Regulation in a volatile market

Updated Wednesday 28th January 2009

Howard Viney explains why it's not easy, or popular, being a regulator when times are bad.

The Government’s recent decisions to first suspend, and then to lift, the ban on short-selling as part of its measures to return the financial markets to some form of normalcy has retrained focus to the role of speculators in financial and commodity markets. Norman Lamont Copyrighted image Icon Copyright: David Fowler | Norman Lamont, Chancellor at the time of the ERM crisis

Speculation is not new – remember the suggestion that George Soros ‘broke the Bank of England’ by short-selling Sterling on the foreign exchanges at the height of the ERM crisis of 1992 - but our attention is arguably drawn to speculators in times of crisis more so than in times of stability.

Interest in the activities of commodities speculators are therefore heightened by the economic gloom of recent months, but in fact reflect a much deeper issue which will be with us long after the economy begins to improve – that of energy security .

However it is the question of the role of speculators in creating market volatility and economic instability which interests us here. The answer to why we notice them more in times of crisis has much to do with two other questions we seem drawn to during gloomy economic times – the morality of markets and the role of regulation.

To be provocative, can I offer two massive generalisations - that in good times we (by which I mean the UK public) are not overly concerned that markets demonstrate morality when in bad times we are, and similarly that in good times we expect regulation to be of the ‘light touch’ variety. While in bad times we expect our regulators to be severe, and in effect to enforce the morality we now believe should be evident in the behaviour of markets.

Before exploring the implications of these assertions, it is perhaps important to note some important characteristics of markets and capital. Firstly as Gabor Steingart, the American political commentator, argues in his recent provocative book The War on Wealth capital has no conscience; it is in its nature to go where it expects to achieve the highest return on its investment within the rules of the game of globalisation.

Similarly, speculators are simply looking for profitable opportunities; it is in their nature. If individual speculators started to develop a conscience about the effects of their actions, arguably they would fail to fulfil their obligations to clients and institutions and probably be replaced in short order.

Secondly, and in contrast, there is a growing and vocal opposition to the hegemony of free-markets and the conscience free pursuit of profit associated with speculation from advocates of a stakeholder perspective and corporate social responsibility . Such opposition is in part a product of concern for the damaging effects of ‘market failure’, which is defined as a situation where a market is not allocating goods or services efficiently from a societal point of view.

in good times we expect regulation to be of the ‘light touch’ variety while in bad times we expect our regulators to be severe

The recent global financial crisis possibly marks the first instance when many of the UK public has been asked to question their faith in markets, and explains the rise in concern that workers in financial markets demonstrate greater awareness of the consequences of their actions for a diverse set of stakeholders.

Markets have however, since the early 1990’s at least, produced record economic growth, historically high employment figures, sustained personal income and asset growth and so on, in the UK. Having benefitted from such prosperity for so long, is this the right time to turn on markets and rein them in? Or to trust that what has worked in the past will work in the future and not to question our commitment to markets?

So where does this leave criticism of the actions of speculators. Speculation is not illegal (providing speculators abide by the rules of the game) but the effects of speculation may act to damage the host economy, creating market failure.

But as markets have no formal conscience can their agents be blamed for bringing about this damage? Perhaps, and again to be provocative, criticism of the behaviour of speculators might arguably be re-focused upon law-makers and regulators for framing inappropriate rules for the game, rather than blaming those who, having examined and explored the rules, have set out to play (and win) the game.

In a recent edition of the BBC Radio 4 programme ‘In Business’ Sir Howard Davies, the current director of the London Stock Exchange and a former regulator, suggested that the financial world will be significantly changed by the current economic disorder.

One impact will be a renewed appreciation of the role of regulation to impose what he called a ‘new social contract’, involving one must presume a requirement for a far greater degree of responsibility to be displayed on the part of all financial institutions. In the same programme, John Plender of the Financial Times, suggested that the public’s appetite for state intervention in markets has been enhanced, and there is a strong desire to see the re-regulation of financial markets to alter the dominant model of capitalism to favour a broader spectrum of interests. If they are right we can anticipate new rules of the game, soon.

Regulation is difficult, and the lot of the regulator is not an enviable one

Regulation is difficult, and the lot of the Regulator is not an enviable one. In good times, the expectation is that regulation will be light and enabling (and regulators are blamed if it is not), while in bad times the expectation is precisely the opposite (although the blame remains if it is not).

Howard Davies notes that, while head of the Financial Services Authority, the attitude towards regulators in Whitehall and in business were that they were tiresome, with a tendency to get in the way of wealth creation. There is a current demand for active and tough regulatory oversight, but what happens when the economy recovers and old prejudices against regulation return, as they are likely to do?

Perhaps what the various recent shocks tell us is that appropriate regulation is better than either light or tough regulation, and that the current appetite for tough regulation might more helpfully be viewed as an interest in exploring what form appropriate regulation might take.

A brave regulator will remember that the distaste of consumers and politicians for market excess in bad times will possibly fade in good times, but still enact regulation which is appropriate. That is to say if speculation is potentially damaging to an economy during bad times then constraints need to be imposed during both good times and bad, and the resultant constraints upon the economy lived with even if they do prevent the optimisation that fully unfettered markets offer. We all await the new regulatory covenant when attention returns to the role of regulation in the new economic climate post the credit crunch.


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