Don't Panic! Defending Cowardly Interventions During and After a Financial Crisis

How should we regulate the U.S. financial system after the financial crisis when we face the task with a radically inadequate understanding of what went wrong and what effect proposed regulations will likely have? This paper explores three quite different approaches to regulating in the face of severe uncertainty: the libertarianism of Friedrich Hayek, the conservatism of Michael Oakeshott, and the liberalism of John Maynard Keynes. Each man thought deeply about the problem of how uncertainty affects human affairs, but each came to different conclusions about how to address such uncertainty. The paper outlines the core, immensely useful insights of each theorist.

The paper then outlines the even more useful and persuasive critiques that each launches at the other two. From this collision of viewpoints, the paper outlines a hybrid general approach to regulating the financial system which it (rather tongue-in-cheek) labels "cowardly interventions." This approach accepts the basic insight of Keynes that unregulated financial markets will be deeply unstable, causing periodic destructive depressions. Thus, fairly strong regulation of finance is needed. But following the insights of Hayek and Oakeshott, I argue that new regulations should be cowardly.

We should as much as possible heed the wisdom embedded in markets and existing institutions. We should identify as best we can the biggest problems that current markets pose, and address those problems with new rules that are measured, limited, market-friendly, and subject to evaluation and pruning. This framework supports a three-part response to the crisis. First, the New Deal structure for regulating banks should be extended to the shadow banking system which was at the heart of the crisis.

(What is "shadow banking"? Read the paper.) In that structure, the government acts as a lender of last resort to forestall panics while using resolution authority and prudential regulation to replicate much of the discipline of an unregulated market. Second, more specific limited rules should address glaring problems in the mortgage securitization chain. Third, regulatory agencies should be prodded to constantly re-evaluate existing regulation in light of new circumstances.

Using this framework, this paper gives a guarded defense of the Dodd-Frank Act. All three elements of a proper response are there in the Act. There are major concerns, however. Most importantly, the Dodd-Frank Act does not do enough to address the largely unregulated shadow banking system.

The Act should also have begun the process of eliminating Fannie Mae and Freddie Mac. Even legislation without these weaknesses would not end financial crises forever. However, if the many regulations implementing the Dodd-Frank Act are largely done well, they may postpone the next big crisis for a decade or two, as well as make the next crisis shorter and less severe when it does occur. The Dodd-Frank Act is imperfect even by the standards of a philosophy which emphasizes inevitable imperfection, but on balance it does pretty well under the circumstances.