The Perils of Financial Over-Regulation

by | Oct 27, 2016 | Money & Banking, Regulation

Financial systems, like economies generally, are organic entities. They must be allowed to flourish in a natural way.

Last Friday, I gave the opening remarks at the International Finance Corporation’s annual FinTech CEO Summit — a meeting of many of the top executives involved in developing cutting-edge alternatives to conventional means for raising capital and making payments, among other things. Because the event wasn’t recorded, I thought I’d share the remarks with you here.


I’m honored to be able to address an audience consisting of many of the world’s leading financial-market innovators. I don’t often get invited to speak on the subject of financial technology. That’s probably because the most advanced piece of financial technology concerning which I possess any real expertise is the steam-powered coining press that James Watt and his business partner Matthew Boulton designed a bit more than three centuries ago.

Still I know enough about more recent developments to realize that, so far as the future progress of financial innovation is concerned, these are critical times. Never has there been a more crying need for financial innovation — innovation to overcome the infirmities, not only of conventional private-market sources of capital and payments services, but also of the world’s official monetary systems. Yet never has the threat government regulators and their academic advisors pose to the unfolding of such innovations been so obvious.

Consider Harvard (and former IMF) economist Ken Rogoff’s proposal for doing away with official paper money, as presented in his new book, The Curse of Cash, which I happened to be reading when I was asked to speak to you today. A decision by the Fed to quit issuing paper currency would ordinarily create new opportunities for private-market innovators to supply new and perhaps superior substitutes for cash.  But so far as Rogoff is concerned, for his plan to succeed in cutting back on crime and tax evasion, the government would have to be “vigilant about playing Whac-a-mole as alternative transaction media come into being,” by making it difficult if not impossible for retailers and financial institutions to accept them. That sort of talk sends chills up my spine; it ought to scare you as well.

Or consider this remark, also from Rogoff’s book:

As currency innovators have learned over the millenia, it is hard to stay on top of the government indefinitely in a game where the latter can keep adjusting the rules until it wins. If the private sector comes up with a much better way of doing things, the government will eventually adapt and regulate as necessary to eventually win out.

For some reason Rogoff doesn’t seem to mind this. Yet surely it ought to be obvious that, when governments “win-out” by suppressing “much better ways of doing things,” the public as a whole — and not just or mainly drug dealers and tax evaders — loses.

But the more serious consequences of a “Whac-a-mole” approach to financial innovation consist, not of its immediate costs to consumers, but to the downstream innovations that it prevents.

As economist Israel Kirzner puts it in an excellent essay, “The Perils of Regulation,” while regulations of the sort Rogoff favors are only supposed to block particular innovations that may have some undesirable features, those regulations also end up blocking desirable innovations that haven’t been foreseen by anyone, including the regulators. What’s more, the same regulatory interference is instead likely to “set in motion a series of entrepreneurial actions that … may well lead to wholly unexpected and even undesirable final outcomes.”

In any event, Rogoff is surely mistaken in claiming that governments are bound to prevent financial innovations from taking place even when they are desirable. Whether they do so or not depends on public opinion.

It’s true that the public has mixed feelings about financial innovation; it has seen both good and bad consequences of such. But there are good reasons for believing that unhindered financial innovation, whatever its risks, is ultimately a lot safer than heavy-handed government interference in the financial sector. Those reasons are necessarily based on the historical record, since no one, except perhaps some of you, can know just what sorts of financial innovations the future may offer.

Consider U.S. experience. Contrary to conventional wisdom, unwise regulations have  been responsible for most if not all of the 19th-century woes of the U.S. financial sector, from wildcat banking and counterfeiting prior to the Civil War to recurring banking crises afterwards. I would regale, or more likely bore you, with the details if I had time. But instead I must settle for pointing out that Canada, with its then-identical gold dollar, avoided practically all of them. Yet Canadian banks were less, not more, heavily regulated than their U.S. counterparts. Nor did Canada establish a central bank until 1935. (Can anyone guess how many of its banks failed during the 1930s?)

When regulations cause trouble, private-market financial innovation sometimes comes to the rescue. Those crises that rattled the U.S. economy in the decades before the Fed’s establishment were due in large part to government regulations that made it very costly, if not impossible, for banks to issue enough paper currency to meet their customers’ needs. Crises happened when customers, anticipating shortages, rushed to get cash before the banks ran out. In response, private clearinghouses in New York City and elsewhere began supplying their own emergency currencies to supplement banks’ supplies. In all they issued hundreds of millions of dollars worth of “clearinghouse certificates” which, believe it or not, was a lot of money back then — enough to make the panics a lot less destructive than they might have been otherwise.

Regulatory solutions to crises are, in contrast, often less reliable than private market ones. During the Great Depression, when bank failures once again threatened to trigger a rush for cash, some old-timers from the New York Clearinghouse begged for permission to issue clearinghouse certificates again. But Fed officials wouldn’t let them. “We’re in charge now,” they said. “And we can issue all the genuine currency that’s needed.” I suppose you know how well that went.

In response to crises the root causes of which are often traceable to misguided past regulatory interference, regulators also tend to erect further barriers to desirable financial innovations. Yet where one sort of innovation is prevented, other, sometimes far more dangerous innovations, often take root.

To take an extreme case, in the very earliest days of banking in the U.S., many states and territories, chose to ban banks altogether. As banking historian Bray Hammond put it, people back then were convinced that, because banks were dangerous monopolies, it was best to have as few of them as possible!

How did that go? Instead of having their own banks to turn to, and no local currency they could rely on, the citizens of those places were compelled to use the notes of far-away banks — or what they imagined to be such. For they quickly became the favorite victims of counterfeiters, who supplied them with fake currency purporting to be from the best of New England banks; and not having those banks nearby to root out the fakes, they fell for it all too often. (Those same fakes were, on the other hand, never seen in New England itself, where alert bank tellers would have spotted them in no time.)

Nor have things changed much. In the 30s, regulators decided they might protect bank customers by preventing bankers from paying interest on deposits. It took some time, and plenty of inflation, but by the mid 80s that step had given rise to Money Market Mutual Funds, which eventually came to play a central part of the “shadow banking system” the collapse of which marked ground zero of the recent financial crisis. The point isn’t that Money Market Funds are necessarily a bad thing; its simply that regulators are not very good at anticipating the ultimate consequences of the regulations they impose. Regulation weaves a tangled web, indeed.

Financial systems, like economies generally, are organic entities. They must be allowed to flourish in a natural way. Financial innovations will, no doubt, lead to occasional troubles even absent government interference. But those troubles will in turn sponsor further innovations aimed at correcting them. Over time, a stable and highly efficient system tends to develop. That’s what happened in Canada, while its system was relatively free; and it is what happened in numerous other countries.

With your help, if we let it, it may finally happen here.

Thanks very much.

This post first appeared first on Alt-M.

George Selgin is a Professor of Economics at the University of Georgia's Terry College of Business. He is a senior fellow at the Cato Institute. His writings also appear on His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought. He is the author of The Theory of Free Banking, Bank Deregulation and Monetary Order, and several other books. He holds a B.A. in economics and zoology from Drew University, and a Ph.D. in economics from New York University.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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