine their effectiveness.

In arguing against a systemic risk regulator, Professor Lambert notes that even Alan Greenspan could not detect the housing bubble. However, based on Greenspan?s beliefs on monetary policy ? he subscribed to Bernanke?s sledgehammer view -- he might not have done much to prick a bubble even if he did see one. And it?s fair to say he didn?t give the other tools in his regulatory toolkit for addressing either asset mispricings or their affects on financial institutions proper attention. Greenspan was in favor of lowering interest rates to handle the aftermath of asset market crashes. This policy asymmetry was famously criticized as giving rise to the ?Greenspan Put.?

Professor Lambert is correct that it is difficult to spot a bubble ? particularly if you don?t have the advantages of hindsight. I?m not so sure though that the primary job of a systemic risk regulator would have to be to try to spot and pop bubbles. Another take on the difficulty of spotting bubbles is not to prevent them, but to make sure that financial institutions and markets can adequately weather their popping. And making sure that financial institutions have enough of a safety margin has the collateral benefit of making sure they can?t get too leveraged. Which means they can?t lend too much. Which would help control asset prices from getting out too far out of whack to begin with.

Admittedly, all easier said than done. And Lambert?s overall question of whether we need a master systemic risk regulator is a fair one. But it would be more than a little odd if the mainstream economic debate moves from ?bubbles don?t exist? to ?we can?t prove when bubbles exist, so don?t try to pop them? to either ?it was a bubble so we can pin the entire blame for the crisis on Greenspan?s monetary policy? (and ignore the role of regulation and government in the crisis) or ?it was a bubble, & spotting and controlling bubbles is hard, so regulation is not useful.?

Part of the problem with talking about a systemic risk regulator is that systemic risk regulation means different things to different people. But, contrary to popular belief, systemic risk was not born in 2008. And systemic risk regulation is nothing new under the sun. The mitigation of systemic risk is one of the ur purposes of bank safety and soundness regulation. Thus, the reform question should be ?what should systemic risk regulation look like in the wake of the crisis?? In a post yesterday, I argued that we already have plenty of safety and soundness tools in the banking law tool kit. The question is when and how they should be applied in new contexts, like shadow banking.

So again, it is a fair question on whether we need a new regulator or whether we should work with the ones we have. Pointing out that the ones we already have didn?t do such a good job in the last decade is also more than a fair point. But I wouldn?t take that to the conclusion that we shouldn?t try to fix regulation ? I think a better conclusion would be that we need to fix the incentives of regulators.  

Professor Lambert?s post also advocated relying on the market to correct bubbles through arbitrage. I agree arbitrage and short sellers can have a valuable role. But, there is a lot of empirical evidence to question whether arbitrage alone will get us all the way there. The ?limits to arbitrage? literature in behavioral finance points out that there are a lot more practical constraints on arbitrage beyond just the old ?uptick? rule. This literature harkens back to that old quote attributed to Keynes, ?the market can stay irrational longer than you can stay solvent.?   True, the now famous ?Big Short? did net Paulson & Co. and other short sellers a very nice gain. But their short selling ? no matter what you think of the SEC vs. Goldman case ? didn?t exactly stop a bad bubble from forming. Bottom line: I wouldn?t place all my anti-bubble eggs in the short seller basket.