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Originally Posted by Yakk
Ace, individual optimizing actions do not generate globally optimal results in a general free market.
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A good question would be what is the goal. At one level I do care about globally optimization, but on another global optimization is secondary to my immediate needs for optimization. (Some will be beside themselves and call me all kinds of names, but I am being honest. If others would put the needs of the world ahead of their own immediate needs, they deserve a special place in heaven.) Also, to be clear I am not talking about extreme unreasonable needs. But for example if caring for me and my family required me to level a forest I would do it, even if the net effect was negative globally.
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That is because Nash equilibriums that are not global maxima exist in most cases.
The hope is that the system is set up so that Nash equilibriums exist close to the global maxima, so we can use each individual processing information and making decisions in their own best interest to generate a good approximation to the global maxima solution, far better than a central resource allocation could do.
The problem is knowing where the global maxima is challenging. On the other hand, it can be easier to see isolated Nash equilibrium failures and fix them without knowing what the global maximum solution is (ie, you see a situation where action X done by all parties would create efficiency, but action X done by any one party would result in the externalities being captured by other parties. That results in no party having an incentive to individually do action X. A regulation enforcing action X on all parties that costs less than the projected benefit is worth exploring, in order move the Nash equilibrium, and hopefully find a better hill to climb.)
Naturally, these experiments can be dangerous -- misestimation of cost of enforcement or return from the policy, or the possibility that the costs cause other more-ideal equilibriums to fall into worse states, can cause damage.
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I think this defines the inherent risk with "government" or any type of centralized planning. Not only is there the risk of misestimation of cost, there is the risk "doing" regardless of the cost to promote a political agenda not related to the collective good.
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The idea of bank regulation is that having companies able to generate market-responsive liquidity, and who have internal incentive to evaluate the worth of people who want cash, is a useful thing for society. But the internal incentives don't line up perfectly -- banks have lots of short-term and medium-term incentives to "bet against the black swan" event. A bank that failed to bet against the black swan would see lower returns on their investments in a systematic way. It would fare better in a catastrophic downturn -- but the damage from that downturn wouldn't be limited to the banks who did bet against the black swan, and the 'cautious' banks would suffer a good chunk of the economic damage that the 'reckless' banks generated.
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But can a market self-regulate? I think the answer is yes in some cases (at least for a time period) because of the point you make. Banks have an incentive to make sure other banks play by a certain set of rules that won't lead to reckless behavior that harms all banks. However, I think eventually all free markets will reach a point of failure without some regulation. I think EBAY is an example of a basically self-regulated market with just enough centralized control to make the market work on a long-term basis.
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So the idea is that we allow banks to do term-inversion of investments on reasonably large scales in exchange for being conservative in their investment actions. The reserve requirements exist so that the bank can survive a black swan event without collapsing. (The damage caused by a bank collapse is not just limited to bank creditors, account holders, and investors -- due to the economic lubricating job of the bank, it creates far-flung damage that is external to agreements directly with the bank and bank counterparties.)
Anyhow, that is how I see it.
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I think the market response in the banking industry was to allow the imposition of regulations through FDIC recognizing the problems with bank failures. but it is interesting how in our current crisis many in Washington did not want to allow existing controls in the system work. I think they should have let more banks fail. Failure would have uncovered all of the weaknesses in the system much faster and solutions would have been more direct.