February 26, 2009

The Problem with Retrospect

Justin Katz

A rule of thumb for government manipulations of the economy ought to be that regulations be as minimally invasive and starkly drawn as possible. That's the principle that has kept the following paragraph from a Providence Journal editorial buzzing in the back of my mind since yesterday:

Some take-home lessons: A prudent society imposes regulations to stop lenders from selling mortgages destined to fail. It doesn't feed an asset bubble, in this case housing, by keeping interest rates absurdly low. And it doesn't tolerate a financial system that takes vast risks and hides them because of campaign contributions to elected officials.

The last clause, about political corruption, is obvious, but the rest steps into some sticky retrospective ground. Allowing government determinance of what investment and loan practices are "destined to fail" is destined to constrict the economy. Popping bubbles assumes that no economic change is possible. And why shouldn't risks be allowed when made with private dollars?

Far less invasive and more easily managed, I'd say, would be regulations that prevent organizations from achieving "too big to fail" status and then allowing them to fail when their risks don't resolve well.