Economist Debate

On Economist.com, two Nobel-prize winners in Economics debate the motion "it would be a mistake to regulate the financial system heavily after the crisis". Professor Myron S. Scholes, the proposition, argues that deregulation since the 1970s have brought staggering increase in wealth and prosperity globally and a heavy-hand regulation will stifle innovations that are key to long-term growth. Professor Joseph Stiglitz, the opposition, counters that financial crises have become more frequent and more severe in the deregulation era. On the innovation point, he highlights that much of the creativity is directed to circumventing regulations and regulatory arbitrage, instead of making the economy more efficient and helping ordinary people. He suggests that inadequate regulation plays a large role in the current crisis.

Scholes argues for a light-hand regulation that would continue to encourage financial innovations. In his point of view, those who propose re-regulation failed to measure the staggering increase in global wealth and income brought to us by financial innovations since deregulation started in 1970s. On the other hand, more regulation would not prevent financial crisis from happening. Banks and broker-dealers have gone bust in countries with heavy regulation on the financial system. Even worse, incorrect regulations often have unintended consequences which add fuels to financial bubbles. Therefore, the matter is not whether to have more or less regulation, but to have better regulation.

The current crisis which sparked off from subprime mortgages deteriorated rapidly because financial institutions have gone leveraging too far and left their capital bases very weak. In light of this, Scholes proposes regulation on requiring that financial institutions meet stricter capital requirements. He is careful to provide detail arguments to weigh the pros and cons of this approach. Citing classical research results in Economics, he points out that although additional equity capital will diminish a firm's expected return on equity, it would not affect the enterprise's value. It is because with additional equity capital, the capital to debt ratio is improved and this, in turn, results in reducing risk of the equity. In other words, expected return on equity is lowered but the return-to-risk tradeoff is unaffected. Scholes concludes that instead of adopting a heavy-hand regulatory approach which almost always does more harm than good, simply requiring banks to boost their capital base is much more efficient and flexible. And flexibility in regulation is necessary for innovations.

After going through Scholes' main arguments, let's have a look at what Stiglitz said.

Professor Stiglitz believed that inadequate regulation is at least as well a reason of the current financial crisis as bad regulation. In particular, he pointed out that the Fed have not employed the full regulatory power it has to keep the financial system healthy until it is too late to remedy. In his words, this is "the unsurprising consequence of appointing as regulators people who only half believe in regulation". He admits that the current regulatory framework is not perfect, but as Paul Volcker once remarked that "even a leaky umbrella can be helpful in a rainstorm", an equally relevant point to inadequate regulation is that current regulators, who ironically doubts regulations, have not made good use of what is already available. Noting that collapses in the financial sector, in addition to doing harm within Wall Steet, always hurts innocent bystanders as the economy plunges into a recession or a depression and they lost their jobs. As a result of this, those whose interest are more unaligned with that of Wall Street should have a larger voice in regulation in the future.

On the benefits of deregulation, Stiglitz remarks that there is no strong evidence in supporting that deregulation since the 1970s led to the increase in global wealth since then. In contrast, what is much more evident is that financial crises have become much more frequent and serious since then, with the largest happening at the moment. He argues that innovations are more often directed at gaming the regulatory system instead of making capital allocations more efficient. Instead of providing valuable services to the economy, Wall street bankers make hard efforts in "predatory lending", taking advantage of the asymmetric information they have against ordinary people, reaping enormous bonuses by lending to those who cannot afford. What happens now is that householders are forced out of their homes, houses are built in nowhere, and capital is massively misallocated and wasted.

Stiglitz argues that inadequate regulation plays a large role in crisis and more regulation is needed to prevent it from happening again. He highlights a regulatory framework which includes corporate governance, accounting methods, incentive structures, speed limits and lending practices. He also proposes setting up a "safety commission" of financial products which would encourage the kind of innovations that make our economy more efficient and discourage those that serve Wall Street in sacrificing Main Street.

He shares commonground with Scholes that the matter is better regulation rather than more of less regulation. However, he believes that much more regulations have to be reformed because they have shown themselves to be too inadequate.