Visiting Scholar Allan H. Meltzer

Congress is about to propose new regulations for hedge funds. German Chancellor Angela Merkel has the same bad idea, meanwhile the British Financial Service Authority, currently worrying about excessive debt issued to finance acquisitions by private-equity firms, may be next in line. But whatever the perceived problem, more regulation is not the answer. It is far better to change some incentives for excessive risk-taking. The old saying is true: Capitalism without failure is like religion without sin. The answer to excessive risk-taking is "let 'em fail."

History has taught us that not only do regulations not rein in excessive risk-taking, but they often do more harm than good. More than 50 years passed before Congress and the regulators repealed mistaken legislation such as the Glass-Steagall Act that prohibited banks from doing business across state lines, or Regulation Q that restricted interest payments on bank deposits. The damage done by the most recent big blunder--Sarbanes-Oxley--has proved no less difficult to remove.

Regulation will not solve the problem of risk-taking that has returned many times, under many different regulatory regimes. If there is a current problem of excessive risk-taking, it arises from financing long-term investments with short-term borrowing. This is an often-repeated problem in financial history that ends badly for many of the risk-takers, especially if the economy experiences a recession.

The good news is that risk-taking, even when it fails, has not stopped prosperity from continuing. The world economy enjoys sustained growth. Household incomes are rising. Corporate profits remain strong. As long as this continues, debt-servicing problems will remain limited. One remaining problem is herd-like behavior among managers and portfolio investors.

There are probably more hedge funds now than will be around in a year or two. Many portfolio managers in large investment companies face a tough choice if they don't follow the herd: They have to choose between a prudent strategy of avoiding big risks or following the herd and accepting those risks. Separating from the herd may sacrifice a year or two of the great returns earned by their competitors. The joy at seeing that they may eventually be right is more than offset by the risk of losing their jobs because of below-average earnings during the interim. Their incentives lead them to act in their own interest, not in the interests of their investors.

The responsibility of financial market regulators is to the market, not to financial firms. Sometimes risk-takers have to be allowed to fail. At the same time, announcement of policy--and acting in accordance--has great advantages. Financial firms can understand the rule: no bailouts, period. That will induce firms to hold more relatively safe assets and to take fewer risks. Incentives achieve what regulation cannot. They focus a manager's attention on the firm's self-interest. The Fed is responsible for aligning self-interest with the public interest.

More than 140 years ago, the late Walter Bagehot (one-time editor of the Economist) highlighted the importance of applying a consistent strategy. In a financial panic, he advised, the central bank should open its discount window as wide as needed and lend as much as needed at a rate only slightly above the market rate. Further, he suggested that the central bank should not be overly strict in deciding whether to accept collateral other than treasury bills. The modern central bank does most of its business by buying and selling in the open market. So the central bank should conduct substantial open-market operations until the crisis ends. The Bank of England strictly followed Bagehot's strategy for many decades. There were no financial panics. The Federal Reserve Board gave lip service to their acceptance of Bagehot's rule during the Great Depression, but they didn't follow it, thereby allowing many banks to fail, weakening the payments system and allowing the depression to worsen.

In its 90-year history, the Federal Reserve has never announced a strategy for preventing financial failures from becoming financial panics. It usually responds in an ad hoc way, sometimes allowing the failing firm to survive, sometimes allowing it to fail. Failure should mean eliminating the firm's equity and management, but allowing the firm to recapitalize under new management if feasible.

There are plenty of examples of how prior announcements of a consistent strategy calmed the market. We saw this good result in 1987 following the stock market tumble, but in 2001, following the collapse of long term capital management, the main effort was to prevent a failure.

A strategy for reducing risk is overdue. Instead of burdensome regulation, the Federal Reserve and other regulators should develop a strategy, announce it and follow it whenever the next round of failures appears. Bailouts encourage excessive risk-taking; failures encourage prudent risk taking.

Allan H. Meltzer is a visiting scholar at AEI.