Regulatory Overkill

The Wall Street Journal today contains an interesting column, entitled Regulatory Overkill, by Alan H. Meltzer, professor of political economy at Carnegie Mellon University. He rebuts current claims that we need more economic regulation of financial markets, by noting several instances in the past 30 years where new financial regulation was met by innovative circumvention in the marketplace.

For example the Basel agreement of the 1970s required governments to create equivalent risk standards in all the principal lending countries. The agreement required banks to increase their capital if they increased mortgage loans and other risky assets. In response, the banks develop new instruments that moved risky loans off their balance sheets. He provides several other examples of similar marketplace responses. He concludes:

“Regulators and most politicians are good at developing rules and restrictions, but poor at thinking about the incentives that the market will face. If the incentives are strong, the market circumvents the regulation.”