Financial Regulatory Reform: The Politics of Denial

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Two bad recent signs concerning the movement to reform financial regulation: The first is the first public meeting of the Financial Crisis Inquiry Commission, created by Congress four months ago to investigate the causes of the financial crisis and report back at the end of next year. The commission has gotten off to a slow start, and even though only one member of the commission could (I believe, though I am not certain, and welcome correction) be described as a professional economist (Keith Hennessey), and even he is more a political operative, the commission has appointed as its executive director not an economist but a lawyer--a prosecutor in the California attorney general's office. And at its first public meeting members of the commission made statements which suggest that they will divide along the predictable political lines (six of the members are Democrats, four Republicans).

One can hope; but it seems unlikely that the commission will do a good job. It will look for crooks and frauds rather than for underlying causes, unless an underlying cause can be pinned to the tail of the politically party to which the pinner does not belong.

Meanwhile the Administration and the Fed plow ahead with their own programs of regulatory reform, without waiting for the commission's report--which may indicate how the commission is regarded by the government's economic leaders. The latest proposal, this one from inside the Fed, is that the Fed should issue regulations empowering it to regulate the compensation practices of all banks that belong to the Federal Reserve System and thus are under the Fed's regulatory aegis--and not just the compensation of senior executives but of all bank executives. The proposal goes beyond the Treasury Department's June 17 white paper, which proposed regulation of compensation only of executives of "Tier 1 Financial Holding Companies," which is to say the handful of major banks and other major financial institutions whose failure might trigger a general collapse of the financial system. The Fed proposal is more ambitious--and highly dubious. Where will the Fed find staff for such regulatory oversight? What is the need to regulate the compensation practices of small banks? And given Lucian Bebchuk's sensible suggestion (about which I have blogged) that if senior executives are compelled to be compensated in ways that would penalize them if their company got into trouble and needed a bailout they will be motivated to prevent their subordinates from taking risks that might trigger such consequences, why does the Fed think it has to reach down and review the methods by which banks compensate traders, loan officers, and other non-senior executives? Why can't that be left to properly incentivized senior management?

It seems that the Fed, and the government more broadly (including Congress), is in the psychological state known as "denial." Or that it is behaving like the drunk who, criticized for looking for his lost change under a lamppost far from where he had dropped it, explained that he was looking for it there because the light was better. Congress, and much of the public and media, can understand the financial crisis only in populist terms, as the product of the machinations of greedy, reckless, overpaid, perhaps criminal denizens of "Wall Street." Systemic causes of the financial crisis, such as unsound monetary policy, deregulation, lax regulation, regulators asleep at the switch, unsound economic theories, complacency, quirks of the tax code, deficits, Chinese trade policy, mindless governmental promotion of home ownership, and so forth, are beyond them. The government is willing to play to the ignorant partly because in a democracy popular views must always be treated deferentially; partly because (in all likelihood) it doesn't think that the people, the Congress, and the media (except for the most sophisticated financial journalists) can understand a serious economic analysis; and partly because the populist account conveniently deflects attention from the failures in which the current economic leaders of the nation were complicit in the run up to the crisis--unsound trade policy, excessive financial deregulation, lax regulation, complacency, lack of foresight, lack of contingency planning.

Of course if the officials who screwed up said they'd screwed up, the people and the Congress would be reluctant to entrust them with responsibility for redesigning the regulatory system. So they must find scapegoats, and where better than on "Wall Street"?

(Photo: Flickr User eflon)

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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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