The ways of the regulatory state go like this: when a crisis erupts, don’t ask how earlier government interventions may have made the crisis possible or worse than it would have been. Rather, denounce private greed, declare good intentions, pile new regulations atop old, and hope for the best.
Unsurprisingly, this does not work. If you misunderstand a crisis you are sure to misunderstand how to end it and prevent its recurrence.
We are living with a clear example of the regulatory state’s perverse dynamic: the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Passed in the Obama administration during the Great Recession, Dodd-Frank declared the government’s intention to “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”
As we’ve come to expect, the legislation did not specify how the financial industry would now be governed. Rather, it ordered the government’s financial regulatory agencies -- along with some new ones created by the legislation -- to write 243 new rules for the industry. In other words, as Democratic House leader Nancy Pelosi said when the Affordable Care Act, which also was filled with rule-writing mandates, was being debated, “But we have to pass the bill so that you can find out what is in it, away from the fog of the controversy.” (Pelosi may not have intended to refer to the indeterminate nature of the legislation, but she may as well have been.)
Since the authors of the legislation and the president who signed it misunderstood the causes of the Great Recession, they of course came up with the wrong “solution.” Instead, Dodd-Frank did little more than decree financial instability a thing of the past and told the bureaucrats to figure out how to accomplish this.
The Great Recession was triggered by a collapse of government-boosted housing prices, which in turn made many high-risk (aka subprime) mortgages unpayable, which in turn dramatically reduced the value of mortgage-backed securities and various “exotic” derivatives that were ultimately linked to those mortgages. This along a slew of financial regulations put large private institutions and government-sponsored enterprises (GSEs) -- Fannie Mae and Freddie Mac -- at risk, some of which were then bailed out (via TARP), or in the case of the GSEs, nationalized, by the federal government or the Federal Reserve under the unwritten “too big to fail” doctrine. Or as President George W. Bush said at the time, “I’ve abandoned free market principles to save the free market system.”
Horror over the collapse and public distaste for the “too big to fail” doctrine begat Dodd-Frank.
The problems are, first, that it was based on a misdiagnosis of the crash (it’s silent about the GSEs); second, that it failed to undo earlier interventions that induced and aggravated the crash; and so third, that it won’t do what its advocates promised it would do.
The Great Recession did not result, as popularly believed, from either Wall Street greed or under-regulation. We may assume that greed (however defined) is a constant, so any such explanation would have to show why it had such consequences in 2007-08 rather than another time.
Similarly, to attribute the crash to under-regulation is to overlook all the ways the government encouraged and in some cases even mandated behavior that sowed the ground for the housing market collapse. It is no secret that the national government for years pushed -- and in some ways compelled -- banks and other lenders to make mortgage loans to people with no, weak, or poor credit histories and then encouraged the GSEs to buy those shaky loans from the originating financial institutions. This may have been a well-intended policy to increase home ownership, but it nonetheless created a boom in subprime lending to uncreditworthy applicants who, for example, did not have to document their incomes, that is, their ability to repay their loans. These loans were then pooled to create securities and derivatives that leveraged financial institutions both held and sold to clients. The policy-driven boom also helped to create a price escalation that encouraged riskier loans featuring initial teaser but adjustable interest rates. People who feared they would be overextended were assured they could refinance when the price of their homes went up.
Wall Street of course understood the risks. So why did banks and other institutions become involved in high-risk loans? One answer is that high-risk investments come with the potential for high payoffs. Those who bought and sold these investments knew what they were doing and usually took appropriate precautions, such as purchasing credit-default swaps and other forms of insurance against loss. Despite the impression left by the popular news media and progressives, the insurance mechanism in the financial markets worked as intended, as Edward Peter Stringham documents in “It's Not Me, It's You: The Functioning of Wall Street During the 2008 Economic Downturn.” Risk was efficiently “allocated” from risk-avoiders to risk-seekers, with profits and losses reflecting this arrangement.
But another answer to why people were willing to deal in high-risk loans is that the national government, besides pushing lenders to make the loans, was understood to be ready to bail out big institutions that got in trouble. Indeed, that is just what it did.
In light of all this, Dodd-Frank is exposed as a futile, although costly gesture. Considering that government guarantees were at the root of the crisis, it is strange that Dodd-Frank does not abolish the government’s power to bail out financial institutions. “Too big to fail” lives, despite the bill’s declaration. For example, federal deposit insurance continues. This is usually thought of as a guarantee to bank depositors, not banks. But if depositors need not worry about the safety of their deposits, the banks need not compete with one another in terms of prudence. All are equal because the FDIC sticker is on all doors. This weakens the market’s check on imprudent banks. Indeed, Franklin Roosevelt, after his election but before his inauguration, agreed with President Herbert Hoover that federal deposit insurance was a bad idea. “The general underlying thought behind the use of the word ‘guarantee’ with respect to bank deposits,” Roosevelt said, “is that you guarantee bad banks as well as good banks. The minute the Government starts to do that the Government runs into a probable loss.… We do not wish to make the United States Government liable for the mistakes and errors of individual banks, and put a premium on unsound banking in the future.” Unfortunately he signed deposit insurance into law along with many new banking regulations.
What about “too big to fail”? Dodd-Frank declares the doctrine null and void, but Mark Calabria of the Cato Institute says it’s not so:
“There is, of course, language about ‘eliminating expectations … that the Government will shield’ parties from losses ‘in the event of a failure.’ But vague purposes do not constrain explicit authorities. And Dodd-Frank is quite explicit. Section 204, for instance, is quite clear that the Federal Deposit Insurance Corporation (FDIC) can purchase any debt obligation at par (or even above) of a failing institution. If rescuing a creditor at par is not the very definition of TBTF [too big to fail], I’m not sure what is. Section 201 goes even further by allowing the FDIC to pay ‘any obligations…’ it believes are ‘necessary and appropriate.’ Yes Dodd-Frank does offer a path for ending TBTF without cost to the taxpayer or the rest of the financial industry. But that path is clearly an optional one.”
So Dodd-Frank fails to address the key means by which the government encourages recklessness: relief from the fear of losses. Meanwhile, it imposes huge costs on financial institutions through collateral and complex reporting requirements. Those costs function as barriers to entry into the industry, adding even more protection for large incumbent firms. Moreover, the costs present new obstacles to smaller community banks.
Thus Dodd-Frank strengthens the sheltered financial oligopoly and thereby endangers us all.