QE3: An Example of Regulatory Capture

One of Nobel Laureate George Stigler’s best-known articles is his “The Theory of Economic Regulation,” in which he argues that over time, regulatory agencies that are designed to regulate industries for the public interest become “captured” by the industries they are supposed to regulate. Stigler’s “capture theory of regulation” concludes that regulators end up regulating industries in a way that benefits the regulated industry, rather than the general public.

The basic logic behind the capture theory of regulation is that while the general public is largely ignorant of the regulator’s activities, those in the regulated industries are well-informed, and pressure regulators for favorable regulation. Furthermore, information about regulated industries is largely under the control of those in the industry, and personal connections between regulators and the regulated also influence regulatory outcomes. The result is that regulatory agencies act as agents for those they regulate, not the general public.

The Federal Reserve Bank’s recent QE3 announcement that they will be buying $40 billion in mortgage-backed securities a month for an indefinite period of time is an excellent example of regulatory capture. Under Chairman Bernanke, the Fed has successfully pushed to increase its regulatory role over the financial industry, and Stigler’s capture theory would predict that the Fed, as a financial regulator, would act to benefit the financial industry it regulates.

In recent posts on The Beacon I have argued that the Fed’s purchases of these securities is unprecedented, that it is an example of crony capitalism, and now am arguing that it is an example of the regulatory capture that Stigler described. Just like the government’s purchase of Chevy Volts, the Fed is creating demand for a product (morgtage-backed securities) that is in weak demand, for the benefit of the industry it regulates.

QE3 offers lots of lessons to students of economic policy, but none of them put the Fed in a particularly good light. Bernanke’s policies create a serious threat to the Fed’s independence. Prior to 2008 one could see the Fed as an impartial administrator of monetary policy. Under Bernanke it has expanded its regulatory powers, is heavily involved in economic policy, and has been captured by the industry it is supposed to be regulating. Bernanke’s actions offer good arguments to those who would like to see the Fed’s independence reduced.