Market Failure Cannot Be Resolved Without Regulation

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by Matthew Richardson

I am all for free markets and not mucking them up with government intervention. But the economic theory of regulation tells us that if there is a market failure, it cannot be resolved privately. The public sector must get involved.

The most illustrative examples of such failures in U.S. financial markets were the frequent financial panics from the 1850s until the Great Depression. Those episodes taught us that when illiquid, asset holdings (e.g., loans) of the financial sector are financed short-term (e.g., by deposits), and are hit by a severe macroeconomic downturn, failures of financial firms can lead to system-wide runs on deposits. This in turn leads to a massive disruption of the system that provides credit to households and corporations. When economists bandy about the term systemic risk, this is the type of event they are referring to.

The market failure here is that, although each financial institution may have been behaving optimally on an individual basis, the firm had no incentive to take into account the effect of their actions on the system as a whole. In economics, we call this a negative externality and it is analogous to an industrial firm causing pollution. In the example above, financial failure of one bank increased the possibility of runs on other banks, leading to the system-wide collapse.

Read the full opinion editorial on Big Think.com.

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The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).

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Previously, many of these faculty developed 18 independent policy papers offering market-focused solutions to the financial crisis, which were published in a book, Restoring Financial Stability: How to Repair a Failed System (Wiley, March 2009).

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