Nobel Laureate Tirole Says Financial Regulation Is Inadequate

My article below, first published on October 17, 2014, is further validated by Paul Krugman’s op-ed piece in the New York Times on July 24, 2015.

Krugman, an MIT-trained Nobel Laureate in Economics, suggests as I did: the MIT-inspired model is more empirically accurate than the one promoted by scholars at the University of Chicago.

MIT economists recommended pragmatic and tailored financial regulations.  Chicago on the other hand – Nobel Laureate Milton Friedman in particular – subscribed to a more laissez-faire, less regulated construct.

Krugman writes:

“The coming of stagflation was a big win for Milton Friedman, who had predicted exactly that outcome if the government tried to keep unemployment too low for too long; it was widely seen, rightly or (mostly) wrongly, as proof that markets get it right and the government should just stay out of the way.

Or to put it another way, many economists responded to stagflation by turning their backs on Keynesian economics and its call for government action to fight recessions.

At M.I.T., however, Keynes never went away. To be sure, stagflation showed that there were limits to what policy can do. But students continued to learn about the imperfections of markets and the role that monetary and fiscal policy can play in boosting a depressed economy.”

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Nobel Laureate Tirole Says Financial Regulation Is Inadequate
By Barry Elias
Friday, October 17, 2014

Jean Tirole, the 2014 recipient of the Nobel Prize in Economic Sciences, believes the financial industry is not properly regulated.

The selection of Tirole, a professor at the Toulouse School of Economics in France, comes on the heels of the 2008 financial crisis that unveiled the serious shortcomings in the regulation of banks and other financial firms, and the extraordinary market power of technology companies, such as Google and Apple.

Tirole, an MIT-trained economist, was mentored by Eric Maskin, another MIT economist and Nobel Laureate. His area of expertise is industrial organization, regulation and competition. The underlying premise of his work, which has been substantially validated empirically, suggests markets are inefficient, reflect choices based on behavioral psychology and require some level of regulation. This is in strong contrast to the long-held view by theorists from the University of Chicago that markets are efficient and require little, if any, regulation.

George Stigler, the 1982 Nobel Laureate in Economic Sciences from the University of Chicago for his work on regulation, acknowledged in his memoirs that he was very surprised by the confidence he had when he recommended the breakup of the U.S. Steel monopoly in the 1950s, despite having little knowledge of how the industry operated. He said this belief was driven by consensus more than evidence.

Tirole demonstrated that game theory and contract theory can be applied to regulatory paradigm, especially between strong market participants under oligopolistic and monopolistic conditions, where the quality, quantity and prices of goods and services are controlled by very few actors. In essence, he says firms factor into their strategic decision making how rivals will react when they vary prices or product offerings. The University of Chicago school recognized this, but did not follow the implications.

In addition, information asymmetries exist, since the regulated tend to have much more knowledge than the regulators regarding the successful operation of their business, specifically in terms of costs and strategic options. Additionally, there is incentive for firms to be opaque and hide knowledge, thereby “playing games” with other firms and those who regulate them.

A clever regulator can offset these asymmetries by permitting the firm to select from a series of contracts. The firms choice will hint at their cost structure and how much flexibility they have to lower prices.

Tirole believes each industry is unique in how the regulations need to be applied, and it is crucial that they not stymie long-term investment in innovation and productivity. He also suggests that regulation needs to apply to vertical industries that control many aspects of the production process, from simple raw materials to multiple end uses.

His research has been applied successfully in many industries, such as communications, technology and banking. In the 1980s, he helped European governments divest state monopolies. His recommended paradigm encouraged investment and innovation, curbed excess windfall profits and enabled consumers to experience lower prices and better service. In many industries, the United States has not adopted these regulatory measures.

In the late 1990s, Tirole stressed the importance of liquidity in the banking system, where assets can be readily converted to cash to meet financial obligations. He now recognizes the importance of systemic risk where regulated banks interact with unregulated financial entities. This was not addressed prior to the crisis, said Tirole.

Recently, he has been focusing more on banking and finance. He has teamed up with Emmanuel Farhi, another MIT-trained economist and now a Harvard professor of economics, to study the optimal bank bailout policy by the federal government in times of crisis. Tirole is also examining how central banks can enhance liquidity to commercial banks when the demand and supply of their assets are low.

Finally, regulators across the globe are requiring banks to hold more liquid assets.
Tirole also stresses, once you devise and implement an effective regulation strategy, it must be enforced efficiently by the state. To her credit, Federal Reserve Chair Janet Yellen is committed to reigning in the excessive risks taken by the financial community in recent decades.

The financial industry needs strong minds to tackle this issue before another cataclysm rears its ugly head.

© 2015 Newsmax Finance. All rights reserved.

First published on October 17, 2014.

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