Regulation Ratchet

A recent email asked me to admit that the current credit crunch shows we need more government regulation; the author thought it "easy to see" regulators could have foreseen and avoided the problem. This made me realize that we often hear claims that bad economic news, such as the dotcom crash, rising oil prices, or rising medical prices, suggests we need more regulation.  But we rarely hear claims that bad news suggests we need less regulation, or that good news suggests we need less regulation. 

Now perhaps it makes sense to change policy more in bad times than good, though even this is not clear; after all, we can better afford to experiment with change in good times. But it seems biased to call for more regulation given a certain cue, without calling for less regulation given some other cue.  If we all agreed we have too little regulation, then we should just add more regardless of whether news is good or bad.

This bias would seem to produce a regulation ratchet: increased regulation after bad times, but little change after good times.  Of course this by itself doesn’t say if we have too much or not enough regulation; it just says the time trend is wrong.

Perhaps this regulation ratchet arises from a hindsight bias, i.e., an illusion that regulators could have foreseen current crises, combined with a tendency to more often think "something must be done" in bad times, combined with the Politician’s Syllogism, (which I previously called Caplan’s fallacy):

Something must be done.
This is something.
Therefore, this must be done.

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  • Unknown Healer

    Perhaps a significant factor here is the existing level of regulation. Many people in India and China call for less regulation (while many call for more) , in part because the benefits of removing some kinds of bad regulations have been made apparent, and because more very bad regulations remain to be removed. The United States is less regulated in a variety of areas than other advanced countries, so this may depress calls for less regulation: there are fewer really objectionable targets.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Unknown, do you or anyone know of nations where you frequently “hear claims that bad news suggests we need less regulation, or that good news suggests we need less regulation”?

  • Unknown Healer

    Depends on the definition of ‘frequently.’ The Wall Street Journal, Economist, Financial Times, Cato policy analysts who appear often in US media, etc all make arguments for less regulation almost daily. That would put the USA in this category.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Unknown, you are not listening.

  • jeff gray

    ‘we rarely hear claims that…good news suggests we need less regulation’

    Confirmation bias?
    Is “good news” evidence that policies or regulations are flawed and should be eliminated, or vice versa, or not related at all? Much good news could be used to reinforce any notions that said regulations are beneficial. Of course this requires assuming a direct positive correlation between the regulations in question and the resultant ‘good news.’ Advocates of the regulation have an incentive to apply the post hoc fallacy to any positive correlation.

  • Unknown Healer

    What am I failing to hear? Should I have specified that much of the advocacy in those publications is framed as a reaction to good or bad news, e.g. poor employment numbers suggest reducing labor market regulation to make markets more flexible?

    The ratio of calls for more and less regulation in response to good or bad news differs for different groups: the general population, politicians, popular press, business press, academic economists, policy professionals, and international institutions.

    I would claim that
    a. The last several groups do frequently suggest deregulation in response to economic trouble in India and China.
    b. In the United States the frequency of calls for less regulation in response to economic trouble is not tiny.
    c. Ceteris paribus, large deviations from the optimal level of regulation lead to more calls to move it towards optimality among educated elites.

    It’s also worth distinguishing between discussion within and outside of a country, as foreign correspondents seem to endorse ‘liberalization’ more often than domestic ones, e.g. the international press frequently cites French labor market rigidities when discussing unemployment and difficulty integrating immigrants in France, and endorses much liberalization in Asia.

  • Tiiba

    “Something must be done.
    This is something.
    Therefore, this must be done.”

    This reminded me of a thought I had recently: it would be nice if, besides the word “to be”, there was also a verb that means “to be a kind of”. That might curb this sort of error, although perhaps not in this case, because the fallacy is thought rather than spoken.

  • Eric

    These ex post regulations are a waste of time. The market makes mistakes, which are really collective errors in judgment, but it doesn’t make the same specific mistakes twice. So the 1990 errors in too lax commercial real estate, the 2000 errors on internet companies, the latest errors on too little collateral for homebuyers…they aren’t repeated. Adding more regulations merely adds to the administrative costs of these activities going forward. Then think about the solutions being suggested, such as increasing disclosure on loan documents. Given number of signitures necessary to get a mortgage currently, these would simply be initialed and forgotten.

    The bottom line per mortgages is that no one is going to buy mortgage pools with the specs that underlay the current pools that are defaulting at very high levels (low or zero teaser rates, negative amortization, zero money down), as exit this summer among issuers of these products (which generally weren’t traditional banks) was large.

    Another point. Given that home prices had risen predictably for decades, and even the 2000 recession didn’t stop it, it is easy to see why, without hindsight, so many people thought lending this way make sense. I used to be a risk manager at a bank, and can tell you that 0% down would never have been attempted there because we all knew how dangerous that was. But I can see why someone on the outside, setting up a mortgage origination office based on the presumption that the collateral would rise, making the individual’s cashflow irrelevant, plausible. The businesses set up on this model made money for years, and then they lost it all and then some. It’s hard to see what kind of regulation, in general, should stop that sort of dynamic: make it harder to start innovative (but potentially flawed) new business models? Who decides that?

  • zzz

    Given that home prices had risen predictably for decades, and even the 2000 recession didn’t stop it … I can see why someone on the outside, setting up a mortgage origination office based on the presumption that the collateral would rise, making the individual’s cashflow irrelevant, plausible.

    This is very unlikely. It’s true that the market does not make “obvious” mistakes (i.e. it is unbiased), but this also means that asset prices _cannot_ consistently outstrip other investments without the possibility of a catastrophic fall. One possibility is that substantial moral hazard was involved in these business models: in this case, regulation can improve matters.

  • http://entitledtoanopinion.wordpress.com/ TGGP

    Bryan Caplan discussed the attitude people have toward regulation in reaction to bad news here, and attributes it to irrationality.

    The “regulation ratchet” may not be in any way different from the normal “ratchet effect” discussed by Robert Higgs in “Crisis & Leviathan” (which it would be interesting to see Naomi Klein review).

  • Jonathan

    That someone believes bad times indicate the need for more regulation does not require they believe good times indicate the need for less regulation. The good outcomes can be believed to be flukes. Or they can ignore the cost of regulators, i.e., regulators reduce bad outcomes but don’t impair good outcomes.

    If you believe regulators can foresee things and therefore prevent bad outcomes or ensure good ones, then the ideal number of regulators is very large: every decision can be made better (although presumably diminishingly so) by the use of more regulation.

    Since many people are uncomfortable with real freedom, it’s not surprising they support ever escalating regulation.

  • http://www.mccaughan.org.uk/g/ g

    The terms “bad” and “good” are ambiguous.

    Plausibly, it’s sensible to have more regulation when times are “bad” (= unpleasant and difficult) and sensible to leave things alone when times are “good” (= approximately optimal, as far as changes we can make are concerned). But those aren’t opposites, and perhaps in times that are “good” (= pleasant and easy) but “bad” (= suboptimal) it would often be appropriate to reduce regulation.

    (“Plausibly” doesn’t mean “obviously”, though, and actually it’s not obvious to me that difficult times call for more regulation — it depends on the nature of the difficulty –; or that optimal times call for keeping things as they are — there might be predictable changes coming.)

    And there’s another possible explanation if people call for more regulation in response to good news but not less regulation in response to bad news: there might just not be enough regulation. In this case there’d still be a bias at work, but not quite the one Robin’s framing suggests; and the “ratchet” at work might be not a unidirectional one, but one that ratchets up (conditional on bad news) in times of general underregulation, and ratchets down (conditional on something-or-other) in times of general overregulation.

    Incidentally, “Caplan’s fallacy” dates back, in exactly the wording given here, at least to the BBC television series “Yes Minister” in the early 1980s, where it was called “the Politician’s Syllogism”.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    g, thanks for the correction, I shall call it that from now on.

    Jonathan, it seems you give reasons, but not rational reasons, for so believing.

  • cw

    This is not a question of bias, but a response to the situation based on first principles. In America, most people tend to support the idea of a free market, which works well most of the time. But when something goes awry, such as when subprime lenders start pushing reckless loans on a massive scale, it is reasonable to ask whether the free market has worked well in this particular instance, or whether some boundaries should be established to prevent that type of failure from occurring again. In other words, regulations are only put in place when there is a perceived need for those regulations. Increased regulation is the proposed solution to a specific problem. It may not be the correct solution, or an effective solution, but it is a logical, defensible response.

    Recommending looser regulations in this circumstance would only make sense if one believed that overly burdensome regulations had somehow caused lenders to push bad loans on people who couldn’t afford them and didn’t understand them, and that the bond rating agencies were subjecting mortgage backed equities to too much scrutiny before slapping them with AAA ratings. It would be hard to make that case.

    Your question about bias seems to suggest that both responses, tightening regulations and loosening regulations, are both equally plausible responses to a financial crisis, and that the tendency toward tightening regulations is somehow irrational. But before taking any action, a rational person should have some working model that explains why that action is appropriate. Increased regulation may not be the right answer here, but I would be stunned if decreased regulation somehow reduced predatory lending.

    A quick example might help: If your boat springs a leak, a plausible response is to patch the hole, then bail out the water. It wouldn’t make much sense to start drilling additional holes in the hull, hoping that would somehow keep the boat afloat. Similarly, after you’ve patched the hole, a rational response would be to do nothing at all, unless another crisis emerges. Faced with a sound hull and no leaks, you wouldn’t start removing the plugs to see if the boat remained afloat. The patches were applied for a reason, and should be left there unless there is a compelling reason to remove them.

    I think that explains the tendency toward increased regulations. The rules are intended to patch specific leaks while preserving as much free market exchange as possible. Sometimes the market and technology change enough that the regulations no longer serve their intended purpose, and should be removed. But removing regulations willy nilly, just because things are going well, would be an irrational action opening up the possibility of the same abuses that prompted the restrictions in the first place.

  • http://entitledtoanopinion.wordpress.com/ TGGP

    Here’s someone arguing that previous regulation in the credit market pushed for lending toward risky borrowers that were previously said to be discriminated against by banks.

    Comparing a regulation to a patch on a boat seems like a rather poor analogy to me. Regulations are rules governing behavior, which do not resemble what we know of material physics that well.

  • http://profile.typekey.com/robinhanson/ Robin Hanson

    Cw, a boat leak is a sudden change of state requiring an immediate fix. Most regulations are not said to respond to a recent change of state, but to a long standing state that has been newly illuminated.

  • cw

    TGGP, Thanks for the link. I hadn’t read that argument before. If you accept the idea that political pressure to extend more mortgages to minorities was at the root of the housing bubble, then I suppose it would be reasonable to limit such interference in the future. But I think that explanation is pretty weak; it doesn’t explain why brokers were pushing subprime mortgages to people who actually qualified for better terms, for example. Also, watching the mortgage market over the past few years, it didn’t seem that lenders were unwilling participants in the lending spree. They were actively seeking out every new customer they could find, trying to maximize profits in a hot market. Given those conditions, I would prefer to see some additional oversight of the industry.

    I admit that the boat analogy was pretty strained; I was just trying to point out that all responses to a given situation are not equally plausible, and the predominance of one over the other isn’t necessarily a result of bias. In this situation, the two most likely responses are increased regulation, or to do nothing at all and let the market sort it out. To loosen the rules after such a major fiasco just seems peculiar.

  • http://entitledtoanopinion.wordpress.com/ TGGP

    I was just trying to point out that all responses to a given situation are not equally plausible, and the predominance of one over the other isn’t necessarily a result of bias. In this situation, the two most likely responses are increased regulation, or to do nothing at all and let the market sort it out. To loosen the rules after such a major fiasco just seems peculiar.
    Why does it seem peculiar? Couldn’t it be the case that regulation caused a major fiasco? Robin also asked why we do not see calls to get rid of regulation in good times, because it is possible that while it does not cause major fiascos regulations simply put a damper on things. The only explanation that would be consistent with calls for regulations in bad times and no calls for less regulation during any times would be that regulation is always a good thing, in which it might actually seem sensible to call for regulation in good times as well.

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