Why I Favor Rules Over Discretion-Becker

Posner shows there is no absolute distinction between rules and discretion (and standards) because most sensible rules allow for discretion in extraordinary cases. Yet there is a difference under less than extraordinary circumstances, and rules are better in the great majority of circumstances when they are feasible.

One important advantage of regulatory rules partly stems from the nature of human behavior. When the great majority of businessmen and consumers are behaving in a particular way, such as the frenzied borrowing and lending on housing and other assets that preceded the financial collapse, it is extremely difficult for regulators to stick their necks out and shut down the party. As a result, SEC and other bank regulators took no extensive actions to rein in banks even though their asset to capital ratios had increased into dangerous levels before the financial bubble burst. Both Fed heads Alan Greenspan and Ben Bernanke in the early stage of the financial crisis said it posed little threat to the real economy (of course, Bernanke later radically changed his view).

Even when regulators can resist getting caught up in the enthusiasms of the businesses and consumers that they are regulating, they are still subject to enormous political pressures to go along with prevailing behavior. Many companies and industries have full time lobbyists who spend their time cultivating and trying to influence the officials who are regulating their clients. Consumers are not as well organized, but they have votes, and that makes regulators reluctant to take actions that reduce the availability of credit or goods and services that consumers want. To take one of many examples, Congressmen and lobbyists put tremendous pressure on Fannie Mae and Freddie Mac to continue to take on risky subprime loans up to the collapse of the mortgage market.

The pressure from interest groups on government officials has long been noted. Simon Newcomb, a 19^th century American astronomer and economist, wrote in 1885, “One cent per year out of each inhabitant would make an annual income of $500,000. By expending a fraction of {their} profit, the proposers of policy A could make the country respond with appeals in their favor…Thus year after year every man in public life would hear what would seem to be the unanimous voice of public opinion on the side opposed to the public interests”(Principles of Political Economy).

Rules set the tone for regulatory actions even though they must allow for discretion under unusual circumstances. If bank regulators had a rule requiring that the ratio of bank capital to bank assets had to be above a specified threshold, they very likely would have been forced to take actions that limited bank lending prior to the financial crash, even when they had misgivings about these actions or when subject to political pressures to let the financial party continue. This is why I favor such capital requirements, and even steeper ones for the banks that are “too big to fail”.

If the Fed had been following a rule that made its intervention dependent on some combination of inflation, output growth, and unemployment- as in Taylor rules- it probably would not have intervened before the crisis hit since all these measures were doing well. But a Fed following such a rule would have intervened quickly after unemployment began to rise sharply and output growth slowed dramatically.

The Dodd-Frank Wall Street Reform and Consumer Protection Act does require capital requirement rules for banks, and introduces other rules as well. However, it offsets these good rules with various new and dubious discretionary powers of regulators. These include the creation of a consumer protection agency with potentially considerable power over consumer actions. It also created the Financial Stability Oversight Council, a panel drawn from the Fed, SEC, and other government agencies, that monitors Wall Street’s largest companies and other market participants in order to respond to what they assess is excessive growth in the economy’s degree of systemic risk.

I am not arguing that rules alone are always sufficient to guide regulators and other government officials. Clearly, at times rules have to be supplemented to take account of circumstances that were not adequately covered by the rules. Also rules have to be adjusted periodically over time as new institutions and technologies develop, and as those being regulated devise ways to get around the rules. In addition, regulators subject to rules may manipulate the implementation of any rules. Nevertheless, we are likely to get far better policies if we begin with a widespread set of rules that guide officials, and then introduce discretion as supplements to this rule-based system of regulations, rather than supplementing a basically discretionary approach with some rules.

 

Comments

[Michael Webster]

Becker writes: "If the Fed had been following a rule that made its intervention dependent on some combination of inflation, output growth, and unemployment- as in Taylor rules- it probably would not have intervened before the crisis hit since all these measures were doing well."

No, by late 2004 the FBI had serious concerns that the mortgage industry was rife with fraud.

It was too easy to mimic mortgage paper.

This was never a signal that the Fed understood - largely because nobody wants to entertain the notion that entire enterprises can become criminal in nature.

What the Fed needs are not rules, but rather the general discretion to decide that what looked like investments were in fact gambles. Gambles are for the most part unenforceable agreements.

The Netherlands took this approach in 1636 and it arguably confined a possible financial run to the taverns where the auctions for tulips had taken place.

[Pointsnfigures]

interesting as traditionally the SEC is a rules based regulator, while the CFTC uses principles. The CFTC has a less fragmented marketplace that is more robust, and creates more equality among its users.

It might be better to throw all the rules out-since they have been lobbied-and all the discretion out since it's lobbied and offer up the entire place to a wild west marketplace with the players setting the rules through their actions and interactions.

[Neilehat]

Michael,
Criminal, Corrupt or both? As for the gambling nature of investments, the old saw still applies, "You puts your money down - you takes your chances - and above all, beware the "fixed" wheel. Not too mention, Pigs in a Poke". In order to combat this problem, the IMF and World Bank have come up with an idea called, "Good Governance". Which ties back into the issue of, "Rules, Standards and Discretion...

[Ed Rector]

How does one know what the correct rule is??

Remember Milton Friedman's rule of an unchanging 4% annual growth in the money supply would render Fed discretion superflous and give us constant economic growth with little inflation? Who would advocate such a rule today?

[Jdwalton]

Rules replace trust.

[bean spout]

The difference between rules and discretion, is the difference in role between the judiciary and the executive. In a business context it would be the distinction between the "business model" or the firm or industry's habits or custom, versus actions that are taken. Which might change those habits or customs.

[bean spout]

The country seems to believe that if we write up a ton of rules, the more the byzantine the better, all that is bad in the world can be prevented. A Deist clockworks. The Emperor's Mechanical Nightingale. We already had all the rules we needed—the Securities Act of 1933. The regulators failed to see that the privatization for resale of a large national insurance scheme for mortgages needed them to set up just a few simple rules for that security type, about loan quality in any resold pool. The complexity of the rules we are constantly writing and adding to, just invites hordes of con artists and manipulation by special interests.