Deregulation and financial stability

We are seeing a turning in the regulatory cycle. After the global crisis in 2008, the excesses of the financial system were blamed, and regulation was turned up. Now growth is lacking, so there are calls for regulatory simplification. Or we should call it what it is, deregulation.

To keep things in perspective, I am discussing regulations that pertain to financial stability, macroprudential regulation or macropru. Even that is tricky, since what counts as macro and what as micro is defined formally, legally and politically, not necessarily by what it really is.

While macropru has always been part of the regulatory agenda, it was only with the crisis in 2008 that it got its formal label and renewed prominence. Many definitions float around. The way I see it, macropru is policy meant to keep the incidence and severity of crises down, while allowing the financial system to support economic growth.

That is controversial. Much commentary holds that the purpose of macropru is to prevent crises, or to keep their incidence very low, and does not like connecting that to economic growth. That is not sensible, conceptually or politically. The only way to prevent all crises is not to have a private financial system, and that means living in a place like Cuba or North Korea. On the other hand, it is not credible either to have no policies for preventing and dealing with crises, if only politically. Bailouts are a middle-class good, as Jeff Chwieroth and Andrew Walter argue in The Wealth Effect. Once assets are widely held, voters expect the state to protect them, and few governments accept the political price of refusing.

There is a continuum, with an optimal amount of macropru somewhere along it. Like Goldilocks's porridge, regulation can be too hot and too cold. Too little, and crises arrive frequent and severe. Too much, and we smother the growth that keeps the system stable, drifting towards the Cuban end of the spectrum.

Which takes me to the current debate. Should we simplify? Simplification, of course, in practice means deregulation, even though in most circles that remains a metaphorical four-letter word.

My thesis is that deregulation would increase financial stability. Several reasons why, but let's focus on populism.

Populism is an enemy of financial stability. For the financial authorities to be effective in regulating, preventing crises and ultimately resolving them, they need to be credible. Populism undermines that. It is built on mistrust of the state and its institutions, arguing that those institutions work against whichever constituency the populist appeals to.

There are many reasons for populism, but one is the perception that society is not delivering, including the lack of economic opportunities. Europe is now in a phase where the political narrative is not about growing the cake but about how to split it, which can only feed populism and further undermine the institutions of the state.

We need growth to get stability, and we need to deregulate to get growth. So deregulation meets the macroprudential objectives.