Regulation and the Financial Crisis

This guest blog is by Mick Moran, WJM MacKenzie Professor  of Government, University of Manchester and is an edited text of the keynote address to the Biennial Conference of the European Consortium for Political Research Standing Group on Regulatory Governance,  and was presented at University College Dublin, 18 June 2010.

Regulation and the Financial Crisis

The mess we are in.

Four quotations aptly summarise the mess we are in, and the way we got there.

‘Complex financial instruments have been especial contributors, particularly over the past couple of stressful years, to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago.’ (Alan Greenspan 2002)

In addressing the challenges and risks that financial innovation may create, we should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it is most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks’ (Ben Bernanke May 2007)

‘the current economic situation is better than what we have experienced in years. Our central forecast remains quite benign: In line with recent trends, sustained growth in OECD economies would be underpinned by strong job creation and falling unemployment.’ (OECD Economic Outlook 2007)

These first three quotations sum up ‘the Great Complacency’ –  the delusion that led so many economists and economic policy makers to announce that the last bubble was ‘the Great Moderation’ – a new utopian age when all the fundamental problems of a market economy had been solved.

And the fourth quotation sums up the sort of intellectual mess that the financial crash left behind.  Buiter puts it with characteristic Dutch bluntness:

‘The Bank of England in 2007 faced the onset of the credit crunch with too much Robert Lucas, Michael Woodford and Robert Merton in its intellectual cupboard.  A drastic but chaotic re-education took place and is continuing.’ (Wilhem Buiter 2009).

What went wrong with economic understanding? 

 The problems with the discipline of economics are surely threefold:

·        It became corporatised: both as to education (especially in the Business Schools) and in practice (economists in financial institutions).  The economist in the study was transformed into the economist broadcasting from the dealing room, laying down the law about what markets would and would not tolerate.

·        It became organised into a conventional academic hierarchy.  What we can learn from the recent fate of economics is that the worst thing that can happen to a social science discipline is that it gets  access to a Nobel Prize

·        It became professionalized: it developed a recursive world of professional economics that heightened the danger of succumbing to groupthink.  Algebra is not substitute for observation.


But while economists were cheerleaders during the ‘Great Complacency’ they were not the only culprits. Hardly anybody – not policy makers, not academic students of regulation – foresaw what was coming.  We all have lessons to learn.  Here are three that we must urgently take on board.

Democracy matters: the end of the ‘Great Moderation’ was also the end of  a ‘Great Experiment’ lasting more than 30 years: the experiment was designed to insulate regulation from democratic  politics.  Hence  the rise of central bank independence and the spread of independent regulatory agencies.  We saw the realisation of Majone’s theory of the regulatory state: a theory that asserted that majoritarian democracy could not cope with the complexity of modern market management.  The Great Experiment proved to be a disaster.  It led us to the catastrophe of 2008; and rescuing the financial system was only possible by turning to those despised figures, elected politicians, who it turned out were the only ones able to mobilise the cash and legitimacy to put the financial system on something like an even keel.

Ideology matters: the core of the crisis was due to the naturalisation of markets: an exercise in ideological hegemony that pictured them as subject to quasi-scientific determined laws.  They need to be denaturalised both to understand the crisis and to avert future disaster. Markets are social institutions to be understood by observation not algebra.

Interests matter: Many of our standard notions in explaining regulatory catastrophe – Groupthink, coordination problems – work contingently to explain things – see my opening three quotes.  But why was something like groupthink so prevalent?  It was linked to three developments

1.     The astonishing rise of a new Anglo-American plutocracy in the markets: the era of the Great Moderation was also the greatest era of plutocratic enrichment since the age of the Robber Barons.  But unlike the Robber Barons these new plutocrats did not practice the engineering of steel of railways; they practised the smoke and mirrors of financial engineering.

2.     The fantastic wealth of the financial sector on both sides of the Atlantic bought an equally fantastic amount of lobbying muscle.

3.     This converted into the kind of hegemony that lay behind my opening quotes: the stories of regulation before the crisis – in the UK, in the US, even in a smaller case like Ireland –are of timidity and subordination on the part of public regulators.

We have to fashion a new ideology of public interest regulation, and a new confidence in that regulation: it existed when the American  New Deal institutions found their feet; it must be rediscovered.  And, as the forces of financial power might regroup, it must be rediscovered in the face of the lobbying machines of the financial markets.



Author: Colin Scott

Colin Scott is Principal, UCD College of Social Sciences and Law and Professor of EU Regulation and Governance at UCD. He is a Co-Editor of Legal Studies (Wiley-Blackwell).

25 thoughts on “Regulation and the Financial Crisis”

  1. + 1.

    Hayek may have been right about a lot but Karl Polanyi was right about a lot more. As he said in The Great Transformation (1947), in which he demonstrated the fallacy of the ‘self regulating market’ notion:

    The mechanism which the motive of gain set in motion was comparable in effectiveness ony to the most violent outbursts of religious fervour in history’

    The subsequent degradation of economics as a science, and as a profession, is neatly described in Econnned by Yves Smith.
    It seems that ‘mainsteam’ economics is no less ideology-ridden (and unscientific) than the much-derided ‘socialist economics. We need political economy.

  2. This post should probably be set the music for the citizenry as they march against the forces of the Masters of the Universe.

    On a more serious note I think there is less of an issue about regulation of activities within national jurisdictions. In Ireland, we have seen that the appointment of regulators (such as Prof. Honohan and Mr. Elderfield) with capability, integrity and a willingness to perfom their duties and apply their powers as required in the public interest may be sufficient. It may be that some strengthening of their powers is required, but this can take place over time. However, there needs to be a similar changing of the guard in all the other regulatory bodies – and a thorough review of their duties and powers.

    The real problem is at the international level where bank and financial MNCs can avail of “regulatory shopping”. (Many US banks and shadow banks were able to evade the strictures of Sarbanes-Oxley by shifting their more risky and dodgy operations to the lax regulation of the City of London.) There is no coherent body of citizens at this level – or coherent definition of the public interest – to demand and require thier elected representatives to enforce effective regulation.

  3. +2!

    Paul H
    Regulation will never work. The financial lobby is in the blog above! It ensures that the public servant has plenty of cover while allowing the maket fallacy to bloom again. It has happened before. It will happen again. The calibre of current appointees is just part of the liberal whitewash: the damage has been done.

    No one wants more borrowing now, except so called sovereigns and that is where the financial lobby can now be found.

    Good news! Those who raped Ireland are able to now get guaranteed debts paying interest from Ireland!

    It is the reverse of the old trick of “the General”. Buy an expensive vehicle, in cash. Drive it off. Return a few minutes later and take the safe. Only this has finesse ……. we are dealing with gentlemen.

  4. Those four quotes do not explain the mess that we are in. Complex financial instruments were not central to the problem – “a plain vanilla property bubble” as Regling & Watson put it- and I think the intellectual cupboard in DoF/CBI was pretty empty.

  5. “Markets are social institutions to be understood by observation not algebra.”

    There has been a major increase in the reportage of market moves as either “return of risk appetite” or a “decline in risk appetite” – covering respectively upward moves in equities/commodities/peripheral bond prices in Eurozone, and downward moves in same. This may be mere journalistic laziness, but it also forms the basis of much market analysis as produced to market participants. It’s as if each asset class, and asset sub-class, has been ascribed a risk number or correlation factor, either or both of which are derived from a combination of moving averages and regression analysis, rather than rational observation.

    If money is genuinely chasing risk numbers as opposed to fundamental principles, then some horrible mispricings will ensue – if they’re not there already. Peripheral eurozone bond spreads, for example, appear to have developed a correlation with US equity markets over the last 16 months or so.

  6. The Great Transformation which was written by Karl Polanyi in the aftermath of the Great Depression is well worth a read nearly 70 years after it was published.
    Polanyi in his writings emphasized the idea that the economy is not autonomous, as it characterized in standard economic theory, but subordinated to politics, religion, and social relations. He recognized that modern economic thought rests on the concept of the economy as an interlocking system of markets that automatically adjusts supply and demand through the price mechanism.
    Polanyi’s analysis of the economic and social changes brought about by the “ Great Transformation “ of the Industrial Revolution show how sharply this abstract theory differs from the reality of human experience. He explains the deficiencies of the theory of the self-regulating market and the potentially dire social consequences of the untempered “ free market”.

    This book should be required reading to break the ideological hegemony of the self-regulating market and “to fashion a new ideology of public interest regulation.”

  7. kevin denny
    On the face of it, Kevin, you are correct. But! We are not privy to the mess that is the IFSC!

    Malinvestments are natural in a bubble, do you agree? The bubble still exists, now being fed by sovereign borrowers. As they borrow, this becomes an asset on someone else’s balance sheet. This enables more lending at an unknown ratio. In Europe, the ratios can be 50 created to 1 in capital. The Americans can be worse. How many sovereign hesitations or renegotiations will it take? The last bubble is always the biggest! The lending seeks the highest return as volatility increases, the risks escalate! Hmmmmmm? How will this end?

    One part of me says that once Ireland has determined the true state of the economy, we should borrow big time and buy suitable natural resources and raw materials…… The lender will soon be in no position to demand anything and many sovereigns will be worse off.

    The rest of me says the sooner we balance the budget, the faster we will have stability and the potential for growth.

  8. @Pat D – bubbles are mass malinvestments, so of course I agree.

    I’m concerned that there is a “reductio ad algebram” going on in the investment community, with attendant misallocation of investment flows. Only a fool wouldn’t make use of risk measures, but only a greater fool would rely solely on them in making investment decisions. Where there is a developing mass tendency to reduce investment decisions to ascribed risk characteristics at the expense of any fundamental analysis, there is a bubble waiting to form.

    How will this end? In tears, of course. Just not sure if they’ll be the lenders’ or the borrowers’.

  9. I would be very interested to read responses from academic economists on the substantive criticisms contained in Mr. Morans section on:

    What went wrong with economic understanding?

    Has anything changed in the field? Are we seeing an economics that is less ideological, and less shaped by corporate and academic group-think. Is it less obsessed with constructing mathematical models based on dubious analogies with the natural sciences, and more willing to recognise that ‘interests matter’ and that economic interventions both theoretical and in in policy are intrinsically political?

    Things may have changed inside the profession, but what we hear on the outside are largely technocratic arguments based on old consensus models that have clearly failed. The notion that political choices can be made in economic policy, or that economies are social constructs that can be shaped politically, seems to be largely absent, except for a few dissenters.

    Why is this?

  10. There is a new ‘truth’ being pushed by those employed by the public to justify their failure to do their jobs.

    After every disaster a bureaucracy goes into self preservation mode. Whether its a big company who has lost market share or a quango who f***ed up, its always the same…. The bureaucracy invents a narrative that suits their purpose, which is to continue their existence and growth.

    This speech is more of the same, an ‘expert’ telling an audience what they want to hear, and contributing to the narrative that suits the growth of the bureaucracy that failed us so spectacularly over the past decade.

  11. I don’t like the word bubble in this context. Bubbles burst. The implication is that property values have “burst” and that we are left with nothing.
    Property cannot form a bubble because property has an intrinsic value. That value is in turn determinded by the disposable income of the people in the country where that property is located. If you increase the disposable income of the people the value is, at least in part, restored.

    With a burst bubble there is no point in re-inflating it because there is no external structure to contain it (external structure being equivalent to intrinsic value). There is a point in re-inflating property values.

    I know I haven’t expressed this very well but inflation of property prices or development land is not as simple as bursting a bubble. There should be less focus on blaming people for not spotting the overvaluation and instead more focus on returning some of that value.

  12. @ Garry

    You can’t have a modern economy without bureaucracies. Check out Max Weber. They can be improved, and sometimes that means shrinking or abolishing certain aspects.

    There is a difference, however, between causing a problem and failing to stop one. The prime suspects in this case are Mr F Market , Ms H Finance and Mr C Politician.

  13. I’m not advocating a return to the fields. Bureaucracies are inevitable but need to be pruned regularly.

    The purpose of the bureaucracy was to stop fraud, criminality and excess stupidity from happening and protect the public. They failed. They should not be allowed indulge in revisionism. Because from this false premise, they will start to dictate the way forward which not surprisingly involves more bureaucracy.

    Agree 100% on the culprits. But the current actions of the bureaucracy are insulating the culprits from the consequences of their actions and leaving the bill with the public; the people they are supposed to protect. Which is guaranteeing bigger problems down the line.

    But it suits the narrative that is being created; that having a few hundred more bureaucrats and a new mission statement will solve things. Whereas we all know that having a few hundred more Paddy Nearys will only add to the problem. A collective of Paddy Nearys will be even more stupid than just one.

    Whether its bishops covering up child abuse or a regulator covering up fraud, they are no longer working for the common good; they are bureaucrats acting in their interests and that of their institution.

    The “interests matters” that the professor refers to needs to be expanded.

  14. @Pope Epopt: I am not sure that Moran’s comments have particular relevance for the case of Ireland where economics is not that central to policy-making unlike many other countries. A lot of the criticism of the alleged apolitical nature of economics is ill-informed. Political economy has been a particularly active field in recent decades. It has been a feature of public economics (taxation, public spending) for some time but is prominent in areas like macro’ and trade now. I think the difference is that its a lot more rigourous now.
    The idea that economists are just a bunch of technocratic would-be physicists with no awareness of politics may be convenient for some but is essentially fiction. Of course there are some in the profession who are would-be physicists but you actually need a few of those.
    As for those, like Aiman, who think there is no role for algebra…sigh…the things that economists are expected to shed light on: inflation, growth, earnings,inequality etc are intrinsically numerical. If you can shed light on these without mathematics, good luck to you.

  15. @kevin denny – Please don’t misquote. I never, nor would I, have suggested “there is no role for algebra”.

    What I said was “Only a fool wouldn’t make use of risk measures, but only a greater fool would rely solely on them in making investment decisions.”

    In which camp do you pitch your tent?

  16. @Kevin Denny
    “I am not sure that Moran’s comments have particular relevance for the case of Ireland where economics is not that central to policy-making unlike many other countries.”

    Why not? Ireland is not a hermetically sealed ideological free zone. What role did the economists in the large banks play in moulding and justifying government policy-making during the housing boom? Some economists did warn about the dangers involved in a massive asset bubble. Why were they not listened to in Ireland?
    As Mick Moran states , “Interests Matter” and “The fantastic wealth of the financial sector on both sides of the Atlantic bought an equally fantastic amount of lobbying muscle.” This fantastic wealth captured, corporatised and promoted a particular economic paradigm which suited their own corporate interests.

  17. @Aiman
    Knew I put it badly. The psychology of language is important – when you think bubble you think “burst” and unsalvagable.
    From a lay perspective property seems like a strange commodity. It’s value is determinded by factors outside itself.
    It’s value fluctuates naturally in response to variations in those factors. I think we’re now all guilty of undervaluing this asset. I think that all this current self flagellation now is as wrong as the hype of the property overvaluation was then

  18. @ garry

    ‘A collective of Paddy Nearys will be even more stupid than just one’

    You know what they say about the camel. Its a horse designed by a committee. So yes. Groupthink and ‘safe’ practice has us where we are.
    If our institutions put their own interests before the general welfare, we need to question their motives, and for as long as it takes.

    There is no better, higher class, ‘up there’. Just citizens. That’s what a republic is all about.


    The money machine is broken. In the USA it is securitization, the art of selling, sorry, stuffing, insurance, banking and municipal bodies from all over the world. Very expensive rare credit does not need regulation. Idiots! But it shows that the government governs. And cares! Ha! More jobs for the boys! By the time credit is freer and dangerous, the message will be growth at all costs! History repeating …..

  20. Garry

    Very true! Lies are their servants. The msm and everything else is used to peddle them and in return the msm etc get a better ride, ie advertizing revenue

    You are naif. Not a bad thing and you will learn by reading here and elsewhere. You know there is something wrong, but not what. You are on a journey. Value of land is its intrinsic value. Value of government permissions to build can be enormous, if there is demand. Value of government permission to borrow money and lend it to ten people is also enormous, if there is demand. After a bubble, there is no demand!

  21. The bubble was not land, nor bulbs from Turkey, nor shares in the South Seas!

    The bubble was credit! The money machine that exists in the form of money bureaus that recognize paper as conferring value!

    Want more borrowing?

    Psssst, I can lend you billions!

    Just sign your name at the bottom and send 1 euro to all those above you on the list and send it on to 10 of your worst enemies! In three months you will have 1,000,000 euros!

    Wealth is easy, just put in your savings and in three years I will make you ten times richer! I use leverage intelligently

    By the way, I do act as an advisor and if you believe anything I have said you are a fool. All I do is tell lies all day long!

  22. Global Debt Crisis

    The greatest private fraud of human history.
    Who are the great fraudsters who are becoming the murderers of the human kind? How does the economy “illness” threaten Democracy and the freedom of people?
    By knowing what happened in indebted Greece, where loan sharks created “bubbles” and the current inhuman debt, one can understand the inhuman plan in total …understand where this plan started just to bring all states at the same end …understand how this type of plans are established…


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