Can we regulate our way towards financial stability?

Published in the Institute of Economic Affairs:

Here a new book by Alex Pollock and Howard Adler gives the answer. The book is called Surprised Again, and for good reason. Central bankers frequently tell us that they have fixed the problems of stability this time, and then, often quite soon afterwards, they are surprised and another shock comes. 

Why is this? However clever they are, the world fools them, and always will. The explanation turns on the difference between risk and uncertainty. Risk is when we know the range of possible outcomes, and the chance of each. There are many such situations about. But there is also uncertainty – when we may not even know the full range of possible outcomes, and we certainly cannot know how likely each is. This important distinction was the subject of a book by Frank Knight in 1921, and was emphasised recently by John Kay and Mervyn King in their Radical Uncertainty. 

The distinction is at the heart of another new book by Jon Danielsson, who shows that to stabilise finance we need to think about the system as a whole. In The Illusion of Control he writes that 

“The more different the financial institutions that make up the system are and the more the authorities embrace that diversity the more stable the system becomes and the better it performs” (p. 9).  

This is an important part of the explanation for the stability of the British banking system in the nineteenth and a good part of the twentieth centuries. The names of banks – Midland Bank, Bank of Scotland, British Linen Bank for example –make one aspect of this diversity clear.