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.


Anonymous said...

It's funny that you didn't see this kind of mortgage disaster occur in Europe or Asia or any other civilized part of the world. Even though we are the supposed moral leaders, the real estate brokers and bankers preyed on the people of this country like space aliens. Sadly many minorities were victimized the worst which is why there is the childish backlash against Obama when he raises this as a moral issue. You can still have your delusional dreams that we are living in Ayn Rand's world of the 1950's but it's time to wake up junior.

Lester Hunt said...

Obama thinks we live in an
Ayn Rand world of no regulation, I do not. As to its not happening elsewhere (yet!), what I've said here suggests and explanation for that too. Since my explanation is ultimately political and not economic, I have to say that the political situation here is different. And it is. America has always been more profoundly democratic in its point of view than other countries. In particular it has always been addicted to two democratic ideas. 1) Everyone should have as much education as can me crammed down their throats. Hence our unique public education system, and you know how well that works. 2) Everyone should be able to own their own home. Hence our monetary and financial systems. And those of us who have said that it doesn't work either are now in a position to say (and believe-you-me this is no fun at all) "we told you so."

Anonymous said...

Well unfortunately it's more of a social problem that turned into an economic problem. During the early 20th century the old line wasp families that controlled wall street preyed on the immigrant class for cheap labor and oversold the market with pure sleaze. GW Bush who is descendent of those people once again sat back as the minorities were victimized and little was done to control the borders as a source of dirt cheap labor. Greenspan who is a Rand disciple sat before congress and the American people; and disassembled on Bush's behalf so we could continue to finance a war which was bankrupting this nation. Obama is correct when he points out our problems are socially based but instead the Rupert Murdochs and Limbaughs of the world unleash their diatribes and raise "moral" issues like gay marriage. The definition of Armagedon is when the devil can't save himself.

Lester Hunt said...

The stock market run up of the twenties was caused by the Federal Reserve deliberately hammering down the interest rate, thus driving money out of the debt market and into the equity market. This was in the short-term interests of the rich, of course, but a lot of non-rich people also joined in the hay ride. Eventually, though, it triggered the crash of '29 and to some extent the Great Depression. Greenspan, as a former advocate of the gold standard, was betraying his earlier principles by doing the very same thing. Sadly, the results will be similar as well.

Anonymous said...

True and this time around the rates were hammered down and money was driven into the mortgage market which wound up as subprime loans which were repackaged into derivatives that found their way into wall street investment bank portfolios. Unfortuantely Mr McCain who graduated 5th from the bottom of his naval academy class along with his millionairess wife who has permanent membership in the Betty Ford Clinic will sell himself as an economic reformer. Of course when the attacks on Obama begin to wane, McCain's running mate will ramp up the evangelical mystics in a crusade to save America. Like Nero, first they lit the fire and now are trying to make themselves look like heros trying to put it out. If you wrote this as a Hollywood script they would laugh.

Lester Hunt said...

As the larcenous bailout package goes into congress, we will soon see whether the Democrats are any better than the Republicans. It looks like we are going to see that they are not. I am worried that they will alter it so it will steal even more.

Anonymous said...

I think you're right. Mr Obama's original appeal was Lincolnesque "to the better angels of our nature" but his own party is full of its devils as well. The Divine Comedy as GW sits in front of the WH fireplace asking, "How do you tune this fiddle?"

Anonymous said...

The Community Redevelopment Act of 1995 (?) made it increasingly difficult for lenders to deny loans to high-risk buyers, who were often minorities, because the 'excessive' credit checking was viewed as discrimination. Thank the socialist-leaning Dems for this piece of the puzzle. There is also a new book out (i've not read it, but plan to) by Amity Schlaes, who presents a new interpretation of the New Deal and how FDR's socialist policies probably deepened a recession into a ten-year depression. Obama had acted like a deer in the headlights since this economic hysteria started. He's also pretty anti-trade; the Great Depression was a time of high trade tariffs, I believe. I'm not a big McCain fan, but to me he's the lesser of two evils. The endless, ad hominem cracks at Palin (whom I am undecided about) only reinforce in my mind that the Obama/Biden platform is just empty of anything besides a raw desire to hold power.

William said...

I've been silently reading this blog for a while and have to say, I think this is the best one yet. "Deregulated does not mean unregulated"? What a glittering gem of reason! The two most insightful and comprehensive articles I've seen so far-

Lester Hunt said...

Maybe someone is coming here who hasn't seen the following, so I'll add it here. Sheldon Richman had this to say on his "Free Association" blog:

The people who refuse to believe that their beloved home-ownership promotion program is largely to blame for what's going on today can't quite make up their minds about what is to blame. They "know" it has something to do with not enough regulation. But what? First they argued that the Bush regime engaged in an orgy of deregulation. They had to drop that line, however, because the last act of significant banking deregulation was signed by Bill Clinton in 1999. So they changed to "someone was asleep at the switch." Vivid metaphor, but no one has come up with an actual instance of a regulator being asleep at whatever switch he allegedly was asleep at. So now there's a new argument, voiced by Hillary Clinton this morning: the Bush regime failed to anticipate the need for a new regulatory structure in the global economy. (I won't ask why her husband also failed in that regard.)

Anonymous said...

I think GW's assessment "that wall street got drunk" is the most accurate so far. Hey, it takes one to know one.

Anonymous said...

Obviously the housing boom was supporting the economy and the war but unfortunately you couldn't export the houses to other countries, so instead they were exporting the subprime mortgage "products" to overseas banks via wall street banks.

The 50's and 60's economy was the economy of Brokaw's "greatest generation" who could build just about anything with their hands (like our dads), Reagan's 80's economy was also the baby boomer economy of Gates and Jobs who could innovate anything, Clinton's 90's economy was the internet economy that globalized everything and GW's 2k economy was the Gen-Xr's economy who had to own everything anyway they could finance it.

Obviously our capitalist cleverness outstripped our true productiveness which was surpassed by Asia. Likewise NAFTA made us into more a Latin country and the hispanic people are more like our dads' generation who work hard, own their own homes and do not get caught up in the stock market.