What if Regulation Isn’t Enough?

President Obama gave a rousing speech today on the proposed financial reforms.

We know that financial regulations can bring far greater stability to the economy. Even Milton Friedman and Anna Jacobson were forced to acknowledge that the FDIC “succeeded in achieving what had been a major objective of banking reform for at least a century, namely, the prevention of banking panics.”

My concerns focus on what was not addressed by the president by seems every bit as important as regulatory reform.  The asset bubble that burst in 2007/08 was itself a product of public policy decisions.  To be more specific:

  • Ongoing regulatory pressure for relaxed underwriting standards as a means of promoting social goals (e.g., higher levels of home ownership, and under Bush, the “ownership society”)
  • The Federal Housing Enterprises Financial Safety and Soundness Act of 1992, which  mandated that HUD set quantitative targets for GSE purchases of mortgages serving a low and moderate-income clientele (the target would ultimately reach 55 percent).
  • The Taxpayer Relief Act of 1997 that exempted the first $500,000 in gains from any home sale (for couples, $250,000 for single filers)
  • Persistent trade deficits that provided funds for reinvestment in mortgage-backed securities combined with Greenspan’s pursuit of historically low interest rates

Voters who can use homes they can’t afford as ATMs to purchase goods they could not otherwise justify may be quite content, even if the policies that make this all possible simultaneously create the preconditions for an asset bubble.

The president, in focusing exclusively on regulatory reform, seems content with changes that will reduce the extent to which, when the next bubble bursts, the collateral damage will not be as great.  It feels like mandating that all cars have better airbags before liquoring up a teenage boy and handing him the car keys. Without the liquor, the need for better airbags might not be as great.

What would be necessary to assure that future elected officials won’t pursue social policy goals (e.g., creating an “ownership society”) that have the unintended consequences witnessed in the past few years?

4 thoughts on “What if Regulation Isn’t Enough?

  1. Marc, have the agencies in question ever stopped pursuing those problematic goals?

    Also (and maybe this is another way of putting your point), isn’t pitching the issue as regulation yes vs. no (as Obama seems inclined to pitch it) a very different thing than asking what regulation is needed to solving the real problems? To address that, of course, we have to know the answers to your questions, yet there doesn’t seem to be much appreciation of that, whether by Obama, or Dodds, or anybody else that’s agitating for this.

  2. It also seems to me that the implicit bailout expectations in the financial sector, solidified by the S&L payouts of the 1980s if nothing else, generated moral hazard. I’m actually pessimistic that the moral hazard will be purged absent a total revolution in our financial architecture, including the elimination of deposit insurance, the Fed, and legal tender laws. So given that those things won’t happen, regulations that require higher capital-to-liability ratios, restrict trading in the most opaque instruments, and use antitrust or other tools to break up “too big to fail” companies may be a second-best solution. What I’m hearing about the Democrats’ bill in Congress now is a mixed bag on this score.

    1. Where do the plans for “consumer protection” that seem to be built into every version of this proposal fit with those aims? I can’t see any relation myself, but I haven’t even see anybody ask the question (even critics), so I’m wondering what I am missing.

      1. You know, Mark, Elizabeth Warren has made a compelling case for consumer protection. If I recall correctly, she claims that some 25 percent of borrowers with good credit ratings were directed into sub-prime vehicles. The kind of consumer protection she advocates–largely along the lines of reducing informational asymmetries–makes great sense.

        However, I don’t think it is accurate to portray the financial collapse as being primarily a story about exploitative mortgage brokers preying on uninformed rubes. Yes, this was a tragic part of the crisis, but I think that adopting a consumer protection interpretation misses the bigger issue.

        Our elected officials–either out of a short-sighted pursuit of political popularity or a misguided attempt to engage in social engineering–created the bubble and they assured that the impact would be maximized once the bubble broke. The reforms do nothing to address the first problem, and are likely insufficient to address the second.

        Thanks for your thoughtful questions.

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