President Obama this week signed the financial regulation bill. Our faith in government to make things worse has yet again been vindicated. Government tends to create problems, and then respond by developing new rules that cause even more harm.
In this case, government created a housing bubble, and then reacted to the crash by bailing out favored institutions. The new bill follows the pattern of government folly, ensuring future bubbles and bailouts, while stifling the over-regulated financial markets with even more regulation. As with the “stimulus” plan and health care “reform,” this bill is laughable in its claims and will be tragic in its consequences.
No good has come, nor can come, from the current Congress and current administration. This bill, along with the health care bill, should be repealed. Further steps should then be taken to end government’s entanglement with financial services.
I. Failure of the Bill
The bill of course will not, of course, prevent bubbles. It leaves the Federal Reserve System in place, assuring there will be booms and busts due to mismanagement of the money supply and manipulation of interest rates.
Nor does the bill prevent housing bubbles in particular, or risk of loss to taxpayers as housing bubbles collapse. It leaves Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA) intact. It also leaves in place the Community Reinvestment Act (CRA), which encourages poor mortgage underwriting; the FDIC, which creates moral hazard in bank lending; and the subsidy of homeowners through the deductibility of mortgage interest. The survival of these agencies and laws means they will continue to artificially cause capital to flow to housing. In addition, the mortgage agencies and the FDIC will expose taxpayers to losses.
The bill also will not prevent bailouts. While the bill purports to address bailouts, the new framework will allow them. In addition, regardless of the provisions of the bill, in light of the precedents, only a radical change in the political culture would prevent government from engaging in bailouts on an ad hoc basis.
II. Inherent Flaws of Government Regulation of Financial Services
There are many specific faulty premises behind the bill. The fundamental premise, however, is also faulty, i.e., the belief government can effectively:
- Protect consumers and investors
- Identify and deal with “systemic risk” (itself a mythical concept)
- Supervise banks
- Regulate hedge funds, derivatives, securitization, executive compensation and corporate governance, insurance, and credit rating agencies
- Determine the correct size of firms
Government Regulation Is Dominated by Special Interests
Congress and regulators serve themselves. Public choice theory warns us that politicians and bureaucrats will do what is in their interest, not in the interest of the public. Congress’s own interest is served by favoring special interests in crafting legislation and overseeing regulatory agencies. The special interests in this case are the largest firms in the financial services industry and the ideological groups that favor government control of commerce.
Government Is a Monopolist
Government monopolizes the regulation in its sphere. This means that, as a regulator, it has little incentive to perform its mission well. It also means that it blocks competition by private regulatory competitors, preventing the creativity that comes from a market.
Government Is Not Omniscient
F.A. Hayek identified the “knowledge problem” that dooms central planning. Markets depend on the knowledge of countless people, and governments are not omniscient. In Hayek’s term, it is a “fatal conceit” for government to believe it is smarter than the market. Government cannot, for instance determine the correct terms of mortgages. The market, absent government interference, finds, through experimentation and competition, arrangements that meet the needs of lenders and borrowers.
III. The Free Market Alternative
Most of the current and pending government regulation of financial services is simply unnecessary. The alternative to government regulation is the free market.
Disentangling the Government From Financial Services
During the debate over the health care bill, opponents of the legislation often cited the aphorism, popularly, albeit inaccurately, attributed to the Hippocratic Oath, “First, do no harm.” This is a good response to most new government programs, since government almost always does harm when it acts. A stronger approach, though, would be to follow this ideal: First, undo the harm.
In the case of health care, much of the government’s interference with the market should have been removed before any new legislation was even considered. A good starting point, as discussed during the debates, would have been the elimination of state restrictions on interstate health insurance. This could have been done even without any federal legislation, by states themselves dismantling their barriers (and, ideally, simply closing their insurance regulators).
In the case of financial services, to undo the harm requires disentangling government from the industry. This means, at the federal level, eliminating the Federal Reserve System, Fannie Mae, Freddie Mac, the FHA, and the FDIC. It also means eliminating or, at the very least, substantially cutting the power of, the SEC, CFTC, and the several banking regulators besides the Fed and the FDIC, and repealing regulatory legislation, including the CRA.
Benefits of Disentanglement
The benefits of disentanglement include that this would appropriately separate public and private interests. This would help discourage political meddling in, e.g., banks’ lending policies, decisions regarding size and structure, executive compensation, and the myriad of other business affairs best determined privately; eliminate taxpayer exposure, through the FDIC, to banks’ losses; and remove a rationale for bailouts, i.e., taxpayer exposure. (The benefits of abolishing the Fed go beyond removing it as a regulator, and this discussion is deferred.)
Ending Government Financial Businesses
The mortgage agencies and FDIC are businesses that are run poorly and politically, like all government businesses. Private firms can better manage the mortgage insurance now provided by the FHA, the secondary mortgage market dominated by Fannie Mae and Freddie Mac, and the bank deposit insurance business of FDIC, and eliminate the economically distorting subsidies and taxpayer cost and risk.
Ending Government Financial Regulation
Just as these agencies are operating businesses that would be better operated by the private sector, this is also the case with the regulators. (The FDIC is a regulator as well as an insurer.) Regulation is just a service. Government is the worst provider of services, and the market, with its competition, creativity, and flexibility, is the best provider. Ergo, regulation of financial services should come from the market.
Banks and brokerage firms, and other segments of the industry, absent government regulation, would have to determine what regulation is actually valued by consumers. Private self-regulatory organizations (SROs) would be formed, and would have to compete for credibility and membership. Private services to rate the SROs and their member firms would also evolve.
Credit rating agencies, currently an oligopoly created through the SEC’s registration requirements, and subject to federal regulation, would be subject to competition. Their means of performing ratings and being compensated would be their challenge and their opportunity. SROs could arise for rating agencies, as well as raters of the SROs and their members.
Consumer protection would necessarily be part of the SROs’ regulatory program, in order for members to gain the confidence of consumers. Matters such as disclosure, fair dealing, and contractual terms presumably would be included in the SROs’ rules. The market approach would avoid the politicization of government regulation, addressing the concern of Milton Friedman:
“Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer from the government.”
IV. Conclusion
The financial reform bill serves to grow the government and add to the country’s unnecessary regulatory burdens. It should be repealed, but this is only a start. There are great opportunities to allow the free market to supplant the role of government in operating financial businesses and providing regulation.
Capital and people migrate in the direction of freedom. Other countries will see the U.S.’s increasingly poor regulatory environment as an opportunity. The U.S. can either create a freer financial market, or watch as other countries learn from its mistakes and benefit from a better approach.
