Self-Regulation and Schumpeter's Wager

Ben’s post on self-regulation is insightful.  But as Gabriel notes it cuts both ways.   I’ll briefly note my position.  The kind of self-regulation or light-touch regulation which is being denounced right now by commentators of all stripes is generally speaking pretty effective in most areas of economic life. Restaurants have good incentives not to poison their customers etc. This suggests that in most places self-regulation is not only the first-best solution, it is also optimal in a second-best world i.e. even in the presence of widespread externalities and irrational behaviour it is still manifestly superior to government regulation or central planning.

Another way of making Ben’s point and Greenspan’s is to note that finance and banking may be different because the magnitude of the externalities i.e. the contagion effects are so large. In this case since the knife-edge is tilted in one direction, it is optimal to lean heavily the other way.  According to this view it is worthwhile missing out on potential beneficial financial innovations and allow relative inefficiencies in the allocation of capital in order to avoid the occasional but catastrophic financial crisis. 

This might be called Schumpeter’s wager since he held precisely the reverse view –  that business cycles are a price worth paying for the winds of creative destruction.

Comments

[Gabriel]

That's a nice way to recast things!

The idea that there's an inverse (or positive) relation between trend growth and volatility could, in theory, be taken to the data (with some care, I suppose). Furthermore, it's not obvious that this trade-off, if it exists, is policy exploitable.

Ramey and Ramey suggest that volatility is bad for growth, i.e. stabilization is growth-enhancing. So that's an anti-Schumpeterian result, if it's OK to identify aggregate volatility with creative destruction (I wouldn't bet on it).

http://ideas.repec.org/a/aea/aecrev/v85y1995i5p1138-51.html
Ramey, G. and V. A. Ramey (1995), “Cross-Country Evidence on the Link between Volatility and Growth.” American Economic Review, 85, December, pp. 1138-1151