resilience, not stability

The “Theory of the Second Best” and the Financial Crisis

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Much of the debate regarding the causes of the financial crisis ignores the fact that we live in a “second best” world. The “Theory of the Second Best” states that in a world that is far from a textbook “free market”, any move towards the theoretical free market optimum does not necessarily increase welfare.

Our current financial system is clearly far from a free market. The implicit and explicit guarantee to bank creditors via deposit insurance and the TBTF doctrine is a fundamental deviation from free market principles. On the other hand, derivatives markets are among the least regulated markets in any sector.

This second-best, hybrid nature of our financial system means that any discussion of the crisis must be strongly empirical in nature. Deductive logic is essential but a logical argument with incomplete facts can be made to fit almost any conclusion. So the Keynesians blame the free market and deregulation, the libertarians blame government action and the behavioural economists blame irrationality. But no one stops to consider any facts that don’t fit their preferred thesis.

The key conclusion of my work is that it is the combination of the moral hazard problem driven by bank creditor guarantees and the deregulated nature of key components of the financial system that caused the crisis. This is not a new argument. The argument for regulation itself rests on the need to protect the taxpayer in the presence of this creditor guarantee. The Fed recognised this argument as early as 1983. As John Kareken noted, “Deregulation Is the Cart, Not the Horse”. The growth of the CDS and other derivatives markets was not a problem by itself. It caused damage by enabling the banks to maximise the value of the free lunch derived from the taxpayer. The same could be said for bank compensation practices.

If re-regulation could work, then I’d be in favour of it. But I don’t think it can. As I’ve discussed before (1,2,3), almost any regulation will be arbitraged away by the banks. The only regulations that may be difficult to arbitrage are blunt and draconian regulations which will dramatically reduce the efficiency of the system. Even then, the odds of arbitrage are not low enough.

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Written by Ashwin Parameswaran

December 28th, 2009 at 12:31 pm

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