Monday, July 21, 2008

Market discipline better than regulation

Here's a link to the Register's editorial on the Fed's decision to keep the discount window open to investment banks, which could presage a move to regulate them directly. As Bill Niskanen, chairman of the Cato Institute, told me, this could create yet another industry with the moral hazard of knowing the government is likely bail them out if they make bad moves, because they're "too big to fail," like Bear Sterns. In retrospect, it might have been better to let Bear-Sterns fail rather than bail it out earlier this year. The reason market discipline is more efficient than regulation is mainly due to the knowledge that a business could fail, which tends to concentrate the attention mightily. Sending the message that investment banks won't be allowed to fail is an incentive for riskier behavior -- probably not immediately, but a few years down the road, when lessons (like the 1980s S&L failures) tend to be forgotten.

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