Capitalism and Regulation
This weekend’s talk among world leaders will be accompanied by opposing diagnoses of economic failure and prescriptions for correction and prevention. The outgoing President of the United States sought to frame discussion in a speech yesterday extolling the virtues of unbridled free-market capitalism, warning that government regulation is a danger not a solution. In contrast, the continuing President of France and Prime Minister of Great Britain signal interest in devising an elaborate international, government-sponsored regulatory structure at global levels, to modulate capitalism’s most acute downsides.
Neither of these extremes is likely to hold. All modern capitalistic economies involve considerable government regulation and no advanced modern government is likely to cede sufficient national sovereignty to international regulatory authorities to forge a single global financial regulator. Reality suggests a combination of continued or enhanced national regulatory oversight with perhaps greater international coordination among senior national regulators.
Deeper policy talk may turn to the form regulations should assume within nations to enhance oversight and facilitate coordination. This may refashion discussion about whether rules or standards are superior. No slogan has been more popular in financial regulatory circles in the past few years than “principles-based systems” as contrasted to “rules-based systems.” Conservative reformers in the US, including current Treasury Department leadership, had been condemning the US system as “rules-based” and celebrating the “principles-based systems” they assert exist in the UK and Europe.
Regulation in general, and rules in particular, are a problem not a solution, in this view. If any regulation is politically necessary or economically justified, it would assume the form of broad general expressions of expected conduct, as standards or principles, not rules. This approach enables reposing maximal discretion in targeted actors, letting them exploit opportunities and take risks sans regulatory shackles. Opponents, skeptical of such discretion, contend that, at least for some purposes, strict rules are required to restrain excesses to which such actions can lead. When taking stances on the form of national and international financial regulation in coming discussions, participants may need to confront several fundamental questions.
First, is it true, and what does it mean, that UK and Europe have principles-based systems and the US a rules-based system? Rhetoric aside, the systems are in fact blends of rules and principles and classification of the overall systems into these binary categories is coarse.
Second, even if UK-Europe models are more principles-oriented and the US more rules-oriented, do those forms of regulation have anything to do with systemic failures? Did US participants design aggressive and highly-risky transactions precisely to avoid detailed rules that would have been prevented by broad general principles? Did UK-European participants evade the spirit of applicable principles in designing similar transactions?
Third, might UK and Europe, interested in greater national and global regulation, and concerned about laxity of their principles-oriented regulations, elect to move away from principles and towards rules? In the US, might the national appetite be less inclined to believe that rules were to blame and prefer regulation in the form of rules?
Fourth, why might a nation’s leadership prefer to design or advertise its financial system as principles-based rather than rules-based anyway, whether or not that is an accurate description? Amid global competition among nations for the business that financial activity brings, national regulators may pitch their financial regulations as products. They may sell them as principles-based to entice participants into their markets. Participants may pressure competing regulators to follow suit—and increasingly turn the rhetoric of principles into the reality of enhanced discretion.
Finally, under what conditions will talk and use of principles instead of rules endure? If national interests remain elevated above global coordination, one may expect to continue to hear rhetoric extolling the virtues of principles-based systems and condemning rules-based systems, and this rhetoric may be turned into action. Even if global interests were more effectively coordinated, to command assent of diverse nations, resulting regulations may more likely assume the form of vague general principles than detailed prescriptive rules.
The pessimistic upshot: national interests continue to dominate global discussion of financial regulation, elevation of principles based regulation continues, and reforms ahead will be unlikely very much to modulate capitalism’s acute downsides. The optimistic case: national interests cede to global ones and regulators forge an appropriate integration of principles and rules that, in combination, facilitate capitalistic risk-taking to promote economic opportunity with prudential limitations against acute downsides.