Economist's View: Procyclicality

Mark Thoma:

Paul Volcker on the difficulty of using discretionary authority to impose banking regulations that are restrictive during good times to discourage excessive risk taking, and somewhat more lax during bad times to encourage more lending:

Volcker Spares No One in Broad Critique, by Damian Paletta, RTE:  ...On procyclicality — “It’s the hardest thing as a regulator in my opinion…when things are really going well, the economy is going well, the market is not disturbed, but you see developments in an institution or in markets that is potentially destabilizing, doing something about it is extremely difficult. Because the answer of the people in the markets is, ‘what are you talking about? Things are going really well. We know more about banking and finance than you do, get out of my hair, if you don’t get out of my hair I’m going to write my congressman.’” .

Rules that automatically vary procyclically can help with this problem, that is, if a Congress subject to regulatory capture will impose them and keep them in place. But rules can't cover everything -- it's often the things that the rules don't explicitly cover that are the most problematic -- and some degree discretionary authority is unavoidable in a well-regulated system.