Sunday, March 08, 2009

Deregulation and the Economic Crisis (part 2)

I am baffled by how so many conservatives (see CPAC or the comment by one of our reader on a previous post) continue with same old “cut tax” and “less regulation” remedy as if nothing had happened. Their denial that deregulation is at the core of the current economic crisis we are in is beyond reason to me.

Their argument can be summed up in these few points: it is the fault of the FED (who of course regulated too much), Freddie and Fannie (which are institutions created by the government and worse originally created by the Roosevelt administration), as well as the Community Reinvestment act of 1977 (“which encourages lenders to lend to uncredit worthy borrowers”) and the “too big to fail institutions which became too big because of regulatory capture”.

The culprits may be the right one (the Fed and F&F for instance), but the reason is not too much regulation, it is not enough of it added with much encouraged greed.

1. Yes, the Fed and Alan Greenspan are largely responsible for a lot of the subprime mess but it is because he encouraged bad mortgages and refused to reign in. Here’s a good example:
"American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage," Greenspan recommended in a speech to the Credit Union National Association in February 2004.
(Greenspan, by the way, has been a proponent of Ayn Rand’s political philosophy of “Objectivism” which is basically a glorification of the right of individuals to live entirely for their own interest).

2. As for Freddie and Fannie, the main problem was indeed that profits were privatized but the risks were socialized – a bad combination if there is no regulation. It is the need for more profits (and the pressure of shareholders) that caused them to push for unreasonable measures. The Clinton administration is also partly guilty as they pushed for more mortgages for poor(er) people. Their intention may have been good but the consequences, not so much. However, it is in 2004 (under the Bush administration) that the problem got worse and got us into this mess. The US Department of Housing and Urban Development helped fuel more of the risky lending and got F&F into that sort of business they previously shunned – and that was a political decision. Not only did HUD not play its regulatory role over Fannie and Freddie but it forced them to take risks.

3. As for the idea that the 2007 mortgage crisis was the result of a 1977 law, it is obviously ludicrous. Besides, most subprime loans were made by firms that were not subjected to the CRA anyway (which is not surprising since the CRA program required higher supervision)

4. There’s been a coherent path towards deregulation in the last 8 to 10 years so I am curious to see how the argument of “too much regulation” may be even remotely used to explain the current mess.

Before deregulation banks were restricted to certain businesses and could not for instance enter into the insurance or brokerage business. Regulation also obliged banks to evaluate risk and the creditworthiness of borrowers (loans could not be sold to the secondary bond). So banks could not package the subprime loans into complex financial instruments.
Not only did deregulation eliminate all the firewalls between commercial banks, investment banks, insurance companies, and securities firms but it also resulted in dangerous mergers.
It is also the lack of regulation in the loan industry that allowed all sort of dubious people to “sell loans” without any background check - no state or federal regulatory body required a license. The pizza guy could become a loan officer!

In the banking industry, it is because the FEC did not do its job (since it relied on “voluntary” supervision program) that banks could run amok.
Competition and free-market are good but just like anything else in human nature, there needs to be a balance. For competition to work, you need fairness. When companies become too big, they disrupt the market. (hence the need for anti-trust laws such as the Sherman laws of the 19th cent.).
The market alone does not have the “the discipline ensued from competitive forces would allow things to be put in check”. With freedom comes responsibility and when companies become too big, the risk they take has ripple effect onto the community at large, and they know it (indeed they become “too big to fail”).


At 02:51, Blogger massud said...

the field of public choice in economics, not casual observation will answer most of your questions.

Discussing social theory divorced from economics is like talking about your health divorced from medicine...

try the following and you will get a good understanding on the unintended consequence of regulation!

Stigler is best known for developing the Economic Theory of Regulation, also known as capture, which says that interest groups and other political participants will use the regulatory and coercive powers of government to shape laws and regulations in a way that is beneficial to them. This theory is an important component of the Public Choice field of economics. He also carried out extensive research into the history of economic thought.


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