As a result of the recent financial crisis, attention has been focused on the need for financial stability.  To address this need, the concept of macro prudential regulation was introduced. Underlying macro-prudential regulation is the idea someone should be both looking for systemic risks that are emerging in the financial system and taking action to reduce these risks.

Macro-prudential regulation sounds good in theory, but are economists really the type of individuals who  should actually implement it?  To answer this question, we need to look at the skill sets we would actually want or not want in a macro-prudential regulator rather than simply accepting the policymakers knee-jerk choice of central banks or committees lead by central banks as the macro-prudential regulator.

It just so happens the choice of central banks having any macro-prudential regulation responsibility is an extremely bad choice.  Why do I say this?  A good macro-prudential regulator has to be focused on facts.  After all, they are trying to determine where excessive amounts of risk are developing in the financial system and taking action to prevent this turning into a financial crisis.

By training, being focused on facts is not a description you would associate with economists.  In fact, economists are particularly prone to theory-induced blindness. Daniel Kanheman described this as

Once you have accepted a theory, it is extraordinarily difficult to notice its flaws. As the psychologist Daniel Gilbert has observed, disbelieving is hard work.

If you think about the training of a PhD economist, it is all about studying and ultimately accepting a theory for how the economic system works at either a micro or macro level.  So upon graduation, an economist is already compromised as a potential macro-prudential regulator as she/he is prone to theory-induced blindness and an unwillingness to concede the theory is wrong despite overwhelming evidence to the contrary.

Confirmation of theory-induced blindness came when the Queen of England asked the economics profession why it hadn’t seen the financial crisis coming.  The economics profession trotted out a couple of individuals who had (Rajan, White and Borio), but failed to also offer up that at the time each of these individuals spoke up, the profession pushed back against their statements.

Since the central banks are dominated by economists with theory-induced blindness, there is no reason to think central bank lead macro-prudential regulation will work out any better than central bank lead micro-prudential regulation.  This hasn’t worked out too well for taxpayers.  Recall, that absent a bailout from the taxpayers, all the Too Big to Fail banks that were under the Fed’s micro-prudential regulation would have failed at the beginning of our financial crisis.