Regulators certainly made mistakes, and there is plenty of room for improvement, but does that mean we should abandon attempts to regulate? Of course not.
It is hard to argue against the proposition that better regulation would be better. But for regulation to be better, I think there has to be some correspondence between the narrative of what went wrong and the proposed regulatory change.
I am to be talking on this at a conference in a couple of days. My current thoughts.
1. My own narrative is that the causes of the problem were a) clumsy capital regulations, which induced a lot of financial innovation that was primarily aimed at regulatory arbitrage; b) housing policy that encouraged lenient, subsidized mortgage credit; c) the suits vs. geeks divide, with people in power (in both large banks and among regulators) having too much confidence and too little knowledge.
2. My policy recommendations match my narrative. Assume that regulation will be clumsy, and aim for a system that is easy to fix as opposed to hard to break; get rid of all policies that encourage lenient subsidized mortgage credit. and break up the 10 largest banks into about 40 banks.
3. The current financial regulation bill matches nobody’s narrative. I will explain this view in more detail subsequently. Briefly:
–if the problem was that we deregulated too much over the past 20 years, then why doesn’t the bill simply reset regulations to what they were 20 years ago? or 30 years ago?
–if the problem was that house price increases and mortgage leverage got out of hand, then why does government policy continue to try to push mortgage loans with low down payments?
–if the problem is that lenders were exploiting borrowers (which would justify a focus on consumer protection), then why is it that we ended up bailing out the lenders?
READER COMMENTS
Les Cargill
Jun 11 2010 at 11:13am
Mortgage prices and leverege were allowed to get out of hand because this “patched” over the deficit in employment around 2002-2004, and because home ownership is perceived to be a conservative value. The problem is that it was difficult to balance these socially useful “goods” against the incurred risk.
It also served the “something must be done; this is something, so let’s do this.” … thing.
Mike Rulle
Jun 11 2010 at 11:28am
While I generally agree—even strongly—with much of your descriptive narrative, I offer up some different perspectives (perhaps consistent with yours) relative to the crisis.
Regulatory arbitrage before the crisis was well known for many years. What was less known is that many believed (and not without good reason—even if proven disastrously wrong after the fact) that the arbitrage was in fact economic–i.e., the rules for derivatives/CDOs/CDS and their inter-linkage better represented true risk than the rules for cash instruments. These were debates that began inside banks at least 15 years ago with both sides being passionate and engaged. Its not clear that unified reg-cap rules would not have gone the derivatives route if it had been forced onto the system and applied prior to the crisis. Now it is possible that unified capital rules would have created more balance in the system between retention and distribution regardless of which way the rules went–but we will never know of course.
This segues into the suits and geeks dichotomy you have frequently employed. I really do not agree in general with that framework. Many senior guys—even at the chairman level—(think Brady Dougan at Credit Suisse) were very well versed in derivatives. Certainly below that level the suits were very well represented from the derivative side of the banks. Plus, I do not believe the issue was one of great geek complexity. It was massive concentration risk combined with a belief the probability of massive market collapse was low. That’s not a geek issue as much as a judgment issue.
One of the lesser known facts—from what I have been directly told by people who would seem to be in the position to know—is that AIG’s CDS problem was a mark to market problem (that does matter of course) and not a default problem. That is, their CDS portfolio has not had any meaningful defaults. One wonders what their current marks are and if they represent true risk/value. During the AIG bailout, there is a great argument to be made that they were being squeezed due to their absurd size which drove market prices to below reasonable levels. Analysis of underlying home foreclosures and defaults–as high as they have been—I think supports this view.
I believe this squeeze is for all practical purposes still in the market given their (AIG’s) CDS over hang—not unlike the volatility over hang was in the market a couple of years after the LTCM blow up as they sought to unwind its equity vol book.
I do think an analysis of the AIG affair still has much fruit to bear—and its not being done.
Finally, I really do not like the 40 into 10 solution. It seems to be the area you and Simon Johnson most agree. Its fraught with unintended consequences. As long as we are fantasizing about things we know the Feds will not do anyway, my fantasy is simply kill “the two big to fail” fallacy.
In any event, as our national problems go, financial regulation is “baseball” sized compared to the “watermelon” sized fiscal problems we face.
Rebecca Burlingame
Jun 11 2010 at 11:39am
Easy to fix versus hard to break is vitally important in your talk, because so much was created that was uncharted territory. No one is going to get these regulations totally right on the second or even the third try. And like Les implied, it would have been great had these financial instruments actually decreased the problem of [a lack of] wealth creation. Government can scarcely be blamed for hoping such financial instruments are still a ticket to wealth if only they are put together right. But if they get it wrong, the public perception of financial instruments such as these will only worsen.
John V
Jun 11 2010 at 11:47am
“–if the problem was that house price increases and mortgage leverage got out of hand, then why does government policy continue to try to push mortgage loans with low down payments?”
Although what I am about to say is obvious, I’ll state it anyway:
Because policy aims have nothing to do with economics…it’s politics. And the aftermath of the problems this causes are then handled by economists who choose to use (misuse) what they know to keep the fruits of this wrong-headed policy while mitigating the problems it causes. The narrative for them is always that they didn’t do enough to regulate those pesky imperfect markets before the problems came. It’s never because the well-intentioned policy is simply at odds with good incentives. There’s a pill for every disease and more pills for those side-effects that come from those pills. Soon you have 9 pills that started from one problem. And more often than not, that initial problem could have been avoided by minding how the body works instead of minding how you can mitigate poison from “performance enhancements”. And then they continue to do this with layer after layer of new regulation as they chase the side-effects while never looking back at the root.
Easy housing = good in politics. Wet-Blankets about economic principles =bad.
Low down payments are the products of incentives and “rules” created by policy. Again, obvious but I said it anyway.
muirgeo
Jun 11 2010 at 4:16pm
–if the problem was that we deregulated too much over the past 20 years, then why doesn’t the bill simply reset regulations to what they were 20 years ago? or 30 years ago?
–if the problem was that house price increases and mortgage leverage got out of hand, then why does government policy continue to try to push mortgage loans with low down payments?
–if the problem is that lenders were exploiting borrowers (which would justify a focus on consumer protection), then why is it that we ended up bailing out the lenders?
The answer to all 3 questions is because we now consider corporations to be people and bribery with money is considered free speech. Corporations are really big people who never die, they have unlimited funds for which to buy politicians and their only purpose is to make more money. They have more free speech and access to policy makers than any living normal person. They don’t want the reasonable changes you suggest. They have captured both regulators and policy makers. That’s the answer to the why of all 3 questions.
Ken
Jun 11 2010 at 6:42pm
“The answer to all 3 questions is because we now consider corporations…”
How does this answer any of the three questions?
” …to be people and bribery with money is
considered free speech.”
How does the ability to use your own money to spend on advertisement or make a movie about an obviously corrupt politician, including audio demonstrating beyond a reasonable doubt the breaking of election laws, translate into bribery?
“Corporations are really big people who never die, they have unlimited funds for which to buy politicians and their only purpose is to make more money.”
I have yet to see any corporation with “infinity” as their bottom line. And you are ignoring decades of research demonstrating that money follows votes not the other way around, i.e., people/corporations/unions back politicians who believe and vote for their cause. And are you including the SEIU, UAW, and the AFT in your rant, or do you just not like the productive parts of society and exclude the parasites of SEIU, UAW, and AFT?
“They have more free speech and access to policy makers than any living normal person.”
I’m not even sure what this means. You seem to be confusing the right to free speech with the right to the audience you want. If you consistently say one thing and do another like many politicians, you will get booted, which is why the dems will lose badly this year. Dems always say their for the little guy, then pass on billions of dollars to large corporations, banks, and union organizations. And if you consistently say dumb/dishonest things people will stop listening. Look at the NYT, MSNBC, etc.
“They don’t want the reasonable changes you suggest. They have captured both regulators and policy makers. That’s the answer to the why of all 3 questions.”
You seem to be forgetting that this is the direct result of intrusive government. Less regulation MEANS less political capture, i.e. rent seeking. You seem to want it both ways, for government to be able to take as much as the want and intrude as much as they want and then have the nerve to act surprised and outraged when people don’t behave exactly as you want them. You seem genuinely incapable of understanding that there will ALWAYS be some political entrepreneur who uses that system to take as much money from tax payers as they can all in the name of the public good.
Mr Econotarian
Jun 12 2010 at 1:56am
I don’t see any evidence that without corporate campaign spending that people would be more likely to vote against the bailout (i.e. for the Libertarian Party, as the others seem to be OK with bailing out stupid creditors).
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