The Regulation Ratchet, Revisited

After some back-and-forth in the comments, Hanson clarified the scope of his regulation ratchet theory in an addition to his original post.

I’m not saying there there aren’t many other reasons/factors influencing regulatory changes, and I’m not saying regulation never gets weaker.  I’m saying that this particular factor, the existence or not of a recent disaster, is often a ratchet factor, since many folks seem unwilling to consider reducing regulation because of a lack of recent disasters, yet are willing to increase it because of a recent disaster.  This is a clear bias, though it might of course be countered by other opposite biases.

So, there are other factors. This I agree with. But I’m still not convinced of the one-way ratchet theory with respect to disasters or lack thereof. Yet, it is hard to disagree with sentences that include “many folks seem unwilling” (italics mine). In fact, as I headed to bed last night I had decided to let this argument drop. But then steve wrote in the comments,

Did not the absence of a banking disaster lead to the elimination of banking regulations? The loosening of regulations? There was more than just capture involved. Leverage limits were loosened. The kinds of securities allowable as collateral for repos was broadened. Why not? We had not had a true banking crisis since 1929.

The absence of disaster, from my POV, after many years in the military and in medicine, leads to not enforcing existing regulations, then if one eludes disaster long enough, the writing of weaker regulations. Then the elimination of the regs. This is often rational. In medicine, at least my specialty, some techniques are much safer now. They do not need as much much monitoring so we changed the regs, eliminating some.

This is what I was thinking last night. The Great Moderation and innovations in financial instruments for risk management led many to think, perhaps say, that we no longer need as tight regulation in the financial sector. Even if this was never said (though I bet it was) it certainly was the context in which Glass-Steagall was repealed, among other elements of relaxed regulation of the financial sector. The very lack of a major recession or depression in so long was a significant factor.

Thus, I really do think this ratchet goes both ways. I think it’s the nature of humans that it does. We freak out when we see disaster, and we relax when none has occurred for a long time. I think many folks do seem willing to think this way, and act on it. Perhaps the ratchet moves more forcefully and easily one way than another, but it does go both ways.

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