Freshwater Economist Cochrane On Free Market Banking

This is from one of Krugman's critics who argues that excessive regulation caused the banking problem.  Nevermind that the part of the financial system that collapsed was almost completely unregulated and that is what took down the regulated part.  GSB news—Initiative on Global Markets Looks at Market Turmoil:

In the recent turmoil in financial markets over the failure of subprime mortgages, investors should remember “caveat emptor,” or let the buyer beware, said John Cochrane, Myron S. Scholes Professor of Finance. “These are matters for buyers and sellers, not regulators,” Cochrane said

Incredibly, he said this on September 25, 2008! I think most economists would have disagreed at that point.

“Nobody else gets hurt if you buy a lousy mortgage pool,” Cochrane said. “The government doesn’t need to write a new rule every time someone buys a rotten tomato. Investors will demand the right amount of transparency, complexity, and risk-sharing – or monitoring of mortgage pools – unless they all get bailed out and learn to count on a bailout instead.”

Actually there is regulation of rotten tomatoes. The FDA, Agriculture department, and various state health departments regulate rotten tomatoes. There is also tort law.  Some of it probably hurts consumers, but most consumers want some sort of regulation of the food supply and it is even harder to imagine a money supply that is not regulated.

The government creates some of the moral hazard that caused excessive risk-taking, but the market created much of it too.  Whenever someone invests other people's money, they have an incentive to take excessive risks and that is largely what the finance industry does. See my entry about Endogenous Business Cycle Models.

Money, Power Serve Up Alphabet Soup Of Regulators : NPR

Money, Power Serve Up Alphabet Soup Of Regulators : NPR: "Exactly one year ago, the U.S. government began planning its takeover of AIG to prevent the collapse of the largest insurance company in the world. The public seemed outraged that taxpayers had to save a private company. Congress vowed to rewrite the rules of American finance, to prevent any bailouts in the future. ...AIG was watched over by 400 different agencies around the world, including dozens in the U.S., and none of them noticed that the company was on the verge of taking down the entire global economy.

Economists say this kind of problem stems from regulatory arbitrage. When more than one regulator oversees the same kind of activity, financial firms find ways to play one off against the other. It's like what every 4-year-old has figured out — if Mommy won't let you, maybe Daddy will. Or worse, if Mommy thinks Daddy is watching you, and Daddy thinks Mommy is watching you, then you can get away with anything.

The other thing Democrats and Republicans agree on is that solving the problem by simply merging some of the regulators will never happen.

Consider one of the most glaring examples — the bizarre division of labor between the Securities and Exchange Commission, and the Commodity Futures Trading Commission. If you buy and sell stocks, your overseer is the SEC. If you trade stock futures or their kin, you get the CFTC.

Much of the current financial crisis is linked to the strange financial products that fell between the cracks of the SEC and CFTC."