So far so good, but I start to lose him later on in the Q&A.Some people have argued that the turmoil was caused by a lack of government regulation. What do you think? Do we need more regulation?
KRF: It is not obvious that financial regulations were weakened during the last few years. This claim seems to have been the product of a Presidential election in which both candidates were running against the incumbent. In fact, one could easily point to important new laws and regulations such as Sarbanes-Oxley to argue that market regulation increased. As more tangible evidence, the SEC's budget increased from $377 million in 2000 to $906 million in 2008. It is certainly true that different regulations could have reduced the magnitude of the current turmoil, but that is like saying a different portfolio allocation could have produced higher returns.
Second, we should improve the capital requirements and other regulations that limit the default risk of financial firms. The ongoing bailout of Wall Street is probably not a one-time event. Even with an improved resolution mechanism, it is easy to imagine that under similar circumstances we will bail out the banks again. If so, they have a strong incentive to take more risk. When things work out their shareholders keep the profits and when they don't taxpayers cover the losses. As we saw with Freddie Mac and Fannie Mae, this is not a good business model for taxpayers. If we are going to insure financial firms, we need regulations that will limit the risk they take.Perhaps greater regulations are necessary if we are going to insure financial firms. But why should we be insuring financial firms in the first place?! Is a private market for insurance really so hard to find? My spam email folder suggests otherwise. To those who would argue that government intervention is necessary because insurance companies (AIG) can mess up just as badly as financials, I have only one thing to say: buyer beware! Don't punish the taxpayers because a bank chose a reckless insurer.
I like how Eugene Fama finishes off the Q&A:
The ideal legal and regulatory system would be ground rules that allow bad financial innovations to fail and work themselves out of the system without government intervention. Again, the devil is in the details.
More generally, current events are certain to produce more regulation, and much of it is likely to be counterproductive. My longtime colleague, George Stigler, was famous for his argument, buttressed by empirical evidence, that regulators are eventually captured by the regulated. As a result, regulation often has results opposite those intended.