Who regulates the regulators? Do we have the right incentives for regulators?

A member of the German Council of Economic Experts discusses incentives for regulators in the The Economist. The incentive mechanisms for regulatory are critical at this time. Bu the incentives may come has positives or as constraints on the regulators. What should the government do if regulators fail in their jobs?

What are incentives for regulators to get their job done effectively? Generally, we do not know. However, more important than the incentives are the goals set for regulators. We are learning that the Great Recession was more complex than originally imagined. The story that greed created a bubble does not do the crisis justice. There were rules in place for regulation. There were rules in place to create housing incentives for lower income buyers. Some of these rules actually lead to greater speculation. The US had a policy for increasing home ownership. The policy was followed by placing people in homes that they could not afford. What would happen if the incentives to follow this policy were even greater?

There were incentives for central banks. They have to testify before Congress on whether they will follow the dual goal of low inflation and full employment. The Fed drove rates down to 1% and created a bubble. The incentives were there. The goal was wrong.

Incentives lead to unintended consequences, so we have to be careful on what structures are put in place for regulators. How do you drive good behavior in policy-makers? Are incentives to follow good long-run strategies? These long-term goals can be used to avoid time inconsistency problems. There are incentives to reduce behavior that will lead to bail-outs. Yet, all of these incentives may create behavior that may lock-in to one view in a complex changing environment.

More important than the incentives are the goals that regulators have in the first place.