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What was the problem with financial regulation?
Here is my NYT column from today. Excerpt:
In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong.
...the Bush administration’s many critiques of regulation are belied by the numbers, which demonstrate a strong interest in continued and, indeed, expanded regulation. This is the lesson of a recent study, “Regulatory Agency Spending Reaches New Height,” by Veronique de Rugy, senior research fellow at the Mercatus Center at George Mason University, and Melinda Warren, director of the Weidenbaum Center Forum at Washington University. (Disclosure: Ms. de Rugy’s participation in this study was under my supervision.) For the proposed 2009 fiscal budget, spending by regulatory agencies is to grow by 6.4 percent, similar to the growth rate for last year, and continuing a long-term expansionary trend.
For the regulatory category of finance and banking, inflation-adjusted expenditures have risen 43.5 percent from 1990 to 2008. It is not unusual for the Federal Register to publish 70,000 or more pages of new regulations each year.
...The biggest financial deregulation in recent times has been an implicit one — namely, that hedge funds and many new exotic financial instruments have grown in importance but have remained largely unregulated. To be sure, these institutions contributed to the severity of the Bear Stearns crisis and to the related global credit crisis. But it’s not obvious that the less regulated financial sector performed any worse than the highly regulated housing and bank mortgage lending sectors, including, of course, the government-sponsored mortgage agencies.
There is much more at the link. Mark Thoma adds comment. So does Arnold Kling.
Posted by Tyler Cowen on September 14, 2008 at 07:49 AM in Economics | Permalink
Comments
A number of blogs have pointed to the amazing INDYMAC: MY EXPERIENCE. One snip from that:
I finally finished my own airport parking lot appraisal report in late March, the same week that the Bush Administration laid off most of the OTS examiners. I don’t know which event precipitated my termination. My appraisal of the airport parking lot estimated the stabilized value at $37 million in year 2003 and the value upon completion as $31 million in 2002. These appraised values were considered insufficient to support the $30 million loan.
We know that the Bush admin has been selective in its enforcement of regulation (see also the EPA). I think that might be the bigger story.
Posted by: odograph at Sep 14, 2008 8:40:33 AM
Great article. I think Thoma is right about hedge funds. Their absolute performance says little about regulations working or not working. Is there any way to determine if regulations were ignored or just not followed?
I think transparency is the best long term solution. What regulations would you propose to accomplish that?
Posted by: steve at Sep 14, 2008 8:40:49 AM
I'd like to take a second to offer hysterical laughter directed towards the people who lost their shirts investing in home loans of all things. If you lose everything on home loans, it's time to throw in the towel.
High rates of leverage is a statement that you don't know what they hell you are doing, whether you realize it or not.
So do generic calls for "more regulation." They are saying "We have a rat problem, therefore stuff more money down that hole!"
Both of these signal the same thing. "We have no idea how good what we are buying is, but more must be better."
Posted by: Andrew at Sep 14, 2008 9:00:05 AM
Although I agree that it might not be possible to determine whether non-regulation has helped the hedge funds, but it has not been the hedge funds that contributed to the credit crunch. As an expert in economics you surely know that economy cannot grow more than the long term growth unless GDP, income, productivity all are increasing very fast. The current economic cycle has inflated housing prices which have been used as leverage to inflate the economy and give credit. It is this fall in house prices that have resulted in the crisis. I donot see how the hedge funds are responsible for the housing prices fall. It is simply the cause and effect... I think you have got the two incorrect thins time.
Posted by: SA at Sep 14, 2008 9:00:29 AM
SA, I think you're misreading what Tyler wrote.
The point is, most people who saw trouble coming anticipated that it would be (unregulated) hedge funds triggering it, à la LTCM in 1998. While some hedge funds have indeed blown up, this has been of little consequence to the rest of the financial system. The cascading slow-motion train wreck we are experiencing has originated not from within the unregulated sector, but from the traditional financial sector deciding to become sorcerer's apprentices. Case in point, there were few companies in existence more tightly coupled to government regulations than Fannie and Freddie.
Posted by: at Sep 14, 2008 9:55:36 AM
I wanted to say something about the vast amount of non-sequitur in Tyler's article, but then I read the comments at Economist's View, and saw most of it had been already said well.
I mean really, agency spending is not the same as amount of regulation. It could represent featherbedding, it could represent more financial exchanges to regulate, or a zillion other things than the level of regulation.
Posted by: Mike Huben at Sep 14, 2008 10:04:58 AM
Again I am surprised to find discussion of regulation without a single mention of the ratings agencies. Weren't they the key crux point, and don't they remain so?
Being paid by securities issuers, and preparing their ratings in collusion with those issuers, they failed to accurately rate the securities.
If they had rated them accurately, it would been harder and more expensive to sell those securities. Which would have made it harder and more expensive--or even impossible--for loan issuers to issue the underlying loans.
What about regulations barring ratings agencies from accepting money from issuers? Or at least, a cigarette-type warning on each rating paid for by an issuer? Would this create a market for less-conflicted ratings?
True, the ratings are free at this point. But they might also be useless.
This is the kind of regulation that supports a truly free market, in which all (or at least more) information is known.
Steve
Posted by: Steve Roth at Sep 14, 2008 10:33:46 AM
"agency spending is not the same as amount of regulation"
True enough, and as true for education, park maintenance, defense spending, space exploration, healthcare, transportation infrastructure, .... input quantity <> quality outcome
Posted by: Eric H at Sep 14, 2008 10:56:38 AM
Point taken.. I misread it.. apologies
Posted by: SA at Sep 14, 2008 11:22:39 AM
Who will regulate the regulators?
Surely the financial regulators are not in bed with those regulated to the same extent the energy regulators were?
Posted by: Andrew at Sep 14, 2008 11:47:24 AM
"Who will regulate the regulators?"
Goes back to why we have three branches of government. I understand some of those energy regulators are in trouble with the judicial branch right now.
Posted by: odograph at Sep 14, 2008 12:17:29 PM
Regulators and legislators tend to think in bulk - if ten rules are good, 20 rules must be twice as good, and 40 rules even better, and.......
Which is why we get hundreds of poorly enforced regulations.
Posted by: save_the_rustbelt at Sep 14, 2008 2:24:06 PM
"In the meantime, if you hear a call for more regulation, without a clear explanation of why regulation failed in the past, beware. The odds are that we’ll get additional regulation but with even less accountability and even less focus on solving our very real economic problems."
I'm confused by this. What is regulation without accountability? Sounds like no regulation, or pseudo-regulation. Either people go to jail, or they don't. Either losses are absorbed, or they aren't.
Posted by: Dan at Sep 14, 2008 3:03:40 PM
The NY Times column is disingenuous to say the least. The case being made as stated in the opening sentence:
'There is a misconception that President Bush’s years in office have been characterized by a hands-off approach to regulation..'
Why then include data from the Clinton administration to make your case:
'For the regulatory category of finance and banking, inflation-adjusted expenditures have risen 43.5 percent from 1990 to 2008'
The fact is, removing the Clinton years, and the last fiscal year (the financial market unraveling had already begun), e.g. 2000 to 2007, spending on financial and banking regulation was unchanged (in constant dollars)!!! Whats more, during that same period the number of employees in that sector was reduced 15%.
The very paper you cite to try to make your case (see Finance and Banking in tables A2 and A3 here: http://www.mercatus.org/uploadedFiles/Mercatus/Publications/1-regulatoryagency20080807_wc-regulators_budget_09.pdf) clearly shows it was an faily accurate conception 'that President Bush’s years in office have been characterized by a hands-off approach to regulation..'
Posted by: Darryl Stoflet at Sep 14, 2008 4:06:25 PM
"Under these circumstances, the real issue is setting strong regulatory priorities to prevent outright fraud and to encourage market transparency, given that government scrutiny will never be universal or even close to it. Identifying underregulated sectors in hindsight isn’t a useful guide for what to do the next time." ---Tyler Cowan
......
1) Nobody really knows what the right degree of regulation should be of a very complex, ever changing web of financial institutions that have --- over the last 30 years or so --- both helped and hindered global economic growth.
....
2) More specifically, the combination of deregulation across numerous industries, not just financial ones, has helped the US economy move quickly from an industrial-based system to a knowledge-based system based on knowledge and ideas . . . but, simultaneously, has repeatedly dislocated the economy because of the excessive risk-taking and poor management of risk and allocating capital efficiently that have marked many of these financial innovations.
......
3) Consider the lengthy list of dislocations:
* The stock market balloon of the 1980s and then the bust on Black Monday in late 1987, the biggest one-day decline in US stock-market history. The balloon was accentuated by promises of brokerage firms that, thanks to computers, they would swiftly move the investments of their clients that were falling a given percentage over to the bond market. The reality: only a few big investors were helped this way.
* The S&L (Savings and Loan) fiasco of the late 1980s, which required a government bailout.
* The dot.com ballooning stock market of the 1990s --- balloons built into the nature of capitalism, it seems (best explained by Hyam Minsky, and not dead Austrian economists) --- and subsequent crash.
* The Long Term Capital Management hedge-fund fiasco, with tens of billions lost even though the hedge fund was run by two Nobel Prize-winning economists with 25 Ph.D. economic analysts. Another government rescue needed (1998). (True: hedge funds have, more recently, done better than commercial and investment banks, never mind independent mortgage-brokers, in staving off a fall in capital and profits . . . a sign, again, of the complexities of financial management and the problems facing regulators.)
*The subsequent accounting scandals entangling firms like Enron, World.com, and the like that, it seems, did little other than manipulate balance sheets. The real shocker was that so-called outside accounting scrutiny of corporations and financial institutions turned out to be something of a joke, with these accounting agencies free, simultaneously, to work out lots of sweetheart deals with those they were scrutinizing . . . not least, thanks to changes in accounting regulations of the late 1990s.
* The head-spinning innovations in "fee structures" that mark almost all the financial sectors of the US economy . . . to the point that credit-card holders, thinking they may have to pay, say, 20% max interest rates on short-term loans may in fact be paying five times that rate.
* The gigantic flaw that followed: the subprime innovation, carried out in a sort of Ponzi-scheme by independent mortgage firms (another innovation), with commercial and investment banks then getting involved --- hey, who cares about credit-analysis, just pass on the risky paper to the buyer down the road
-- and then excessive snowballing of all this on a vast global scale.
* The subsequent bust of this subprime hoopla, and the worse consequence, a huge credit-squeeze . . . credit the life-blood of our economic system. Then quickly followed by the failure of certain key brokerage firms and the near default of Fannie and Freddie, both necessitating rescue by the US government and Federal Reserve, even as the same was true of certain key commercial and investment banks . . . with more bailouts certain to occur.
* And, if we're to believe Alan Greenspan --- a follower and true-believer of Ayn Rand ---- the speculative causes of the huge upsurge in oil prices starting last winter, with its dislocations, followed by the subsequent collapse starting in late July.
.......
3) All this has occurred in the US, with world-wide repercussions.
I pass over, just in mentioning, nothing else, the Asia financial meltdown of 1997-98, with (interestingly) China and India --- both not deregulating their financial markets --- the only countries not to have been badly hurt.
No, I am not recommending Chinese or India-style regulations here. That would be absurd, even loony.
.....
4) Let's leave aside, too, the underlying causes of these financial excesses and subsequent crashes --- analyzed effectively by Hymam Minsky, a great economist who had been a former stock-broker and investor --- and look at the mix of regulations and deregulations in finance that mark this country's current combination.
On Minsky, see: http://en.wikipedia.org/wiki/Hyman_Minsky
Cowan, in his article, does not mention the kind of appointments that the Bush-W administration has made to head most of our financial regulatory agencies . . . virtually one and all headed by political hacks and incompetents, with little or no interest in effectively carrying out their regulatory role.
.
The causes of such bungling may be numerous --- not least, just plain incompetence, with the Bush administration specializing in way too many outrageous appointments (though not, fortunately, at the top in the Treasury department or in Bernanke's nomination to take over the Federal Reserve).
Just as the private sector needs highly qualified managers, so does the public sector --- and that includes, note, the military, where the appointment of General Petraeus, after nearly 4 years of disastrous occupational policies in Iraq, radically and fairly quickly changed the situation on the ground in that country.
Political ideologues opposed to regulation, regulators who identify with the interests of the industrial firms --- like the accounting firms who had sweetheart deals with the firms they were supposedly monitoring --- and hack incompetents will botch things up just as much in the public sector as they will in the private sector.
.........
5) The conclusions?
Nobody really knows the right degree of regulation in the financial sectors, not least because the rapid innovations --- facilitated by the Internet and all sorts of excessive capital running around the world as China and India and Russia and Middle East oil-rich countries boom (with no effective internal financial markets for investment and hence huge outflows into the US and the EU) --- are hard to keep up with.
But with do need to find ways to make all these financial institutions more transparent and accountable --- the latter meaning to their investors, borrowers, and the public in general.
And that requires an administration and a Congress that don't seem to toady to special interest money and ideologies opposed, in rigid principle, to effective regulation.
......
6) On a wider political level, the new populist backlash --- with 80% of the US public repeatedly saying our country is on the wrong track and suffering from a very bad or fairly bad economy --- has been fueled by these financial dislocations, one after another, and to the point that it seems punched out mentally.
Add in the rapid growth of income inequality --- not unrelated, to put it mildly, to these financial innovations and instabilities and outright shenanigans at times --- and all of us should be geared to deal with a soured American public view of our economy until far more confidence in our economic, financial, and political elites is restored.
Otherwise, ladies and gentlemen, it's a repeat of the 1790s Whiskey Rebellion, the Jacksonian populist onslaught on new financial institutions, the populist agrarian rebellion of the late 19th century against Wall Street and industrial giants, the muckraging surge that followed, the Progressive breakthrough that accompanied it, and the 1930s more radical turn in the Great Depression.
And restoring confidence means that people like us posting in this thread are again convinced that our financial institutions do what they are supposed to all the way back to Adam Smith: allocate capital efficiently and managed financial risk-taking properly.
.....
Michael Gordon, AKA, the buggy professor
Posted by: the buggy professor at Sep 14, 2008 4:23:04 PM
just out of curiosity, given the efficacy of Bush's FEMA and Bush's Iraq Adventure, and to a lesser extent Bush's FDA -- what makes you think financial regulators were running smoothly?
Posted by: Jor at Sep 14, 2008 7:02:11 PM
I also woudl like to SECOND Darryl Stoflet. If I'm reading the tables right, Tyler's numbers are extremely misleading. Between 2000 and 2007 (Bush's years in office, before the crisis became obvious), regulatory spending in finance increased by 5%. If you count the Clinton years, and the up-tick in 2008 budget (after it was obvious we were in trouble) -- then you get a 43% increase. That is really, really, really misleading.
Posted by: Jor at Sep 14, 2008 7:09:49 PM
The Clinton/Greenspan years are also commonly charged to have been deregulatory. In some ways, yes, but not nearly as much as people think and the numbers show this. Bush spending on this category went up too and I am rebutting the myth of laissez-faire. Some people have charged that Bush cut the staff assigned to financial regulation. I disaggregated the change in staff numbers, which do appear to show a decline. The apparent decline is driven by RTC resolution, due to the final cleaning up of S&L issues and not to a disregard of staffing concerns at the agencies. A number of people have been misled by these numbers because they have not looked into where the cutbacks in staff came.
Posted by: Tyler Cowen at Sep 14, 2008 7:46:12 PM
I was struck that the professor didn't mention regulatory capture. This has gummed up the whole process, and driven a good bit of the cost of regulation.
Posted by: masaccio at Sep 14, 2008 9:40:42 PM
So, Mr. Cowen notes: "For the regulatory category of finance and banking, inflation-adjusted expenditures have risen 43.5 percent from 1990 to 2008."
Now, the first-year economics student in me says: "how much did the assets/risk/profits (or ANY measure of the size and importance of the financial sector) change on an inflation-adjusted basis during that time?"
I'm willing to bet that it is substantially higher.
Posted by: GA at Sep 15, 2008 3:16:29 AM
"The NY Times column is disingenuous to say the least. The case being made as stated in the opening sentence:
'There is a misconception that President Bush’s years in office have been characterized by a hands-off approach to regulation..'"
Wasn't it Bush who tried, but failed to remove oversight of Freddie and Fannie from Congress? Seems if he had succeeded, a lot of this crisis could have been averted.
Posted by: Tom at Sep 15, 2008 8:58:37 AM
"in his article, does not mention the kind of appointments that the Bush-W administration has made to head most of our financial regulatory agencies . . . virtually one and all headed by political hacks and incompetents, with little or no interest in effectively carrying out their regulatory role."
This is a great point. For a few years, John Snow was treasury. John Snow! Can you imagine what would be happening if this guy was still around! Then prior to him was Paul O'Neil! No wonder we have a huge mess to clear.
Posted by: mickslam at Sep 15, 2008 2:36:56 PM
I think we are in desparate need of reform
With Websites like http://www.FAKEPAYCHECKSTUBS.com promoting the fact that if you buy their $50 program you can get any loan you apply for, Is it really any wonder why the banking system is in the turmoil it is in today? I have read that using this "Novelty Paycheck Program" was standard practice by Greedy Loan officers trying to push the loan through so that they can make the 6 percent commission on every real estate transaction! SIC
Posted by: danny bonadueche at Sep 15, 2008 3:46:47 PM
