In the coming weeks and months, Congress will be turning its attention to financial market reform, in hopes of avoiding future financial crises. According to perceived wisdom, the root cause of the 2008 financial crisis was excessive risk-taking, and proper regulation can detect and prevent such excess in the future.
This view is a pipe dream. Most new regulation will do nothing to limit crises because markets will innovate around it. Worse, some regulation being considered by Congress will guarantee bigger and more frequent crises.
Government-Induced Moral Hazard Caused the Crisis
The Financial Crisis of 2008 did not occur because of insufficient or ill-designed regulation. Rather, it resulted from two misguided government policies.
The first was the attempt to promote homeownership. Numerous policies have pursued this goal for decades, and over time they have focused mainly on homeownership for low-income households. These policies encouraged mortgage lending to borrowers with shaky credit characteristics, such as limited income or assets, and on terms that defied common sense, such as zero down payment.
The pressure to expand risky credit was especially problematic because of the second misguided policy, the long-standing practice of bailing out failures from private risk-taking. This practice meant that financial markets expected the government to cushion any losses from a crash in mortgage debt. Thus, the historical tendency to bail out creditors created an enormous moral hazard.
One crucial component of this moral hazard was the now infamous “Greenspan put,” the Fed’s practice under Chairman Alan Greenspan of lowering interest rates in response to financial disruptions that might otherwise cause a crash in asset prices. In the early to mid-2000s, in particular, the Fed made a conscious decision not to burst the housing bubble and instead to “fix things” if a crash occurred.
It was inevitable, however, that a crash would ensue; the expansion of mortgage credit made sense only so long as housing prices kept increasing, and at some point this had to stop. Once it did, the market had no option but to unwind the positions built on untenable assumptions about housing prices. Thus government pressure to take risk, combined with implicit insurance for this risk, were the crucial causes of the bubble and the crash. Inadequate financial regulation played no significant role.
New Regulation Must Avoid Moral Hazard
If government-induced moral hazard caused the crisis, then new regulation should avoid creating or exacerbating this perverse incentive. Yet two components of proposed regulation will increase, rather than decrease, the chances for moral hazard.
One proposed change in regulation would give the Federal Reserve increased power to supervise financial institutions, especially bank holding companies such as Citigroup or Bank of America. This approach is a triumph of hope over experience. Why should an expanded Fed role be beneficial when the Fed erred so badly in the previous instance?
Defenders of an expanded Fed role will claim that, in the lead up to the crisis, the Fed did not have explicit powers to supervise and monitor non-bank financial institutions, and that such powers could have avoided the crisis.
Yet during the years before the crisis, the Fed had more than ample power to recognize the unprecedented level of risk that was building in the economy and to issue stern warnings, whether or not it had explicit regulatory authority. In fact, far from cautioning the market to behave, the Fed promoted the notion that it could solve any problems that might result from a bursting of the housing bubble.
Regulators are fallible. Alan Greenspan, once thought to be the Maestro, got it fabulously wrong. Ben Bernanke, regardless of the merit’s of his stewardship, will not be Fed chairman forever. Centralized and expanded power to make things better is also centralized and expanded power to make things worse. In particular, any mistakes made by a powerful, centralized authority have a magnified impact because they distort the behavior of the entire market.
Just as problematic as granting the Fed additional powers is the proposal to allow the FDIC to resolve bank holding companies using taxpayer funds. Under the proposed arrangement, the FDIC rather than bankruptcy courts would be responsible for bank holding companies, and the FDIC would be authorized to make loans to failed institutions, to purchase their debts and other assets, to assume or guarantee their obligations, and to acquire equity interests. The funds would be borrowed from Treasury.
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Alex|10.27.09 @ 4:52PM|#
I'm still confused why otherwise intelligent people fall for this notion of ex nihilo risk-taking.
|10.27.09 @ 5:10PM|#
Caption Contest!
"And soon I'll be handing out stacks of money this big...everyone will be millionares!"
Kroneborge|10.27.09 @ 5:19PM|#
Some great points here, but also some huge errors.
First, you are correct that the attempts to promote homeonwerhip, along with the Fed artificially lowering interest rates are primary drivers of the crises. Also, the implicit guruantees also helped.
However, you are wrong that bad regulation didn't have a hand in creating the crisis. Regulation that allowed 30x+ leverage, along with 500 TRILLION or so in dirivates etc, also contributed to the crises.
More regulation isn't the answer, but setting up the right regulation (IE the rules of the game) is part of the solution.
You need to have incentives properly aligned, along with risks. IE bonuses, as well as the risk of failure. This becomes particurlary important because of the risks assosicated with agency. IE, the ones who are getting the bonuses are usually different than the ones that sustain the majority of the losses.
Finally, the solution for to big to fail, is break up the large banks. NOT, just to let them fail, and hope for the best.
So to summarize, the solution is
1. higher capital requirments
2. break up banks, and allow them to fail
3. reform incentives so that actors behave properly
4. have smarter, NOT more regulation.
5. Stop having the Fed print so much damm money
6. Get government ouf of promoting housing
Chad|10.27.09 @ 5:51PM|#
Yeah, lets have no financial regulation, other than the shotgun we have sitting next to our pile of gold hidden in our bunkers. THAT will surely stimulate economic growth.
And lending? Forget that, unless your home is within range of the aforementioned shotgun.
|10.27.09 @ 8:17PM|#
Sarcastic or liberal?
Chad|10.27.09 @ 8:20PM|#
Both
|10.27.09 @ 11:43PM|#
Confused then: are you being serious or are you being sarcastic?
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Capitalism After the Crisis - Page 3 links to this page. Here’s an excerpt:
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Juan|10.27.09 @ 8:45PM|#
How about we just "force" all the Congressmen, Senators, and Presidents, and members of his Cabinet to have a fundamental background in Economics?
These guys are either the stupidest people on the planet or else they are stridently corrupt... or both.
Chad|10.27.09 @ 9:52PM|#
How about we "force" all libertarians to get past chapter one of their Econ 101 textbook?
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The government policies were indeed crucially wrong. It was inevitable that the crash would ensue.