Over at the Financial Post, Jagadeesh Gokhale and Peter Van Doren meet calls for tighter regulation of financial institutions with the argument that tighter regulation won't make things better, it will make things worse. I've heard many argue that financial institution deregulation following adoption of the Gramm-Leach-Bliley Act a decade ago, coupled with the Federal Reserve Board's policy of keeping interest rates low, caused the current crisis or at the very least, were the major fuels that caused it to burn as fiercely as it has. Gokhale and Van Doren disagree.
First, they don't believe that economists can detect coming bubbles (like the housing price bubble) even when the indicators run up and bite them in the backside.
Even if they could, we doubt the Fed would have altered its policy in the early 21st century, and we suspect that political leaders would have exerted considerable pressure to maintain that policy.
Yes, but current day arm chair quarterbacks claim they could have seen it all coming and would have turned the tide. You don't believe that? Well, you aren't reading the comment boxes of blogs, are you? No, neither am I.
As to tighter regulation, Gokhale and Van Doren believe that simply would not have helped avert disaster.
Concerning regulation, we find that the banking reform of the late 1990s had little effect on the housing boom and bust, and that the many reform ideas currently proposed would have done little or nothing to avert the crisis.
Among the points they make to support that contention are:
- Hybrid subprime loans (and "teaser rates") didn't sucker people into loans they couldn't afford. "[T]he majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans." In other words, no matter what the loan terms, many people were taking out loans they couldn't afford to repay regardless of the exotic or vanilla features involved.
- Tighter regulation of swaps wouldn't "have avoided the mispricing of risks in underlying contracts." In other words, regardless of the market used to price and sell and swaps, if the underlying contracts are toxic, the swaps will be toxic.
- The previous (and ongoing) bailouts of large financial institutions will encourage the same, and similar, institutions in the future to do everything they can to skirt whatever regulatory restrictions are put upon them. They know that no matter what regulatory screws are tightened on them, they'll hire the best legal minds to figure a way out of or around the traps, and if those avenues lead to financial failure, Uncle Sam ultimately will save their bacon by stripping it from the hides of the American taxpayer.
- At the same time that the big boys are figuring how to avoid the trap and grab the cheese, the rest of the industry will become a wasteland of financial product innovation. After all, nothing says "cutting edge" and "entrepreneurial spirit" quite like the phrase "we're the federal government and we're here to help you."
- "prudential regulation" sounds nice in theory, but the problem isn't necessarily the inherent prudence of regulators, but the fact that they swim in a sea filled with bottom feeders called "professional politicians." "[A]s recent experience with fiscal stimulus packages shows, political pressures prevent politicians from leaving such systems well enough alone. Any whiff of financial-sector problems will incite Congress and Treasury bureaucrats to tinker with the rules. Which institutions and officials are likely to be sufficiently prescient to correctly calibrate such regulations each time the financial sector hiccups? And would politicians be able to resist calls for regulatory relief when financial sector lobbyists flood their offices as profit opportunities surge? Even more likely, any new regulatory attempt to globally control profit-driven risk-taking will spur new attempts to circumvent regulations." Amen, brothers.
A couple of months ago, I listened to economist David Kotok talk about past banking crises in the United States. He reminded his audience that the banking panic of 1907 spurred Congress to create the Federal Reserve Board to ensure that no such crisis ever occurred again. When it did as a result of the Great Depression, Congress again enacted sweeping legislative and regulatory changes, including the creation of the FDIC and the FSLIC, to, once again, ensure that no more banking crises would occur. Inasmuch as I'm now working on the second banking crisis of my career (the first one having cratered the FSLIC), color me as skeptical as the authors Gokhale, Van Doren, and Kotok of the power of the federal government to prevent human nature from taking its course and to perfect life as we know it through better central planning and control by flawed human beings.
So what's the alternative? How about exercising restraint and actually thinking long and hard before you act to change the world "for the better"? How about letting the losers lose and quit trying to rig the rules of the game to predetermine an outcome that can never be achieved without a lot of the mess and pain that is the natural order of things in a world where freedom means the freedom to hit the ball out of the park or, conversely, to hit into a triple play? How about recognizing both the limitations of federal legislation and regulation to achieve lofty goals and the always present danger of unintended consequences?
The key lesson from the current financial crisis and recession is that a government-imposed financial architecture is unlikely to persist for any significant length of time. Global market developments, and the need to channel resources toward opportunities perceived to be the least risky and most profitable, will continue to modify institutional financial arrangements. Imposing onerous financial regulations will only impede the reconstitution of financial institutions, delay the recovery, and dampen the pace of long-term economic growth.
Makes sense to me. However, if someone put a gun to my head and forced me to place a bet, I'd bet that this country will opt for "imposing onerous financial regulations." These days, that's just the way we roll.
