The Thermostat Theory of Financial Regulation


Economist Arnold Kling wonders why some analysts who seem to lament the repeal of Glass-Steagall don't also openly plump for its return, or have a coherent theory of how its lack contributed to the Current Crisis:

People are not specifically arguing that Glass-Steagall was wonderful regulation. Instead, they are waving around Glass-Steagall in order to make a vague, generic claim that regulation works and deregulation fails.

…In contrast, I say that housing policy, securitization, and regulatory capital arbitrage were at the heart of the crisis. I propose changing housing policy to stop trying to use cheap, lenient mortgage credit to promote affordable housing. I propose disconnecting the feeding tube of government support from the mortgage securities market. And I propose attempting to make failure of financial institutions a viable, credible option for regulators. There is a connection between my proposals and what I see as the causes of the crisis.

[Others seem to think that] financial regulation is a thermostat, which you can set on "more" or "less." As long as you turn it toward "more," everything will be fine. Never mind what actually caused the crisis (regulatory capital arbitrage) and what was actually irrelevant to the crisis (the erosion of competitive boundaries between commercial and investment banking). Just adjust the regulatory thermostat to "more."

Arnold Kling talking bailout over at Reason.tv.