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The globalization paradox


In the aftermath of the global financial crisis, it has become apparent to most that financial markets require adequate regulation. In the absence of appropriate regulation, asymmetric information, agency problems, systemic risk and bubbles can too easily overwhelm the operation of financial markets, producing boom and bust cycles and financial crises. The more overgrown and interconnected the financial system, the larger the cost of the eventual financial busts.


The practical question is what form financial regulation should take. This is a hard question, which does not have a unique answer. Part of the problem is that even if we all shared the same values, needs, and preferences, we might differ as to our views on how the world really works – on whether, for example, the efficient market hypothesis really applies, or how severe agency problems are in the real world. In the presence of such disagreements, we would be collectively better off in a world where a certain degree of heterogeneity and experimentation with respect to financial regulation is the norm. This way we could learn about which type of regulation works better and is more robust by observing how each works in practice.


This argument for regulatory diversity presumes convergence in the long run, as we learn more. Of course, the long run could be a very distant long run, especially if the state of the world keeps changing. But there is a second argument for diversity that generates no convergence. Different societies, organised around different political systems, may well have distinct needs and preferences with regard to what they desire from a financial system. Some societies may value financial stability over financial innovation and will desire a tighter regime of regulation, willingly giving up on some financial innovation. Others will want greater financial innovation, and may prefer a lighter regulatory touch. There is nothing a priori that makes the first choice less desirable than the rest. Each society deserves the institutions that fit its values best.


Similarly, some poor countries may want to use their financial system more actively in a developmental way, by allowing financial cross-subsidisation or directed lending. Others may think this is too interventionist and prefer more market-based systems. Again, both of these choices are defensible on a priori grounds.


For either set of reasons, a single global regime of financial regulation is not desirable. Regulatory diversity means that the full benefits of financial globalisation cannot be reaped. It also means that complicated problems of regulatory arbitrage will arise. I discuss both sets of issues at length in my book. The general point is that a sane global financial system is one that falls short of full financial integration.

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