Now that health care reform has passed, attention will turn to other initiatives. Financial regulation is already moving briskly ahead, although we have to wait and see whether the regulatory changes actually address the problems at the heart of the financial collapse. Call me skeptical.
There are competing ways of understanding the collapse. Let me generate a quick list of interpretations:
1. The problem was the ruthless mortgage brokers who exploited informational asymmetries and naïve borrowers. Here the crisis was a story of black hats and white hats, your typical melodrama. It demands additional consumer protection efforts similar to those promoted by Elizabeth Warren, chair of the Congressional Oversight Panel for the TARP currently being considered for a Supreme Court vacancy.
2. The problem is one of ideology. As Barney Frank noted in a piece a Financial Times piece entitled “Why America needs a little less laissez-faire,” the collapse was an indictment of “America’s 30-year experiment with radical economic deregulation.” As Congressman Frank should know, it is easy to overstate the extent of deregulation. Consider regulatory budgets. In 2008, the last year of the Bush presidency, the combined regulatory budget was $48 billion. To place this number in perspective, inflation-adjusted regulatory budgets grew by 310 percent since 1980, outpacing the growth of GDP. The inflation-adjusted budgets for the regulation of finance and banking grew some 316 percent during this period, 16.7 percent during the Bush presidency. Yet, there is clear evidence that regulators provided too much discretionary authority with respect to capitalization levels and the management of risk.
3. The problem is one of misguided regulation. Critics might concede the above point and note that while we continued to invest in regulation, we simply regulated the wrong things. There was no meaningful regulation of credit-default swaps. And if Gary Gorton is correct, the crisis really stemmed from a bank run in the shadow banking system that was virtually unregulated. (For more on Gorton’s argument, see the Finance Blog).
4. The problems cited above were products of a larger public choice problem. When the real estate industry is contributing some $40 million to members of the two key congressional committees during the 2004-08 election cycles and the securities and investment industry is contributing another $46.7 million, it may be difficult to introduce policies that will suppress the real estate boom and impose greater regulatory oversight.
5. The problem was a classic and tragic example of moral hazard. The so-called government sponsored enterprises (Freddie and Fannie) engaged in reckless behavior on the assumption (correct as it turned out) that the costs they imposed would be socialized. Large financial institutions engaged in excessively risky behavior on the assumption (once again, largely correct) that they would be deemed too big to fail.
6. The problem stemmed from misguided efforts to promote social policy goals through financial markets. Banks were pressured to increase their loans to traditionally underserved populations through a loosening of underwriting standards. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 mandated that the Department of Housing and Urban Development (HUD) set quantitative targets for GSE purchases of mortgages serving a low and moderate-income clientele. Between 1993 and 2007, the target increased from 30 percent to 55 percent, creating a large secondary market for subprime mortgages. Clinton was enamored of “third way” solutions and Bush sought to promote an “ownership society,” both of which found an expression in regulatory interventions to increase levels of home ownership.
7. The crisis was a result of excessively low interest rates, a product of our persistent trade and budgetary deficits (and the influx of Chinese dollars) and the Greenspan doctrine. Had we made a decision not to be consumer of last resort to the world, had the Maestro abided by the discipline of the Taylor Rule, the bubble would not have been created (and hence, it would not have collapsed).
Which interpretation is correct? My guess is that some combination of all of the above. Public policy decisions over a two-decade period created a massive asset bubble and assured that its devastating effects would be maximized when the bubble popped (and all bubbles pop). Clearly there were tragic examples of exploitation, policymakers wearing ideological blinders (or their financial equivalents, thanks to the constant inflow of campaign finance). There were poorly designed regulations that failed to address the financial services industry as it had evolved in the post 1970s era. There were obvious problems of moral hazard. The Fed held interest rates artificially low with impacts that were magnified by our failure to manage our own fiscal affairs and tame levels of debt-fueled consumption.
Now for the big question: how many of these problems have been addressed by the proposed regulatory changes?
A second question: had these changes been implemented, is there any reason to believe that the financial collapse would have been avoidable.
And a third question: should I take comfort in the fact that I am once again receiving preapproved offers for credit cards and home equity loans that exceed the value of my house?
If so, than I guess the crisis is behind us. Thank goodness.