Don’t bash Larry for this September 5, 2013 at 11:42 pm

Let me be clear: if it was my choice, I’d pick Janet Yellen as FED chief. But that said, I wouldn’t rule Summers out on the basis of his prior statements on financial regulation. Reading this, for instance, I don’t see the outrage. The key section seems rather well balanced to me:

Let me be clear, it is the private sector, not the public sector, that is in the best position to provide effective supervision. Market discipline is the first line of defense in maintaining the integrity of our financial system.

The public sector, for its part, has three fundamental roles.

  • First, it needs to create an environment in which market discipline can work effectively. Counterparties and creditors have more knowledge of their counterparts, more skill in evaluating risk and greater incentives than any public regulator will ever have. The best approach to regulation is therefore to maximize the quality of counterparty discipline and to ensure that public activities do not crowd out the supervision provided by counterparties, creditors and investors.
  • Second the public sector must promote the maximum degree of transparency, because transparency is the necessary corollary to counterparty discipline. The government cannot impose counterparty discipline, but it can help to enhance the effectiveness of market discipline by creating an environment of greater transparency and disclosure. Indeed, the long history of transparency in our financial markets has been a source of great strength, and a leading factor in maintaining the integrity of U.S. markets.
  • Third, the public sector has a duty to maintain the competitiveness of the system as a whole. Just as there is a sharp distinction between support for the free enterprise system and support for individual enterprises, so also the task of public policy must be to ensure the stability and integrity of the market system rather than to seek to ensure the survival of individual firms or investors. Regulation must never hold out the prospect that it can eliminate risk or that it can prevent any individual institution from failing. Any regime that had that effect would be perverse and counterproductive and undermine market discipline.

For me, that passage has aged rather better than many similar vintage remarks on the same topic. Perhaps if we had actually done some of those things post LTCM – notably improved disclosure, improved private sector risk management, and ensured the integrity of the system – we wouldn’t have had the same intensity of crisis. There are many reasons to prefer Yellen to Summers, including the Shleifer affair and his investment management record, but Larry’s views on financial regulation aren’t amongst them.

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