Very Likely Indiscretions of Discretionary Regulation

Behind a veil of ignorance, if asked to specify a single simple rule for regulating political economy, it should be “minimize the discretion of rulers and regulators”.

That’s my opinion. I will discuss Avinash Persaud, James M. Buchanan, John Cochrane, Luigi Zingales, Max Weber, Niall Ferguson, who all have in common an interest in the priority given either to rules or discretion, with opinions either side of mine.

Bye the bye, I’m moving house. When I finish packing my books and have waved so-long to the removals van, in the blissful interlude during which the container crosses the oceans I shall re-read Luigi Zingales’ new book (on Kindle). It richly deserves the extra attention.

1. Luigi Zingales

I really welcome A Capitalism For The People because a world-class economist has written an accessible and practical outline of -- and expansion upon -- three long-standing overriding and universal priorities of political economy which I passionately support:

1. Preventing politicization and capture of market economies.
2. Promoting competition with simple regulation and simple enforcement.
3. Formulating a vote-winning politics of true capitalism.

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That’s not to say I entirely endorse how Zingales handles the task. I detected a small inconsistency yesterday, a straw man large enough to break the camel’s back, an item that has stimulated the writing of this post.

First, Zingales praises common law for the fairness applied by judges, which protects against corruption and lobbying. In continental civil law countries, in contrast, “little discretion is left to the judge, whose role is simply to map codified legal norms onto real-world situations. This creates a strong incentive for various interests to lobby legislators [whereas] in a common law system the legislature is supposed to provide only general principles, limiting the payoff that lobbyists can obtain”.

Second, Zingales praises simple rules, simple enforcement, and the policy of zero tolerance. His example: “If a police officer observes a small criminal act on the street, should he intervene? Of course. But if he is allowed to use his own discretion, he will likely intervene to a lesser degree than the rule requires. Since he bears the personal and physical cost of intervening, consciously or subconsciously he will lean a bit too much against acting. Other officers observing his behaviour might assume that his decision reflects the effective rule… and will likely copy his leniency. Little by little, standards are eroded, unless a zero-tolerance policy dispenses with ambiguity”.

Does Zingales not see a contradiction between these two claims? If the police officer uses discretion the outcome will be less than ideal, he argues, but then claims the reverse will be true for the judge.

Like Zingales, I want zero tolerance. I know ambiguity and discretion are enemies of progress. General principles, if they are not codified, are hard to interpret objectively and more likely to be interpreted politically. Simple rules deter undesirable behaviour by clearly defining unwanted conduct. Although rigid, their advantage is that interpretation and application is fairly mechanical. I advocate “rules-first” at all levels and development of the legal system.

Legal theorist, economist, and judge, Richard Posner, says: “The less discretion a judge has in making decisions, the easier it will be to determine whether a case has been decided contrary to law or whether there is a pattern favoring one class or group of litigants over another”.

All is well, nevertheless. It turns out Zingales does appreciate why best policy is to minimize discretion. In a section dealing with specific proposals for something functionally equivalent to impartial bank bankruptcy with protection for depositors as a means to control bank debt and impose discipline on investors and management, Zingales identifies “two major risks posed by regulatory intervention in the financial system. One is that a regulator could arbitrarily close down well-functioning financial institutions for political reasons. The other is that a regulator, under intense lobbying by the regulated, might be too soft… My mechanism [a regulator intervenes in response to an impersonal market signal] removes most of the regulator’s discretion to make either error”.

It looks promising, though the proposal itself is a little complex… Must reread.

2. Niall Ferguson

Often I nodded in agreement listening to Niall Ferguson deliver the 2012 Reith Lectures. The implied criticism of “social relationships organised along personal and dynastic lines, which means that laws are enforced unequally”. The implied praise for “social relationships governed by impersonal forces like the rule of law, involving secure property rights, fairness, and (at least in theory) equality”.

The desirability of having welfare states adopt “Generally Accepted Accounting Principles” so as to prevent fiscal death spirals. The inadequacy of rules relating to bank capital-asset requirements. The “lop-sided doctrine of monetary policy” in the absence of sensible monetary rules. The discriminatory nature of US mortgage regulation which exacerbated subprime risk. Ferguson criticises “over-complicated regulation”, the great unwillingness to simply “enforce payment of debts and punish fraud”, and regulatory capture. Problems leading up to crisis were certainly not primarily ones relating to deregulation.

All the above are fine observations. Were it not for his preference to run high budget deficits during recessions, Ferguson apparently would in principle like to have a “balanced budget amendment” to “reduce the discretion of lawmakers to engage in deficit spending”. 

I nodded ever more vigorously as Ferguson began intoning Charles Darwin metaphors about the natural selection functions of “extinction”. Where, he asks, are financial “extinctions” today equivalent to ones that followed earlier financial crises? “The dinosaurs still roam the financial world”. Why was financial regulation not attuned to the possibilities of “intelligent design” in imitation of evolution and in accordance with what we know about finance, which is “one of the most complex systems that human beings have ever made”?

The next step in Ferguson’s argument is a big disappointment.

After seeming to recognise the importance of "impersonal" institutional rules, functional Darwinian extinctions, the inherent limitations of the knowledge of regulators, Ferguson accepts the contradictory advice of 19th century economist Walter Bagehot for “discretion as opposed to set rules”, with all “discretionary power” given to the central bank governor.

Ferguson repeats in an interview touching on the Libor scandal: "The discretion of the governor [Bank of England] is the key source of discipline… If he had raised his eyebrows in the old way they might have done something about it. It is that combination of power and discretion which produces a good regulatory system, not 2000 pages of legislation.”

3. Inconsistencies

It is true, a central bank must have defined discretion in monetary policy to act independently of parliament or legislature. Yet its regulatory discretion should be not much greater than other statutory bodies with responsibility for assessing risk and communicating and enforcing rules, with the needed data transparency and rule-enforcement triggers that facilitate those tasks. Banks operate not in response to the governor’s eyebrows, but in a framework of legislation (20 pages could be sufficient) comprising the discipline of market competition, and rules for bankruptcy, fraud, consumer protection.

Everybody with a political agenda is naturally tempted to seek discretion to implement their favoured ideas. But from the standpoint of classical political economy, discretion is exactly the wrong route. I can only think that Ferguson’s illogical conclusion -- which depends so naively on the quality, credentials, and disinterested motives of persons who will exercise discretion -- is inconsistency resulting from the lack of cohesive theoretical framework.

The virtue of political economy in the style of Weber or Schumpeter or Hayek is that it blends economics seamlessly with insights of political science, sociology, psychology, and law.

Any of the political economists would advise against placing trust in one group or person with the right connections or desirable ideology and powers of influence. The style of pre-capitalist 19th century ‘old boy’ networks of bushy-eyebrowed bank governors is even less appropriate today.

4. Indonesian warning

I was reminded of Ferguson again when I saw a revealing comment by a bank executive welcoming the Bank of Indonesia’s “discretion” in approving bids by foreign banks wanting to expand their investments in Indonesia: The Jakarta Post reports:

“Bank Indonesia’s (BI) move to limit bank ownership is not likely deter foreign investors, although the move will expose it to lobbying and political pressure to grant exemptions. The central bank announced a 40% ownership limit in local banks, but sound banks are allowed to have ownership more than the maximum level if they meet requirements set out by the central bank. ‘BI’s discretion to make exceptions to the rule is the important part of the regulation, as it gives BI flexibility and thus exposes BI to a lot of lobbying to ensure a bank is deemed to have a good corporate governance’”, said the senior economist of a large foreign bank.

Hmm, a large bank “lobbying” to persuade the central bank of its “good corporate governance”… that's not a wonderful advertisement for central bank discretion!

5. Avinash Persaud

Ferguson specifically rejects macroprudential and rules-based counter-cyclical regulation on the grounds they would be “hopelessly complex”. This is debatable. I lack expertise to pass confident judgement on macroprudential policies. I am not sure if these rules might slow financial innovation or bank financing of entrepreneurial innovation in comparison, for example, with the kind of policy advocated by Zingales or the UK Vickers Commission proposals for structural separation of casino and retail banking (I've not seen evidence of awareness of ‘discretionality’ issues in the Vickers Commission).

The macroprudential arguments are persuasive if only because simple rules about capital adequacy conform to theoretical requirements of impersonal rules-based structural regulation. A useful Vox article: “Rules vs Discretion in Macroprudential Policies”.

A leading proponent of macroprudential regulation, Avinash Persaud, gives his views here in brief. In a World Bank paper, Persaud wrote regarding international efforts to lessen the extremes of financial cycles: “There should be greater emphasis on rules rather than supervisory discretion to counterbalance the political pressures on supervisors. And these rules should include leverage limits and liquidity buffers”.

In a an interview last week Persaud explained:

“I used to believe discretion is better than rules, but over time realized we find it very hard to apply discretion correctly in the boom… So we need to put in place rules which constrain the amount of lending and borrowing in the boom time. We can’t get rid of the boom-bust cycle, but maybe we can reduce the amplitude of that cycle and make the bust much less devastating”.

6. Back to basics

Nobel Laureate James M. Buchanan provides theoretical support for the view that discretionary state action should be vigorously limited. Constitutions can remove incentives that encourage public officials to exercise a level of discretion that is dysfunctional or unnecessary. Constitutions are designable institutional instruments for improving state effectiveness. They establish the procedural rules for political and legal action. Ideally, the smallest number of formal rules can manageably guarantee a desired outcome without running the risks of government overload.

Decisions relating to government goods and services tend to be influenced by substantive norms that reflect the personal preferences of bureaucrats and politicians about claimed
social goals or national priorities. Instead, processes of government decision making should “be interpreted as a surrogate for a complex of exchange among all citizens [in which] all outcomes that are reached through agreed-on and efficient procedures for decision-making become equally acceptable”. The decision reached will be “desirable provided only that the procedural norms are followed”.

Government decisions are too frequently an outcome of the “grubby, quasicorrupt, day-to-day settling of intergroup, interpersonal claims. The enforceable constitutional choice of rules on how policy decisions should be made represents a “higher-stage” of “rule making politics”

Rather than discretion “the proper principle” for politics and regulation “is that of generalization or generality”. Procedural rules of administration written into constitutions should discourage discretion about public expenditure and public services. A discretionary mode of governance is based always on a “personalized identification” with some groups over others employing criteria of interest, culture, or ideology.

Max Weber saw that even in modern societies “creative administration and judicature would not constitute a realm of free arbitrary action and discretion”.

Before the ideal of creative discretion can be attained, “general norms” for regulating regulatory activity are needed to prevent “personally motivated favour and valuation”.

It is always the case, Max Weber said, that “equality before the law and the demand for legal guarantees against arbitrariness require a formal and rational objectivity of administration, as opposed to personal discretion”.

7. Back to the future

I end with words from a reliable contemporary campaigner for rules as against discretion, the Harvard economist John Cochrane:

“And then there is discretion. Congress empowers ‘czars’ who can do as they see fit, and tell businesses after the fact how to operate. They issue thousands and thousands of pages of rules, but the rules are often vague, impossible to satisfy, and serve to limitlessly expand rather than limit the discretionary power of the regulator. This is really the basic problem with the Dodd-Frank approach to financial regulation. The Financial Stability Council can simply "determine" you pose a "systemic risk," and that's it. The Fed can then tell you how to run your business, in any way that it deems appropriate. Imagine what chaos would result if ‘speeding’ were defined simply by the cop's authority to ‘determine’ that your speed poses a ‘risk to the traffic system’. We pride ourselves that we are a society based on the rule of law. Well, if not law, at least rules, clearly and publicly written, with limits on government power and right of recourse. We abandoned the model that an unelected aristocracy would direct our affairs as they saw fit. The aristocratic temptation is understandable. If you can't define "systemic risk" it's tempting to just put a Wise Regulator in charge who will know it when he or she sees it. But we became a society of laws not based on whim or philosophy, but on hard experience with the discretion of even the most benevolent aristocrats. An experience we seem, alas, destined to suffer again.”

In the UK that experience will surely repeat when Mervyn King, central bank governor, gets the additional powers he seeks to energetically twitch his eyebrows at the bankers … Face to face conduct regulation! It’s pretty pitiful that this idea is even seriously considered.

Sections of the media are bemoaning “rules” without bothering responsibly to distinguish between good and bad rules; plumping lazily for discretion over rules because, if wielded by trustworthy and intelligent hands, discretion will surely cut through regulatory systems bunged-up by the “mad rules”.

The bottom line is growing resistance to discussion of rules-based policy among Keynesians, because so much Keynesian policy is inherently discretionary. Rules reduce the Keynesians’ room for maneuver, then they get really mad.