Gary Becker says markets aren’t rational; endorses Yglesias approach to financial regulation

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University of Chicago economist Gary Becker, in the midst of a mostly predictable analysis of the financial crisis and criticism of the Obama stimulus package at lunch at the Milken hoedown today, said a couple of interesting things:

1) Becker has built an estimable career around the notion that individuals generally respond rationally to economic incentives, even in areas not normally thought of as economic. But he (pleasantly) surprised me today by admitting that “group rationality is questionable.” When you look at what happened in housing and related credit markets, he went on, “you cannot call these rationally functioning markets.” So even Gary Becker thinks the rational market is a myth. Well I’ve got a book to sell him …

2) Should regulators do more to tamp down this kind of irrational group behavior? “We know already that regulators get caught up in the same type of optimism that market participants get caught up in,” Becker said. “When you give a lot of discretion to regulators, they don’t use the tools that are given to them.” The only regulations that work are simple, automatic ones—make the Fed follow the Taylor rule, force banks to hold more capital.

This wasn’t entirely surprising coming from Becker, whose teacher Milton Friedman was a big advocate of rules-based monetary policy. And there are problems with the rules Becker cites—the financial system has a tendency to evolve in a way that leaves simple monetary rules outdated (this was certainly true of Friedman’s proposed money-supply rule for Fed policy) and to find ways to game capital standards. But Becker’s words did remind me of a really smart blog post that Matthew Yglesias wrote last fall that I meant to discuss at the time but never quite got around to. (It took me a while to find it today—Googling “yglesias david brooks behavioral regulation” finally got me there.)

Yglesias was discussing a David Brooks column on behavioral economics (which teaches that individuals aren’t quite as rational as Becker thinks) and regulation. He concluded:

If traders are likely to overestimate the effectiveness of their risk models, then regulators are prone to those exact same errors. Where does this leave us?

Brooks, I think, thinks it leaves us just as skeptical of regulation as we were before we took the behavioral turn. I think it arguably leaves us somewhere else. It leaves us with an appreciation of crude measures rather than hubristic efforts to get the regulations precisely right. Until the 1980s, banks couldn’t operate across state lines at all. This didn’t make any real sense. Some states (California, New York, Texas) are much bigger than others either in terms of land area or population or both. And of course New York City is much more integrated with parts of New Jersey (and even some parts of Connecticut) than it is with, say, Buffalo. So whatever the “right” rule was here, this clearly wasn’t it. At the same time, this rule, for all its arbitrariness, has the virtues of being clear and largely self-implementing. It doesn’t depend on anyone’s discretion being used wisely or honestly, and it doesn’t depend on anyone’s calculations being right. And it had the effect of limiting the size of banks so that you never had a really enormous bank failure.

Now that’s not to say we should go back to the ban on interstate banking (I honestly have no idea), but I think it shows the general shape of what we should be looking at. The best you can hope from a regulatory regime is that it will be a satisficing solution wherein some fairly crude rule will improve on the outcomes generated by the unfettered market. When that’s not the case, we may as well let the market go unfettered even though that, too, will be somewhat sub-optimal. But at the same time when we’re looking at a regulatory regime that seems to be working okay, and the regulated parties start saying we need tweaks x and y and z and oh there’s no danger there we should be very suspicious. We shouldn’t count on being to fine-tune our results to perfection, we should either lean in with a heavy hand or else stay away.

Much of the talk about regulatory reform so far has been about the Fed or some other agency assuming the role of systemic risk regulator—a discretionary job if ever there was one. If Becker and Yglesias are right (and I’m pretty sure they are), this is bound to fail, and we’d be far better spending our time thinking up cruder, simpler rules to keep the financial system from going bonkers.