Forty years ago, Friedrich August von Hayek received the Nobel Prize in economic sciences for his "pioneering work in the theory of money and economic fluctuations" and for "penetrating analysis of the interdependence of economic, social and institutional phenomena."Officially known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, it was first awarded only five years earlier.
In his banquet speech, Hayek mused that perhaps such an award never should have been created, lest its recipients think too much of themselves. He told the Nobel Committee that he was "almost inclined to suggest that you require from your laureates an oath of humility, a sort of Hippocratic Oath, never to exceed in public pronouncements the limits of their competence." Our regulators should take a similar oath, and I nominate the financial regulators to be the first to take it.
Reshaped by the Dodd-Frank Act, financial regulation has taken a decidedly anti-Hayekian turn. The legislative response to the financial crisis consisted primarily of handing more powers to expert regulators in the hopes that they would prevent the next crisis. A group of these regulators, for example, are part of a new regulatory body, the Financial Stability Oversight Council. The FSOC — informed by the Office of Financial Research, a new governmental data aggregator — must "identify gaps in regulation that could pose risks to the financial stability of the United States."
The FSOC also picks out financial institutions that "could pose a threat to the financial stability of the United States" so that the Federal Reserve can watch over these companies, guide their every move, and try to ensure that they never fail. If the Fed slips up, the Federal Deposit Insurance Corp. stands by to design a special rescue plan under Dodd-Frank's so-called orderly liquidation authority to protect the institution and its favored creditors.
Viewed through the lens of Hayek's Prize Lecture, entitled "The Pretence of Knowledge," this financial regulatory regime is troubling. In his lecture, Hayek observed that:
The recognition of the insuperable limits to his knowledge ought indeed to teach the student of society a lesson of humility which should guard him against becoming an accomplice in men's fatal striving to control society — a striving which makes him not only a tyrant over his fellows, but which may well make him the destroyer of a civilization which no brain has designed but which has grown from the free efforts of millions of individuals.
Dodd-Frank's financial stability regime, however, is built on the belief that a group of regulators can gather and comprehend enough knowledge to manage our complex financial system. These regulators are charged with using their allegedly superior knowledge to override decisions made by countless individuals and firms in the marketplace. Dodd-Frank is by no means the first statute to displace market-based decision-making. The pre-crisis financial markets were shaped by a messy tangle of market and regulatory forces. But Dodd-Frank allows regulators an even freer hand to substitute their own thinking for the "free efforts of millions of individuals."
The FSOC, the OFR, the Fed, and the FDIC employ very well-educated lawyers and economists, but all that education still leaves them decidedly less knowledgeable than the markets they regulate. Hayek, in his Nobel lecture, remarked that "[w]e are only beginning to understand on how subtle a communication system the functioning of an advanced industrial society is based — a communications system which we call the market and which turns out to be a more efficient mechanism for digesting dispersed information than any that man has deliberately designed." Even after all these years, we still cannot fully appreciate the market's ability to collect and process information. Consequently, we must assess any proposed interference in the market with skepticism.
Defenders of the new regime speak of bringing financial activities out of the shadows and into the regulatory light. Allowing regulators a better view of what is transpiring in the financial markets is fine, but it is more important for regulators not to stand in the way of market participants' access to the information, because they are able to act on it. Regulators are often inclined to keep information from market participants for fear they will act on it. (Think bank to crisis-era regulatory commands that healthy banks take TARP money so that the banks that actually needed it would look as if they were healthy too.)
Especially after a deep financial crisis, it is tempting to believe that we can avoid another by giving regulators additional controls over the financial markets. A more radical — and more effective — approach would have been to acknowledge regulators' limits and embrace the markets' superior ability to make the tough live-or-die, expand-or-contract decisions for financial firms. Doing so would have required eliminating government guarantees, subsidies, and barriers to entry that interfere with the market's ability to collect, communicate, and act on information.
Four decades after Hayek received the Nobel Prize, there are many corners of the world that have yet to absorb his message of humility. To change that, financial regulators and their legislative benefactors should commemorate this two-score anniversary milestone by revisiting Hayek's pioneering work.