The Dangers of Overreaction Regulation

The human tendency to believe we have overcome the problems of the past, the American tendency to believe we are indestructible, and a failure of our education system to teach basic economics and financial history has all led to the nation being more shocked at our current recession than we should be. Despite a history of ups and downs in the market, we are always surprised when economic downturns hit. And, as history has shown, this can lead to overreaction in trying to correct the problem.

The fear that government will overreact is widespread. Niall Ferguson, author of The Ascent of Money, wrote in The New York Times Magazine, “In the months ahead, the world will reverberate to the sound of stable doors being shut long after the horses have bolted, and history suggests that many of the new measures will do more harm than good.” Despite the need for change, regulators should know their limits before going about the process of creating a 21st Century regulatory structure.

Regulation writers have plenty of information about the past, but little about the future. Decisions of banks and investors in the past are known and documented, decisions those same actors will make in the future are unknown. There is a limit to the knowledge regulators have available. And writing regulations to the past won’t help solve problems of the future.

Regulating the past ignores the fact that financial institutions will find ways around rules to create wealth. Hedge funds and private equity groups have been hiring experts specifically to help them innovate around regulation. Creating rules based on the past doesn’t keep up with market evolution. Plus, piling on more regulations does not address problems like assets being devalued at all firms by the bankruptcy of one due to the interconnected nature of the system.

Overreaction also tends to stem from political interests, and not what is best for the market. The incentives of politicians constantly focused on reelection makes them ill suited for the job of regulation writer. The interests of a lawmaker are what is best for their constituents, not necessarily what will be best for the market long-term. As a result, new regulations from Congress are often focused on the past, and not future problems; they are watered down after heavy lobbying by special interest groups seeking economic rent; and they tend to set too high expectations regarding the impact of their response. Consider three acts of Congress that were designed to prevent any future breakdown in the financial sector or housing industry:

  • the Financial Institutions Reform, Recovery and Enforcement Act of 1989;
  • the FDIC Improvement Act of 1991; and
  • the Housing and Community Development Act of 1992. (HT: Alex Pollock)

After the passage of these acts Treasury Secretary Nicholas Brady said of the then-economic downturn, “This will never happen again.” But of course, it did. In fact, twice since then: after the Dot-Com Bubble and after the Housing Bubble. So don’t overreact, and be realistic about the future.