Friday, 20 March 2009

Wolf on Turner

Martin Wolf's article on Lord Turner's review is a good one (by which I mean, of course, that he agrees with me). He identifies irrationality as "the main analytical conclusion" of the report, but he doesn't take the next step of suggesting that it can be directly regulated.

There are a range of interpretations of Turner's report. Some think his diagnosis was that banks are too thinly capitalised. Some that he condemns financial innovation. I think Martin Wolf has found the most important part: his conclusions about irrationality, both collective and individual.

But while Turner has diagnosed the right disease, he doesn't propose a workable cure. To combat irrationality, he suggests a set of tools that work through rational means. Counter-cyclical capital requirements, leverage ratios, remuneration and centralised CDS clearance are perfectly sensible measures, but - like interest rates, the main tool of existing counter-cyclical policy - they work by market participants responding rationally to incentives, with consistent discounts on time and risk.

As Turner points out, this criterion is unfulfilled often enough to matter. Investors and borrowers do not always act rationally, and if regulators want to combat that, they need to tackle it directly.

Fortunately, they are starting to gain the ability to do so. Behavioural economics research provides tools both to measure irrationality - on an individual or aggregate basis - and to influence it. If equity market participants take too much risk (as they, sometimes, objectively do), there are specific framing mechanisms which can increase risk aversion and have the effect of making investors more rational. If monetary and fiscal policy fail because of hyperbolic discounting, there are 'mental accounting' techniques which can correct for this.

Naturally such policies will require research and testing before being implemented; in particular, the methods for transmitting central policy decisions into the marketplace need work. Just as the mechanisms for transmitting central bank interest rate decisions into the money markets and the consumer debt markets have gradually developed over decades and are still not fully understood - quantitative easing, anyone? - rationality transmission will need time and experimentation to take root.

But if effective controls can be developed, we will be able to avoid restrictive controls on financial innovation by using a more targeted and direct toolkit to mitigate irrational exuberance or irrational fear. The economy - with help from the financial markets - will have room to grow, with a much lower chance of building up large internal imbalances.

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