Tuesday, September 23, 2008

Is Being Unregulated the Problem? I Struggle with a Conundrum

So the housing market has melted down, the stock market has crashed and rallied, and the banking industry is in such bad shape that it is said to need the largest welfare check ever written. If you haven't soiled your knickers at some point during the past week you are a better man than I am.

Then Barack Obama and most of the folks in the punditocracy said that the cause of it all was that the relevant parts of the economy are "unregulated." My first reaction was: Huh? What century are these people living in? What sector, industry, nook or cranny of this economy has been left unregulated?

Seriously, I've been trying hard to figure out what these people mean, and I have come up with an idea. Bear in mind that I am not an economist and am really trying to figure this out. (If you stop reading this right now, I don't blame you. But we're all stuck in this mess and we have to try to figure it out, experts or not.)

There is one, and only one, regulatory lacuna that I have seen mentioned in this context that looks at first glance like it could be directly relevant. In 1999 the Financial Services Modernization Act was passed. It abolished what was left of the Glass-Steagall Banking Act of 1933, which separated commercial banking from investment banking, and also separated the banking, stock trading, and insurance industries. I'm not sure what the old law prohibited anyone from doing, but obviously the idea is that it was something relatively risky, stuff that could go wrong (more easily than something else).

Right away I have two questions about this. First, this single-cause explanation only explains, at best, something about the banking industry. What about the rest of the mess? Don't you think these things are connected somehow? More seriously, it is obviously a very incomplete explanation. The explanation is: people were allowed to make mistakes. So they did. Well, why? Look, this was a huge number of clever, experienced people who were doing their jobs. And they made a huge number of mistakes. And it was very, very much in their interests to use their cleverness and experience to avoid these particular mistakes. Even more odd, it sounds like they made similar sorts of mistakes. And at about the same time. Pretty interesting, don't you think? Wouldn't a complete explanation be able to explain these things too?

The assumption that they were allowed to make mistakes (that the system was "unregulated" in this respect) is not enough to explain why they did. What does explain it? Some unimaginable conspiracy? Some epidemic brain disease? An invisible ray from outer space? What??

Were there special conditions that encouraged them to act rashly? The answer to this I suspect is: Yes there were, and these conditions were created by the government. The interest rate was kept artificially low by the Federal Reserve bank. This, and various other government policies, regulations, and government sponsored enterprises were designed to pressure the banking system to freely extend credit. In addition, there was the promise of government insurance against the effects of massive mistakes. As Thomas Ekeland and Mark Thornton have said:
The Financial Services Modernization Act of 1999 would make perfect sense in a world regulated by a gold standard, 100% reserve banking, and no FDIC deposit insurance; but in the world as it is, this "deregulation" amounts to corporate welfare for financial institutions and a moral hazard that will make taxpayers pay dearly.
On this theory, it's only in the wider regulatory context that the FSMA could have worked its supposedly evil magic. Deregulated does not mean unregulated.

Still, there is room for doubt, at least in my brain, about whether this was a major source of the problem. Do we have banks failing because the banks were buying stocks? I thought the major part of the problem was that they were making home loans to people who were perfectly nice people who deserved to get some money just like the rest of us, except that they couldn't pay the banks back. Making home loans is what they were doing in the supposedly safe old regime of Glass-Steagall. For some reason though they were morphing into George Bailey from It's a Wonderful Life. [It's only in a movie that you would like George Bailey. In real life, you wouldn't want him running your bank. You want mean, rational Mr. Potter -- so that your bank doesn't die.] It doesn't seem like the FSMA could have been responsible for this. Rather, the system -- the regulatory system -- was apparently designed to turn banks into George Bailey. And it seems to have succeeded in doing so.

Further, the demolition of the regulatory wall of Glass-Steagall may have actually had a benign influence on recent events, as Alan Reynolds explains:
If it was somehow possible in today's world of global electronic finance to the rebuild such a wall, that would mean J.P. Morgan could not have bought Bear Stearns, Bank of America could not have bought Merrill Lynch, Barclays could not buy most of Lehman, and Goldman Sachs and Morgan Stanley could not become bank holding companies. It is hard to imagine how things would have worked out in that situation, but it surely would not have been an improvement.
Barack Obama seems to think that our problem is that in a mere eight years those darn Republicans brought us back to real laissez faire capitalism. I don't think that this is the problem for two reasons. First, it never happened.* Second, I learned my economics, such as it is, from Ludwig von Mises (pictured above) and I don't think it would be a problem if it had.
* By the way, the FSMA was a product of the Clinton era.
Added Later: Here is a remarkable article in the New York Times archive (hat-tip to Jeffrey Tucker here). It concerns certain events in 1999, the year of the FSMA. But these events, unlike the FSMA, are clearly relevant to understanding the current catastrophe. The article contains the following stunning remarks:

''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''

Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''

In an "economic turndown": exactly what eventually happened.

BTW, in case I sound like I am picking on the Demos, I suggest you take a gander at this, comments by GWB recorded in 2002. (Hat-tip to Calculated Risk finance blog.) It hardly seems to matter which party is in power any more.
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