Last week I blogged on the Administration's ambitious proposals for altering the regulation of the financial markets, proposals set forth in the 88-page report Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation, which the Treasury Department issued on June 17. (I'll call it the "Report.") The proposals require a fuller analysis, which I shall conduct in four parts published this week. The first--the subject of this blog entry--addresses what seem to me the fundamental weaknesses in the Report: weaknesses in the overall conception rather than the specific proposals. The second entry will take up the proposals concerning the problem of "systemic risk." The third will address the proposals concerning consumer and investor protection, and the last will consider a few alternative proposals.
The Report's fundamental weaknesses are prematurity, overambitiousness, reorganization mania, and FDR envy--and let me start with the last. It is natural for a new President, taking office in the midst of an economic crisis, to want to emulate the extraordinary accomplishments of Roosevelt's initial months in office. Within what seemed the blink of an eye the banking crisis was resolved, public-works agencies were created and hired millions of unemployed workers, and economic output rose sharply. But that was 76 years ago. The federal government has since grown fat and constipated. The program proposed in the Report could not be implemented in months, in years, perhaps in decades--as would be apparent had the report addressed costs, staffing requirements, and milestones for determining progress toward program goals and attempted an overall assessment of feasibility.
The Report is premature in two respects. The first is that it advocates a specific course of treatment for a disease the cause or causes of which have not been determined. Now it is not always necessary to understand the cause of something you don't like in order to be able to eliminate the effect. If you have typical allergy symptoms you may get complete relief by taking an antihistamine and not think it necessary to find out what you're allergic to. But in the case of the current economic crisis, unless the causes are understood it will be impossible to come up with good solutions. The causes have not been studied systematically, and are not obvious though treated as such in the report. (The Great Depression of the 1930s ended 68 years ago and economists are still debating its causes.) We need some counterpart to the 9/11 Commission's investigation of an earlier unforeseen disaster.
The Report asserts without evidence or references that the near collapse of the banking industry last September was due to a combination of folly--a kind of collective madness--on the part of bankers (in part reflected in their compensation practices), of credit-rating agencies, and of consumers (gulled into taking on debt, particularly mortgage debt, that they could not afford), and to defects in the regulatory structure. This leaves out a lot that other students of the crisis have emphasized. The Report does not mention the errors of monetary policy by the Federal Reserve that pushed interest rates down too far in the early part of this decade. Because houses are bought mainly with debt (for example, an 80 percent mortgage), a reduction in interest rates reduces the cost of owning a house and can and did cause a housing bubble, which when it burst took down, along with the homeowners, the banks and related institutions that had financed the bubble. Mortgage debt is huge--$12 trillion--and the banks (a term I use broadly, to include financial intermediaries besides commercial banks) were therefore deeply invested in the housing industry and incurred substantial losses when housing values fell precipitately.
Alan Greenspan has argued that because the Federal Reserve controls only short-term interest rates, and mortgage interest rates are long term, the pushing down and keeping down of the federal funds rate (the interest rate at which banks borrow from each other overnight in order to meet loan demands) could not have created the bubble. I disagree. Short-term and long-term interest rates are linked in a variety of ways, one of which is that many mortgages in the bubble era were "ARM" (AR = adjustable rate) mortgages. That is, the interest rate was altered from time to time, rather than being fixed, to track changes in prevailing interest rates, and usually the adjustment was based on current short-term rather than long-term interest rates. Another linkage is that banks tend to borrow short and lend long, and the difference between the short-term interest rate they pay and the long-term interest rate they charge generates a spread that includes profit. Competition limits profits and hence tends to push down the interest rates that banks charge when the interest rates they pay, the short-term rates controlled by the Fed, fall. In any event, when finally the Fed raised the federal funds rate, mortgage rates followed and the housing bubble collapsed.
The Report also does not mention the Bush Administration's large annual budget deficits, even though they have made it difficult for the government to dig the economy out of its hole without setting the stage for high inflation, heavy taxes, devaluation of the dollar, or increased dependence on foreign lenders. The Federal Reserve may have to push up interest rates in order to head off these looming consequences, but if it does so this will retard the recovery.
There is no mention in the Report of the deregulation movement in banking, which allowed essentially unregulated nonbank banks (constituting a "shadow" banking system of investment banks, money-market funds, broker-dealers, insurance companies, and hedge funds) to offer banking services, and lightened the regulation of commercial banks so that they could compete with the free-wheeling nonbanks.
There is no mention of lax enforcement of the remaining regulations. Regulatory errors are tepidly acknowledged but ascribed to defects in the regulatory structure--the sort of thing a government reorganization might repair, and of course the Report goes on to propose an ambitious reorganization. One gets the sense that the solution to the problem of financial collapse was chosen first and the problem was then fitted to the solution--first the treatment, then the diagnosis.
The regulators were asleep at the switch. That is the elephant in the room that the Report ignores. When suddenly awakened last September by the financial crash they reacted with spasmodic improvisations that sapped business and public confidence. The Report is scathing about the financial incontinence of bankers and consumers but complacent about regulatory failures, perhaps because authors of the Report were implicated in that failure and (a related point) because the failure was bipartisan; the deregulation of banking began in the Carter Administration. Since many of the Report's authors are economists as well as officials, it is unsurprising that the Report also does not mention the economics profession's complacency and short-sightedness as causal factors in the crisis. And the omission to mention budget deficits as a factor in the crisis may reflect the fact that the Administration's programs will if enacted in the form proposed create huge deficits.
The emphasis the Report places on the folly of private-sector actors--investors, consumers, credit-rating agencies, but above all bankers--ignores the possibility that most of these actors were behaving rationally given the environment of dangerously low interest rates, complacency about asset-price recognition (the bubble that the regulators ignored), and light and lax regulation--an environment created by the government. Again, it is unsurprising, given where the Report is going, that it should depict the problem as having been created by private rather than public folly. Since the solution is to be a series of structural changes in government that will prevent regulators from repeating their mistakes, there is no need to dwell on those mistakes and by doing so shake the readers' confidence in the Report's proposals, which depend on regulators' being competent.