Rules will not quell economic troubles

This is my comment from this week’s Fund Strategy.

A lesson that should have been learned from the economic crisis is that there are severe limits to the efficacy of rules and regulations.

Although rules have their place they cannot quell problems if the underlying troubles are sufficiently bad. Indeed over-regulation can make matters worse.

Barack Obama’s plan to add additional restrictions to the size and activities of banks shows he is either unaware of the limitations of rules or choosing to ignore them. It is hard to see how his proposed regulations could quell any financial crisis. For example, they do not cover “non-bank” financial institutions–a category which included AIG, Bear Stearns, Lehman Brothers and Merrill Lynch. Nor do they have any impact on the likelihood of bail-outs.

Fixation with regulation is not unique to America. It is easy to forget that until a couple of years ago New Labour was boasting about its two fiscal rules. These were meant to a way of stifling any return to the bad old days of boom and bust.

In the event both rules were busted. The Sustainable Investment Rule stipulated government debt should be set at a “prudent level”. This was taken to mean below 40% of GDP. Yet according to the latest pre-budget report the net debt of the public sector will be 55.6% this year and will exceed 75% for several years in a row.

No doubt the government would claim the rules needed to be breached because of the global recession, just as it explains away the return to bust. But it was the government’s fault that the economy remained so heavily dependent on financial services rather than becoming more diversified. In any case Britain’s performance in the downturn is among the worst of the developed countries.

What the breaking of the rules really shows is that Britain’s fiscal framework, supposedly so clever, had little effect. When economic troubles emerged the rules were swept aside.

A similar failure is apparent in the European Union’s stability and growth pact. Under these rules annual budget deficits were supposed to be no higher than 3% of GDP and national debt was meant to be lower than 60% of GDP. Yet many governments have breached these levels.

Rather than obsess over devising more rules and regulations it is time for governments to pursue a different approach. The sooner they start promoting economic dynamism the better able they will be to cope with any challenges ahead.