A Failure of Criticism (X): New Regulation of Banking

This is my last entry subbing on Andrew Sullivan's blog, but I will continue blogging about the economic situation on my Atlantic Correspondents blog, http://correspondents.theatlantic.com/richard_posner/, next week.

The movement to alter the regulation of banks, and the financial system more generally, is gathering steam. I think it is premature. Congress rarely does anything in haste without screwing up, and as I have emphasized in my previous blog entries, regulatory reform instituted before the end of a depression is likely to retard recovery because it further unsettles the business environment, and uncertainty tends to freeze investment.

One reform measure has passed Congress and is about to be signed by the President: a law to make it more difficult for credit card issuers to squeeze customers who do not pay their credit card debt on time, and in general to "protect" people who take on more credit card debt than they can afford--which means simply people who are at a high risk of defaulting because they are highly leveraged. Although Congress rejected placing a ceiling on how much interest credit card issuers can charge, anything that makes it more difficult for a creditor to collect a debt has the same effect as an interest ceiling: it increases the creditor's costs, which reduces the amount of credit and therefore of debt. (A ceiling on interest--a usury law--reduces loans to borrowers who have a high risk of defaulting, because the lender is not compensated for the risk by being able to charge an extra-high interest rate. The new credit card law is a form of usury law.)

The law is premature, since it will reduce borrowing and hence economic activity, which is the opposite of what we want in a recession or depression. The law will have that effect even if the credit card issuer cannot identify the applicants for credit who are most likely to default, and therefore raises the interest rate to all borrowers.

But we should consider the law's effects in the next boom. The gravity of our current bust is due to excessive borrowing and lending during the preceding boom, and anything that increases interest rates, whether directly or indirectly, will reduce borrowing. But a law aimed at just one type of loan may not have a significant effect on borrowing. A person who owns a house can increase his leverage (the ratio of his debt to his equity) by taking out a home equity loan if he owns a house, by pawning items that he owns, by taking out payday loans, by borrowing from relatives and friends, and by paying his bills late.

A law that raised all consumer interest rates (or all interest rates, period) would tend to moderate the boom phase of the business cycle. But it would also increase the gravity of the bust by reducing people's access to credit during an economic downturn, since the law would apply equally whether the economy was healthy or sick. So it's probably not a good idea.

A related idea that is being bandied about is to create a financial products consumer protection agency, which would try to prevent deceptive sales pitches by mortgage brokers and other sellers of debt to the public. Such an agency would be unlikely to affect the amplitude of booms and busts, because of offsetting effects. To the extent that it reduced consumer search costs or even just made consumers feel better protected against sellers of credit, it would increase the demand for credit, while to the extent it burdened the marketing of debt to consumers, it would reduce the supply of credit.

What makes no sense is subsidizing credit, as is done by the deductibility from income tax of mortgage interest, and by the refusal to allow business firms, including banks, to deduct the cost of equity capital. There is no reason to allow homeowners to deduct the interest on their mortgages, but there is reason to allow banks and other firms to deduct their interest expense, because it is a cost that reduces their income. However, since a firm cannot operate without equity capital, the cost of obtaining such capital is also a business expense, and the average return on equity could be used to approximate the cost for the individual firm. Without any deduction for the cost of equity capital, companies have an incentive to borrow capital, and this increases their debt-equity ratio and hence their risk of bankruptcy, since debt is a fixed cost, which does not decrease when revenues decrease.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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