Ghostbuster Economics

With Halloween just around the corner, I thought I’d show you how economics can even rid you of those pesky haunting spirits. But seriously, here’s my second column in the South Florida Sun-Sentinel. The question I address lies at the heart of public choice economics, though I didn’t have enough room to delve into the details too much. I’ve written briefly about this subfield before, and I think it deserves more careful consideration by economists, not to mention the voting public. The peak of public choice came under James M. Buchanan (who won the Nobel Prize) and Gordon Tullock, both of whom concluded that most government intervention makes things worse. You can debate their opinion—and I do, on many counts—but too often we talk about market failure and don’t even think about the negative consequences of the government “solutions” we are proposing.  

In finance, for example, the international banking regulations that governed during the height of the housing bubbles—“Basel II,” they were named after the city in Switzerland where they were created—arguably encouraged financial institutions to accumulate risky mortgage-backed securities (MBSs). They set capital requirements—basically, the amount of money the banks had to hold in case of emergency—based on the riskiness of the assets held by each bank. So far, so good. But how did they measure riskiness? They left that up to the rating agencies, which are private companies with severe conflicts of interest (which is, they are paid by the banks). In other words, they outsourced their most important regulatory function, with results every bit as successful as the outsourcing of military work has been in Iraq. Then, they allowed the banks to take loans off their balance sheet entirely by placing them in “structured investment vehicles,” if they financed them with very short-term loans called “commercial paper.” Meanwhile, the rating agencies were using the wrong probability model (Gaussian/normal instead of fat-tailed, if that means anything to you) and the wrong assumption (housing prices wouldn’t fall across the nation all at once). Finally, the biggest banks were given special exemptions from all of the above, so they could set their capital requirements based on their own “risk management.”

This course of events has led some economists to conclude that it was not market failure that caused the Great Financial Crisis but regulatory failure. I don’t think there is a doubt in any reputable economist’s mind that regulatory failure played an enormous role, but it’s silly to think that the market wouldn’t fail without government intervention. Every “regulatory failure” that I described above was the absence of regulation, which means when you give Wall Street even a little bit of rope, they hang us all with it. Either way, we’ve learned that it’s not enough to prescribe the right rules today because tomorrow they may be outdated. The regulations above were all designed in the past couple decades, not in the wake of the Great Depression. Glass-Steagall and the SEC may have served us well for awhile, but by the late 1980s, governments were starting to realize newer, more sophisticated rules were needed to keep financial “innovations” from finding loopholes in the old laws. (That loophole-seeking behavior is called “regulatory arbitrage.”) There are all sorts of problems with regulators trying to keep up with Wall Street’s latest “innovations”—from the fact that they attract less talent with lower salaries, to the issue I take up in this latest column: regulatory capture. Read my column here to get the rest of the story.

Once you’ve read it, you’ll probably be interested to know that Leaver is now applying her theory to another group of government employees: the judiciary branch. She kindly sent me a recent paper titled “Are Tenured Judges Insulated from Political Pressure?” Here’s the abstract:

Tenured public officials are often thought to be insulated from political pressure. This paper investigates this proposition empirically using data on promotion decisions taken by senior English judges 1985-2005. We start by exploring the populist view that insulation led senior judges to favour candidates from elite backgrounds over their non-elite counterparts. Our data confirm that elite candidates were more likely to be promoted, but also that most of this differential can be explained by promotion-relevant characteristics. Across empirical models, support for the insulation hypothesis is surprisingly weak. We then exploit an unexpected government proposal to remove control over promotions from the judiciary. Both the conditional elite differential and the partial effect of personal ties to the committee fell significantly (and were negative) after this announcement. We argue that these results can be viewed as an attempt by senior judges to forestall reform and hence as evidence against the insulation hypothesis.

Very important and relevant work. If you’ve read through to here and you don’t know who she is, then you haven’t read my column, so get on over to the Sun-Sentinel site! And if you like that, you’ll love my forthcoming book. Since I haven’t mentioned anything in this post about the primary subject of my column, the late great George Stigler, I will conclude by encouraging you to carve out 15 minutes in your Sunday to read his Nobel Prize lecture. It’ll give you a renewed appreciation for economics.