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Banks: Liberty or Regulation

Gordon Brown has just said that he made a big mistake about financial regulation. His remarks are in line with many politicians on the financial crisis: regulation failed therefore we need more regulation. But do we?

Frideswide Square is a notorious traffic junction in Oxford, and it’s a nightmare. It has about 20 sets of traffic lights and small problems here lead to long tailbacks in many directions, tripling journey times for many otherwise short trips. So you can imagine how awful it was when the traffic lights all broke down recently.

Except it wasn’t.

For the two blessed days the lights were out of action the traffic ran more smoothly through the junction than ever it usually does, and the improvement was especially evident during rush hour. In fact this shouldn’t have been a surprise: the taxi drivers had said years ago that the introduction of the lights in Frideswide Square had made the whole thing much worse, but their comments were not much heard. You will perhaps not be surprised to hear that the response of the council was to fix the lights.

In Frideswide Square we see writ small typical government failure and the typical response of government to government failure: implement regulation without any evidence that it will improve anything,  suppress the people who know it didn’t work (want your taxi licence renewed, huh?), see regulation fail, ignore better functioning in the absence of regulation, increase regulation.

The last government announced when it first came in 1997 that henceforth it was going to do evidence based policy. One could hardly object, although naturally one felt the same pang of terror as when hearing the medical profession announce that henceforth medicine was to be evidence based. Now plainly, evidence based policy would be policy that was based on knowledge of what is effective at achieving the aim of the policy, followed up with examining whether the policy implemented resulted in an outcome closer to or further from the aim.

Clearly evidence based policy never got through to Oxford Council. To be fair, it never got far in the last government either. After the fine words comes the return to business as usual, and business as usual for politicians is the retention of power. The promises you make get you into power but there is no incentive to implement evidence based policy in pursuit of those promises, since on the whole no one knows how to achieve the promises that are made. After all, following up the effects of the Law to Make Everyone Healthy, Wealthy and Wise will show that it didn’t work.

No,  it is more effective instead to appeal to the peculiar popular prejudice that nothing should be going on without prior approval. The prejudice is insinuated into the promise, dressed up in the rhetoric of democratic accountability: it turns out the aim will be achieved provided only the people submit to a proper and necessary regulation, whereby every failure is that of the people rather than of the government, and is itself proof that we haven’t got all the right rubber stamps in place yet. After all, if once people find out the traffic is better without the traffic lights, why, they might do anything!

What’s this got to do with banks and regulation? Well, the banking industry is the most regulated part of the economy and we have an historical example of no traffic lights being better in banking: Scottish banking 1716-1845. During that time banks were almost entirely unregulated, essentially bound only by the laws of free contract. Scotland’s economy grew faster than England’s and the banks were more stable. So it is at least possible, and indeed has been argued by eminent economists, that regulation causes rather than cures financial crises. Furthermore, politicians have all the wrong incentives to ever acknowledge that if it is true, since a regulatory regime on banks that fails just gives them more ammunition to keep them in power. And that may be why you won’t ever hear Gordon Brown or any other politician say that what he got wrong was too much bank regulation.

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8 Comment on this post

  1. Anthony Drinkwater

    You may be right, Dr Shackel, to criticise some so-called evidence-based policies. But if you live in a glass house …

    I would like to see the evidence that banking is "the most regulated part of the economy" (how on earth do you measure the amount of regulation in banking compared, say, to the food industry?).
    And if it is true that Scotland benefited from the free banking movement from 1716 to 1844 (which is not accepted by all economists), I would like to see the evidence that policies that were successful then would necessarily be successful now.
    Perhaps not surprisingly, your post ignores all the considerable and very widely accepted evidence amassed by the Financial Crisis Inquiry Committee on the major causes of the current crisis.
    Finally, the false antithesis in the title (as if liberty and regulation were mutually exclusive) strikes me more as rhetoric than philosophy.

  2. Scottish banks during the 18th century were a bit of a mess with a high number of bank runs. With the exception of Scotland, banks in the UK during the 1700s were required to operate under conditions of convertibility. After numerous bank runs the Scottish banks were forced by regulation to return to convertibility in 1765. The Scottish banking systems remained in difficulty and in 1772 there was a run on the Ayr Bank, which was, according to Adam Smith, ’more liberal than any other had ever been’ (WN II.ii.73). Only four private banks in Edinburgh survived the crisis. The depression at this time was for the most part caused by incompetent bankers.

    To quote Hume in a letter to Smith (27th June 1772), ’Do these Events any-wise affect your Theory?’

  3. “Such regulations may, no doubt, be considered as in some respects a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.” – Adam Smith, famed free market economist and 18th century Scot.

    That said, I agree with Anthony Drinkwater that the alleged conflict between liberty and regulation is false. Regulation may well distribute negative liberty more fairly, rather than reduce it. See Stuart White's comments on this important issue at:

    On Frideswide Square, what Nick doesn't mention is that Oxford City Council were already in the process of planning and publicly consulting on schemes to remove the lights and install a *safe* alternative road layout at Frideswide Square. So the claim that they are "suppressing" those who know the traffic lights aren't working well could not be further from the truth.

  4. This has to be one of the most silly articles I've ever seen on this blog. One badly-designed traffic-light system in Oxford is extrapolated into an argument against bank regulation…and without even bothering to advocate abolishing all traffic lights (not to mention speed limits) along the way. Unbelievable.

  5. "Furthermore, politicians have all the wrong incentives to ever acknowledge that if it is true, since a regulatory regime on banks that fails just gives them more ammunition to keep them in power."

    Last time I checked, politicians in the UK acquired power by winning elections. Some of them, in particular conservatives, tend to do so in part by lobbying for small government and deregulation.

    I don't know why Scotland's economy grew fast than England's between 1716 and 1845, or why it's banks were more stable. I don't know whether there was a causal link between these two phenomena, which way round it was, and whether either have a causal link with deregulation.

    It's been amusing to read about a wonky traffic junction in Oxford and a historical curiosity about Scottish banks, but come on…this isn't a serious attempt to elucidate ethical issues.

  6. It seems the title has distracted some commentators and led others to broaden the meaning of regulation in order to accuse me of posing a false dichotomy. If we broaden the term sufficiently then liberty itself is a regulation, indeed the most effective, since the freedom of customers to take their custom elsewhere is the most powerful and least costly restraint on bad behaviour by business. In the context that I was considering, however, regulation is a matter of extensive rules regulating the detail of banking activity and the intrusive checking, management and authorisation of businesses affairs by national and international agencies created for the purpose of regulating an industry, and is to be contrasted with broader laws of property, contract, tort, just compensation, coordination etc, that go to protect market participants from force, fraud, coordination failures and the imposition of externalities. The use by Adam Smith of the term in the quotation given by Simon falls into the second of these, since he is in effect considering the potential for fractional reserve banking to create a tort and whether it should be treated ante or post factum in the law. I also have in mind the distinction that Professor Kay makes between what he calls behavioural regulation (detailed rules and agencies) and structural regulation (liberty within rule of law). The Frideswide Square example is again helpful, if we consider the distinction between traffic lights which instruct specific behaviours and a layout of the roads that, as it turns out, functions without traffic lights as rules of the game within which the liberty of drivers gave a better outcome than under the behavioural regulation of the lights.

    I think the point of this post is pretty clear, namely, to attack the naive and regrettably widespread assumption that regulation improves things, and if some regulation fails then what is needed is more. Regulation is always a cost but its benefit is uncertain, and if something fails that is evidence that it should be got rid of. I am also attacking the epistemic immorality of politicians, who regulate without evidence that the regulation will achieve the desired effect, ignore evidence that it doesn’t work, hoodwink us by appealing to a prejudice, etc. It seems to me that the Frideswide Square example illuminates these points nicely, but apparently not at the brilliancy required by Mr Wicks. What Simon says about it only strengthens my case, since his testimony is evidence that governments can pull the wool over people’s eyes. As I understand it, these lights were put in more than ten years ago (and that is when the taxi drivers testified against them) but Simon still wants to give the council credit for (not actually doing anything but) merely thinking about doing something more than ten years later to undo the very problem they created in the first place. These modes of government deception and failure are well known and we can be quite sure they have had and will continue to have a significant impact on regulation of the banks. The burden is on the government to prove that the consequence will be better than liberty, but that burden is one rarely attended to by governments.

    Mr Drinkwater demands evidence that banking is the most regulated part of the economy, but there is nothing controversial about this claim and if he wants the evidence he can pursue those economists who have made it. It is true that it is difficult to measure quantity of regulation, since it is possible for verbally short regulation to entail the most intrusive and wide ranging regulation (e.g. the bank shall do nothing without the explicit permission of civil servant Mr X). Nevertheless, pages of regulations can be counted, and presumably are. A further telling proof of high levels of regulation is lack of entry into a market, since a well established consequence of regulation is that it protects incumbents from competition. At 1900 there were 5 major clearing banks in Britain, in 2000 the major clearing banks were the same (one of which had been absorbed into another). No other industry has escaped the rigours of competition so successfully. For further evidence about Scottish banking, I refer Mr Drinkwater to the economic historians such as White, L. Free Banking in Britain.

    Mr Taylor’s remarks that Scottish banks ‘during the 18th century were a bit of a mess’ and ‘the Scottish banking systems remained in difficulty’ should be contrasted with Adam Smith’s opinion crediting Scottish banks with significant responsibility for Scotland catching up with England economically over the 18th century. In effect, Mr Taylor is representing the banker’s interests in the way he talks about it, but we don’t care about the banker’s interests: that’s their business. What we care about is what Adam Smith was attending to, namely, their success in their economic role of financial intermediation between savers and investors, an important part of which was an efficiency gain in the fraction of savings in productive investments rather than gold. Nor does the impression Mr Taylor gives fit with the views of economic historians I have heard on this topic, who say the Scottish banks were more stable, less risky and with lower losses to depositors than banks in other countries of the time. No doubt there were numerous bank runs, but there were bank runs everywhere, and the Ayr bank was more liberal in the sense of issuing too many notes, i.e. behaving with irresponsible profligacy (you know, like central banks do), which was quite rightly punished by a run. Mr Taylor is also mistaken in thinking that what we should be doing is stopping banks from failing. Not at all. The reason capitalism has done so well by us is precisely because it is an effective discovery mechanism that rewards businesses that find out how to use resources to provide us things we want at a cost lower than their value to us and kills off the crap businesses that consume more resources than the value of their products. So we want banks like Lehman to go bust. What we want to be different is we want them to go bust without the rest of us having to pay for them and we want them to go bust quickly and early. Yet time and again we have ignored the illiquid/insolvent distinction and bailed out the creditors of the insolvent, thereby removing the market constraint on limited liability banks (their creditors) taking on excess leverage in order to take on higher yielding but fat tailed risks. Contrast this with one of the interesting facts about Scottish banking of the period I mentioned: that the shareholders had unlimited liability.

    1. I did not mean to give the impression that I want to prevent the failure of banks, for it may well be in the public interest that they do so. I am also aware that the Scottish economy grew quicker during the 18th century than that of England, and that some of that growth was due to a more liberal banking regime during this period (trade with the Colonies was a significant factor). However, the number of bank runs were a problem and, as Smith details at WN II.ii, the Scottish banking system had to be regulated by parliament, for example in 1775, to restore ’the exchange between England and Scotland to its natural rate’.

      Smith was suspicious of regulation when it came from the top or what we now call “capitalists”. He nonetheless recognised that it was necessary but also, as you correctly observe, believed that the ’multiplication of banking companies in both parts of the united kingdom, an event by which many people have been alarmed, instead of diminishing, increases the security of the publick’. I am in full agreement with Smith, but we now need legislation to break-up the big banks and make space for new ones. This might mean some will fail in the future, but so long as this is not the result of other banks engineering a run, as was the case in Scotland before the 1765 regulation, I am, as I have said, content. However, I doubt if this is fully realisable, so we cannot rely upon free competition. Given this, I think Smith if he were here now, would regulate to increase their number as far as possible, keep larger reserves, restrain their lending in some areas, separate the “retail” side from the “dealers“, etc.. He would no doubt repeat his warning that: ‘The proposal of any new law or regulation of commerce which comes from this order [Dealers], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.’ (I.xi)

    2. No I do not require brilliance. What I do like to see when I check this blog is serious exploration of ethical issues. And what I hate to see is advocacy disguised as philosophy, backed up by sloppy arguments. This struck me as an example of the latter.

      About the "epistemic immorality of politicians": I think this fashion of attacking politicians is dangerous for democracy and therefore irresponsible. I'm not saying we should never criticize individual politicians – I hope that's obvious – but to suggest that they are all over-regulating zealots is simply wrong. It is also unrealistic to expect democratically elected politicians to hold to the standards of rational argument that one might expect (and which one sometimes finds, but alas not always) in a university philosophy faculty. That's why we have checks and balances.

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