Is more effective international regulation the answer?

No, it is not.

I am prompted to write this by a piece in today's NYT, which centers around my colleague Ken Rogoff's views on financial globalization and its pitfalls. I think Ken is quite correct in his diagnosis of the problem, but I disagree with him on the policy implications that he draws.

This crisis has shown the Achilles’ heel of a globalized financial system to be a lack of high-quality, and consistent, regulation to prevent overconfident bankers from taking irresponsible risks. A year and a half ago, when it appeared to be a subprime mortgage issue for the United States, most countries thought they could glide past it. But it turned out that everyone in that globalized system was vulnerable to the collapse that began at the center.

“I believe we need a global financial regulator with real teeth,” Mr. Rogoff said this week, “to prevent the lowest common denominator problem.” Before this crisis, capital flowed to the place where it was least regulated, and some countries competed to be that place. It is worth remembering that the Bush administration was trying to use the threat of overseas competition to relax regulation before the financial system blew up.

If that doesn’t happen, then the most rational thing for many countries may be to insulate themselves from the globalized economy. “Countries will feel required to put on more capital controls so they are not exposed to countries that are taking risks,” Mr. Rogoff said.

That is absolutely right.  But Ken's preference for a "global financial regulator with real teeth" overlooks three major problems. Global financial regulation is a bad idea because it is neither desirable, nor prudent, nor feasible.  

It is not desirable because countries at different levels of development and with different national preferences with regard to how much risk they want to encourage as the price of financial innovation will want to select quite different national regulatory regimes.  There is a large element of a "local public good" in the financial system, and you need to recognize the heterogeneity of national preferences. 

It is not prudent, because a common global regulator will require global harmonization of rules. What if we converge on the wrong ones?  That was one of the points brought out by Katharina Pistor recently.   

Finally, it is not politically feasible because I just do not see that major countries will surrender national sovereignty to a global regulator with teeth. There is not enough political convergence globally for this to happen.  But the major principled objections are the previous two, rather than this one.

What is the alternative?  Ken is right that the only real alternative is a system of capital controls.  But viewed in the context of the arguments I just made, it is not at all clear that a system that allows and legitimizes capital-account management would not dominate a futile and undesirable effort to set up a global regulator.  In fact, the danger is that we will obsess on getting international regulation right with no plan B, and in doing so will simply prepare the groundwork for the next crisis.

But if we create a world of nationally segmented finance, won't we give up the benefits of global financial integration? Please.   

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