The Political and Analytical Diversions of ‘Financial Regulation’

by Paulo L dos Santos

The only thing governments seem to be doling out in greater amounts than bailouts to private banks these days are promises for all sorts of ‘financial regulation’. The EU recently promised sweeping financial regulation. Gordon Brown insists it must be international, while the Obama administration promises it will be wide-ranging and strict.

My first problem with these promises is not simply that the horses bolted long ago. It is that those now calling for doors to be shut are the same political forces that only yesterday sang the virtues of open barns and assured us that competition would ensure horses always came back. That in itself should give pause and good reason to question the motivations behind these proposals.

But my bigger problem is the implicit presumption that the current financial crisis is simply the result of a lack of effective (sweeping, international or wide-ranging) regulation, with little to no serious relationship to the underlying economic and social trends of recent years. This is not only plain wrong, but also politically diversionary.

Analytically, this presumption mirrors the weaknesses of mainstream economic theory. First there were perfect markets, financial or otherwise, and they would lead to socially efficient outcomes. Then came ‘imperfections’, typically caused by ‘informational’ or other micro-level problems with transactions, which gave rise to conflicts of interest, potential misallocations of capital and crises. Virtue lies in deducing the contracts, ‘institutions’ and state regulation that can ameliorate these microeconomic conflicts, align incentives, and help earthly markets become more perfect.

This scheme not only leaves out the destructive endogenous tendencies of financial markets towards instability, but also abstracts from the historical, social, economic and political processes that condition the formulation, enforcement and avoidance of regulation. There is no ‘optimal regulation’ that applies equally to all periods and benefits the interests of all social groups. Financial regulation is an important but nevertheless secondary element of broader economic and political regimes. It is only ‘optimal’ in relation to specific socio-political interests.

Following the Second World War, financial regulation imposed a degree of ‘financial repression’ to facilitate the reindustrialisation of Europe and Japan, the restoration of international trade, and the stabilisation of capitalism in the face of the USSR and radicalised domestic working classes. Over the past two or three decades, financial regulation has served the broader push for international market liberalisation and privatisation. The result of this push has been growing inequality, falling real investment and the rising levels of household debt that triggered the current crisis. Sustainable economic recovery requires the reversal of these realities.

The first issue for those committed to equitable societies and economic justice cannot be what kind of financial regulation is necessary. The first issue is the kind of economy we want—more equitable distributions of income, full employment, increases in environmentally sound productive investment, increases in the growth of physical productivity, high standard of universal social services, the rapid and environmentally responsible industrialisation of developing countries, etc. The second issue is the kind of political, economic and financial institutions that can help deliver those goals. A third issue arises if and only if those institutions include private financial firms (and I take a dim view on that possibility): how to ensure regulation represses their destructive tendencies and forces them to deliver in line with broader social aims.

A debate that jumps straight into discussions about financial regulation and its minutiae, without questioning the economic and policy regime of the past few years, will be a debate on how to build the shiniest new pails to serve up the old garbage of rising inequality, privatisation, low investment and underdevelopment.