Cycle-proof Regulation
By Raghuram Rajan
Economist.com April 8, 2009
In a guest article, Raghuram Rajan argues for a regulatory system that is immune to boom and bust
AS THE G20 summit showed, we typically regulate in the midst of a bust. That is when righteous politicians feel the need to do something, bankers’ frail balance-sheets and vivid memories make them eschew risk, and regulators have their backbones stiffened by public disapproval of past laxity.
But we reform under the delusion that the regulated, and the markets they operate in, are static and passive, and that the regulatory environment will not vary with the cycle. Ironically, faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will take care of themselves is most widespread at the top of the cycle, at the point of most danger to the system. We need to acknowledge these differences and enact cycle-proof regulation.