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Government regulations may have played a role in the creation of the crisis, but there were many causes of the crisis and indeed many different negative outcomes. The credit crisis in particular occurred when the financial system began to collapse under the weight of bad assets that had been purchased under the assumption that they were AAA quality. This calls to account three areas where added regulation could have at least mitigated the fallout from the credit crisis.
The first set of regulations would have been with respect to leverage in the banking system. Too many banks carried too much leverage, mainly in their investment banking operations. As a result, when the bottom fell out of the MBS market, these banks developed solvency problems. As a general rule, banks that did not take on too much debt did not have solvency problems, and would have been able to keep lending. Naturally, the market system is supposed to discourage bankers from making such gambles in the first place, but successive government bailouts have taught the industry that the shareholders and executives need not suffer in the event of solvency problems.
The second set of regulations has to do with bank ownership. American banks struggled because some became too big. They bought investment banking operations that became too great a share of the size of the bank as well. Thus, when some banks began to fail, the sector lacked sufficient diversity to withstand the shock, and most banks were exposed to the same products. In countries where tight restrictions exist on bank mergers and bank ownership -- Canada and Australia have been frequently cited -- there was no credit crisis.
Lastly, regulation on the activities of rating agencies would have helped. These agencies for some reason handed out AAA ratings to securities that were tied to the broad real estate market, not considering the possibility of systemic failure or downturn -- this is an industry known to be cyclical. There was simply no oversight of the ratings agencies, and since they operate in a three-firm oligopoly it is difficult for them to be removed from their positions, even when they make catastrophic errors in judgment.
2. a. By definition, "too much" and "too little" are inadequate in some way. With respect to the greater good, both have problems. Too much regulation tends to bog down the flow of capital, the flow of goods and the flow of labor. This can be seen in many emerging economies, where government agencies act as gatekeepers for the engines of economic progress, thereby creating bottlenecks. Too little regulation solves the bottleneck problem, but it also creates an environment where there is little rule of law. At some point, this discourages investment. Anarchic countries tend to have the least amount of investment of all -- Somalia's lack of regulation certainly does not make it a capitalist paradise. In the case of too much, the outcomes are usually stunted growth, which suppresses investment, wages, and employment. Where there is too little, people withdraw from the formal economic system altogether, creating a terrible environment for people to increase their wealth.
B. The effect of too much regulation on business is to suppress or constrain business activity. This reduces profit potential, and removes incentive for investment. Too little regulation allows business to leverage its power, but there is a fundamental difference between limited regulation and too little, the latter being an amount insufficient to provide confidence in that market. Without confidence in the institutions of the market, the environment is horrible for business because even they will not invest, and consumers have no money to spend anyway.
2. The optimal level of regulation therefore is that which promotes business growth by removing needless constraints and obstacles, but which is sufficient to provide security and confidence in financial institutions and the rule of law. The degree of regulation that an industry faces should reflect the externalities associated with that industry's activities. Out of control banks can destroy the economy, resource extraction companies can kill off vast swathes of the environment. Such businesses should face a higher standard of regulation. By contrast, boutique wineries and B&Bs pose little risk and should not face regulatory impediments to their activities.
Different political viewpoints have no place in this question. Facts and rational thinking, not ideology, should drive the answer. For example, while some "believe" that the marketplace is self-regulating, that is misappropriation of an…[continue]
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