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.
Now when I say that the Report places undue emphasis on the behavior of the market participants as distinct from the regulators, I mean, undue on the basis of what we know, or at least of what I think I know. I may be wrong, but my point is that it is too early to draw firm enough conclusions about the causes of the crisis to base radical policy changes on those conclusions. Remember that economists are still debating the causes of the Great Depression, and of its unusual severity relative to economic downturns before and since. This suggests that no account of the causes of our current depression is likely to be definitive, no matter how long we wait for the account. But the causal account in the Report is notably thin, one-sided, unsubstantiated, and implausible. And yet the validity of its proposals hinges on the accuracy of its causal account.
The Report is premature in a second sense, one illustrated by the proposals (discussed in greater detail in Part III of this series of entries) for limiting the provision of credit to high-risk borrowers. In an economic boom, thrift (restraint in consumption) reduces the amplitude of the business cycle by reducing consumption and increasing savings, which can be reallocated to consumption at the bottom of the cycle. Thus thrift makes the peak of the cycle lower and the trough higher. But in the trough, thrift, by reducing consumption, retards economic recovery. The less that people spend on consumption goods, the less production there is and therefore the higher the unemployment rate, which by reducing incomes further depresses spending, which further depresses production, and so on. To want to tighten credit at the bottom of the cycle is bad timing. And while the Report creates the impression that high-risk borrowers are feckless consumers unable to curb their greed for material goods, many high-risk borrowers are small businesses dependent on credit-card debt to finance their business, and they are struggling.
Furthermore, throwing a raft of proposals at abanking industry struggling to regain its footing is sure to distract the banks' management, not to mention the Administration's economic team. There is a danger, in short, of information overload. And some of the proposals in the Report are contradictory, which reinforces their effect in increasing the uncertainty of the economic environment. For example, the banks are not to make unsafe loans, but the Community Reinvestment Act, which encourages lending to "underserved" individuals and communities, is to be vigorously enforced, even though many of the individuals intended to be protected by the Act are poor credit risks. The banks are to be placed on a razor's edge.
The proposals are presented as if their merit were self-evident. A more thoughtful document would have discussed the objections to each proposal and explained why in the authors' view the objections were not decisive. Consider the proposals for substantial reorganization of the regulatory structure. Government officials and politicians typically respond to a government failure (in this case the failure to prevent the economic crisis that has engulfed us) by proposing a reorganization, because reorganizations are relatively cheap, visible, and easily explained. More precisely, plans for reorganizations are cheap, visible, etc.--and plans are the easy part; it is at the stage of implementation that our government falls down. But even when the plan leads to an actual reorganization, the reorganization usually fails, because of inertia, turf warfare, passive resistance, and lack of follow through, leaving in its wake merely more bureaucracy. One of the Report's proposals is to create a powerful new agency for the protection of consumer borrowers, and this agency, if it is ever actually created, will overlap and scrap with the Securities Exchange Commission and the Federal Trade Commission. Another proposal, to create a National Bank Supervisor, will incite conflict with the Comptroller of the Currency, who regulates national banks. (The Comptroller is to hand over his "prudential responsibilities" to the NBS.) There is also to be a council of regulators (the "Financial Services Oversight Council") layered over the regulatory agencies themselves, and if the council is not merely a committee of kibitzers, it will muddy the regulatory process.
We have seen a similar process at work in the national intelligence field. After the security agencies failed to prevent the 9/11 attacks, the system was reorganized by the creation of the Department of Homeland Security, the Office of the Director of National Intelligence, the National Counterterrorism Center, the National Security Branch (in the FBI), and other entities. The main result, after several years, has been--many competent observers believe--new layers of bureaucracy, turf wars, overstaffing, and confusion, rather than improved performance.
Politics, as an impediment to effective regulation, is not mentioned. The Report worries about actions by private persons that can precipitate an economic crisis, but not about actions (or inaction) by regulators. Its concern with market failures is not matched by a concern with regulatory failure. If brilliant bankers screw up, why not not-so-brilliant regulators? Don't the enormous disparities in income between successful bankers and financial civil servants have implications for the competence of the latter? And isn't there a revolving-door problem?
Congressman Barney Frank made a telling comment in an interview with Charlie Rose last fall. He said that the basic problem in the regulation of banking is that financial regulation lags financial innovation. This problem is compounded by the dependence of regulators on information supplied to them by the regulated firms, which have of course superior knowledge of their own businesses. As soon as the proposals in the Report are implemented (if they ever are), or even before, the banking industry will game them, looking for loopholes and openings for counter strategies, and as a result when the next financial crisis hits it won't look like the current one and the regulators may be unprepared and ineffectual.
If one may judge from the current crisis, which is global, regulatory organization is uncorrelated with failures of financial regulation; for the nations' regulatory structures are diverse, but none is pointed to as a model for the United States. The pathologies of regulation are not rooted in tables of organization or curable by adding new bureaucratic layers. Ignored by the Report are problems of regulatory capture and regulatory culture, though the subject of a large academic literature; the timidity of civil servants and the contamination of public administration by politics and interest groups; the mutual dependence of regulators and regulated, which resembles that of prison guards and prisoners; and the power of the "office consensus" to marginalize independent thinkers for failing to be "team players."
Finally, despite its length, the Report is lacking in detail. There is nothing about the cost of implementing the proposals, the staff required to man the new agencies and shoulder the new regulatory responsibilities that are to be imposed on the existing agencies, the time it will take for implementation, or the methods of determining the capital requirements of the banks and other financial institutions that are believed to create "systemic" risk (a concept I will examine in my next entry in this series). No evaluation of the feasibility of the package of proposals is possible without carefully attention to impediments to implementation.
So there is a sense in which the 88-page Report is at once too short and too long: too long to be a statement of principles that would provide a basis for discussion, too short to enable an assessment of the desirability and feasibility of the specific proposals that the Report makes.