The 2008 international financial crisis spawned an avalanche of financial regulation. As Europe’s banks struggle to raise fresh capital and cut back on certain types of transactions, questions are beginning to be raised about whether financial regulation is going ‘too far’. It seems unlikely that the financial sector in Europe will be able to contribute to the Eurozone’s already anemic growth prospects. If the economic forecasts for the Eurozone are to improve, there will have to be extensive deregulation of labour and non-financial service markets.
What is happening in the Eurozone illustrates our deep ambivalence towards regulation. One moment we want more of it; the next we want less.
This ambivalence is nothing new. There has long been a tradition of regarding regulation as an inferior form of social coordination.
It seems unlikely that the financial sector in Europe will be able to contribute to the Eurozone’s already anemic growth prospects
Democracy and deception
In order to understand this ambivalence towards regulation we need to examine regulation in relation to each of the main alternative systems of social coordination – democratic politics, the law, the market, and civil society. What is important about these relationships is that they are always changing. In good times we can allocate more resources through political processes. In times of austerity we need to rely more on the market. If, in turn, market processes go wrong, we can resort to the law to correct damaging behaviour.
In this broader democratic setting, regulation is often seen as providing a deceptive response to matters of public policy. The deception lies in the attraction of relying on experts to provide solutions to systemic failures. According to this view, regulation risks ‘crowding out’ other better forms of response. Not only can it reduce the scope for politics, the market, and the law to intervene, it can also disincentivize people from acting responsibly in their everyday behaviour.
Analysing our ambivalence
In my book The New Regulatory Space published earlier this year, I analyse our ambivalent approach to regulation. In particular I try to get to the bottom of why we think of regulation as ‘inferior’ and our concerns about the ‘crowding out’ of alternatives.
The main approaches to regulatory analysis in recent years have relied on what is called ‘responsive regulation’ to conceive of how we regulate and on the social construction of ‘risk’ as a means to understand why we regulate. These approaches offer diminishing returns. At the same time, concepts drawn from economics such as ‘capture’ and ‘rent seeking’ appear to have equally limited applicability. Some specialists in the field refer to a ‘crisis’ in regulatory analysis.
I therefore turn to the concept of the regulatory ‘space’ and to what is known as ‘social framing’ in order to shed light on why we prefer to regulate rather than to rely on the alternative forms of coordination. Social framing has its roots in cognitive theory. It provides a broad basis for conceptualizing behavioural preferences, including the cognitive behaviour of regulators themselves.
The findings of this across-the-board assessment of the goals of regulation do not support the view that regulation is an inferior form of social coordination. Nor do they support allegations of ‘crowding out’ or ‘demotivation’. What, however, they do suggest is that we should look at regulation in a different way. We need to consider the regulatory system as a whole, rather than just focus on regulation in the context of specific responses to particular problems of public policy.
If we take a systemic overview of regulation, what stands out is the role that regulation now plays as an adjustment mechanism between our different systems of social coordination. If we want to rely less on publicly supplied services provided through democratic process we may not want to go straight to market provision. In sensitive areas of public policy, such as health care or education, we are wary of the ‘creative destruction’ of the market. So instead we instigate reforms that are buffered and mediated by regulation and regulatory bodies. The same process works in reverse. If we think that the market is not going to provide us with resilient critical services, and we are wary of handing them over to daily interference by government departments, then we regulate them instead.
In sensitive areas of public policy, such as health care or education, we are wary of the ‘creative destruction’ of the market
Foresight and reform
Regulation as an adjustment mechanism has a distinctive quality that makes it of particular interest. This distinctiveness lies in the fact that, for professional reasons, the regulatory world tends to be forward-looking. If you are a sector regulator, for instance, you will probably spend quite a lot of time thinking about the future of your sector.
By contrast, other systems of social coordination possess what is called ‘adaptive bias’. The short-termism of politicians blinds them to what lies beyond the next election, while the law pays particular attention to past precedent. The regulatory world therefore provides one way in which we can counteract adaptive bias in other systems.
This does not mean that the regulatory world always gets it right. Most financial regulators, including the IMF, famously failed to foresee the 2008 crisis. But that tells us more about their cognitive weaknesses rather than about their professional propensity to look to the future.
In view of the amount of political capital expended on financial regulation in recent years, two aspects give cause for concern. The first is the enormous legal uncertainty that has been created, for example in the area of proprietary trading (where financial intermediaries trade for their own account). The second concerns the weaknesses in the knowledge judgements of regulators. Do they really know better than the markets whether or not ring-fencing and other structural reforms to the banking sector are justified, or what the side-effects on non-bank finance and market liquidity will be?
Do regulators really know better than the markets whether or not ring-fencing the banking sector is justified, or what the side-effects on non-bank finance and market liquidity will be?
A system of coordination that acts as a forward-looking adjustment mechanism can offer significant benefits. The way in which we rely on different systems for social coordination is in constant flux. An adjustment mechanism is necessary to mediate changes in an efficient way. We should value that mechanism.
At the same time, we need to keep some overall perspective on the changing interplay of alternative forms of social coordination and the role of regulation in the adjustment process. There is no evidence to suggest that systems are self-correcting. Examples to the contrary abound, however, such as when powerful politicians favour their cronies in the market and corrupt the processes of the law. The end result is undemocratic politics, a distorted market, an absent rule of law, and an uncivil society. More subtle changes to systems may be less easy to trace, but damaging nonetheless, and oversight of all these patterns is essential.
Traditionally, the job of maintaining the overall integrity of a democratic system of government is the role of a constitution.
In recent decades constitutions have been seen primarily in terms of contracts and constraints. I would argue that this new approach to the regulatory space should instead lead us to regard constitutions as mechanisms that trigger reflection and corrections in relation to complex interchanges between systems of coordination. Few constitutions are fit to meet the demands of the shifting interconnected systems that define modern democratic governance.
He will develop the ideas in this blog in a lecture to be held at the Manor Road Building on 20 November. To reserve your place, please visit the event webpage.