Steve Waldmann’s recent post explains why giving financial regulators discretion in choice of policy is almost always a bad idea. In his words:
“An enduring truth about financial regulation is this: Given the discretion to do so, financial regulators will always do the wrong thing.”
The reason of course is the time consistency problem . The temptation for the regulator and central bank to use their “discretion” to bail out the banks is overwhelming. The market will correctly equate a discretionary regulatory environment to be a bailout-prone one. As Lacker and Goodfriend observed in their paper on central bank lending policies in times of crisis:
“The problem with adding variability to central bank lending policy is that the central bank would have trouble sticking to it, for the same reason that central banks tend to overextend lending to begin with. An announced policy of constructive ambiguity does nothing to alter the ex post incentives that cause the central banks to lend in the first place.”
But what about the alternative? Would a regulatory environment that is written in stone perform any better? Most likely it would not – regulations that are written in stone suffer from Goodhart’s Law. The clearer and more detailed the regulation, the easier it is for market participants to arbitrage it.
Goodhart’s Law is the reason why algorithm-based technology services such as Google and Digg prefer to keep their algorithm private and opaque. However, as we’ve discussed above, discretion and opacity is not an option in financial regulation.
So how do we avoid arbitrage without having to resort to discretion and ambiguity in the regulatory framework? Goodhart’s Law is applicable only when we focus on intermediate targets that we presume are good proxies for our objective. The answer is to shift focus from intermediate proxy indicators of excessive risk, such as executive compensation or capital requirements, to the ultimate objective itself.
But is this even achievable? For example, Google and Digg have no option but to focus on a reasonable accurate proxy. The same may be true for financial regulation.