Saturday, November 15, 2008

Financial deregulation? What financial deregulation?

Lawrence White, a professor of economic history at the University of Missouri - St. Louis, tells of walking across campus and hearing two non-economists blaming the financial crisis on greed and deregulation. "If I had butted in, I would have made two points. ... What deregulation have we had in the last decade? Please tell me."

What? An economist questions the role that excessive economic freedom played in the nation's current bath of red ink? How can that be?

"On the contrary," White continues. "[W]e’ve had a strengthening of the Community Reinvestment Act, which has encouraged banks to make mortgage loans to borrowers who previously would have been rejected as non-creditworthy. And we’ve had the imposition of Basel II capital requirements, which have encouraged banks to game the accounting system through quasi-off-balance-sheet vehicles, unhelpfully reducing balance sheet transparency."

White isn't alone, although you could be forgiven for thinking so given the volume of "blame deregulation" voices on the country's editorial pages. They may be overlooked by most journalists, but quite a few economists are not just questioning the role of deregulation in current troubles, they're suggesting that lttle if any deregulation has occurred in recent memory.

In Canada's Financial Post, Pierre Lemieux, an associate professor in the Department of Management Sciences of the Université du Québec en Outaouais and a research fellow at the Independent Institute, allows that there has been some deregulation, such as the gradual repeal of the Glass-Steagall Act by the late 1990s and the Commodity Futures Modernization Act of 2000 which, he says, "eliminated some regulatory Damocles swords over derivatives." But, he adds:

Other traces of deregulation are not easy to find. Robert Buzzanco, a history professor at the University of Houston, blames the financial crisis on “[t]he repeal of Glass-Steagall specifically, and the orgy of financial deregulation more generally.” The orgy, however, looks rather monastic as the author provides no other example, except for a cryptic reference to an obscure change in a Securities and Exchange Commission (SEC) rule. Prodded for more examples, he wrote to me: “I was also referring to the Fed’s ‘hands off’ policy during the early stages of the housing bubble, the government’s refusal to step in to stop predatory lending practices, the failure to address, or even understand, derivatives.” Pretty thin, if not totally misleading.

And as for the repeal of Glass-Steagall ... that certainly is getting some blame for the financial crisis, but it's not clear that the blame is well-placed. Lemieux points out that the result of the repeal was nothing more than "permitting American banks to do what European banks had long been allowed to do all along."

David Leonhardt, an economics columnist for the New York Times and generally a member of the blame-deregulation brigades, concedes "anyone trying to understand the causal chain — how the end of Glass-Steagall led to the end of Lehman Brothers — will have a hard time doing so. To many banking experts, the reason is simple enough: namely, that the law didn’t really do much to create the current crisis. It is a handy scapegoat, since it’s easily the biggest piece of financial deregulation in recent decades."

Not just the biggest piece -- but a rare example of such deregulation in a period marked more by an increase in red tape imposed by the government on financial activities. In the New York Times, Tyler Cowen, professor of economics at George Mason University, points out:

THERE is a misconception that President Bush’s years in office have been characterized by a hands-off approach to regulation. In large part, this myth stems from the rhetoric of the president and his appointees, who have emphasized the costly burdens that regulation places on business.

But the reality has been very different: continuing heavy regulation, with a growing loss of accountability and effectiveness. That’s dysfunctional governance, not laissez-faire.

For evidence of heavy regulation, Prof. Cowen points to a steady increase in spending on regulation over the years. Citing research 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, he says, "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."

That research is available online (PDF) and reveals surging budgets for financial regulators in recent years.

And yes, regulation really has increased in significant ways in recent years. Specifically, there was Sarbanes-Oxley, an ill-considered reaction to the Enron disaster. Intended to toughen financial reporting requirements, Sarbanes-Oxley so enmeshed many companies in red tape that they took their business -- and their money -- overseas. The International Herald Tribune reported last year:

Two studies have concluded that excessive regulation was making the United States an unattractive place to sell new stocks. One study was conducted by McKinsey for the mayor of New York, Michael Bloomberg, and U.S. Senator Charles Schumer, also of New York. The other was done by a group of executives and academics. In particular, the reports single out the Sarbanes- Oxley Act of 2002, the anti-fraud law passed after the debacle at Enron.

Both studies point to figures that show initial public offerings are migrating to Hong Kong and London, where underwriters charge half of what they do in the United States. If IPOs flee, the thinking goes, trading, investment and jobs will follow.

The result has been a fow of capital away from the United States -- capital that could have helped shore-up American banks.

Far from an example of deregulated markets, Prof. Lemieux describes the financial world in the U.S. as "a regulatory jungle" in which "[t]o be a banker or financier has become quite risky."

But if U.S. markets are enmeshed in red tape and closely scrutinized by well-funded regulators, how did the financial crisis happen? Well ... part of the problem is that we often assume that regulations are created by rational people to achieve public-spirited ends. We assume this even as we accept that everybody from our accountant to our dentist may have an agenda and not always act with our best interest in mind. Economists who work within the public choice school apply the same commonsense assumptions to politicians and bureaucrats that we apply to the guy trying to sell us something on the phone. These economists would tell us that the people writing and enforcing regulations may have reasons of their own -- such as ideology or post-government career plans -- for doing a less-than-stellar job of regulating markets.

But the problem may be more deep-rooted -- and irrational. In a paper (PDF) presented last year, David Hirshleifer, professor of finance at the University of California-Irvine, argues that regulatory policies are often crafted and enforced based on irrational factors such as scapegoating, xenophobia and misplaced ideas about fairness and ideology. He warns, "since the universe of possible tempting regulations is unlimited, the theory predicts a general tendency for overregulation, and for rules to accrete over time like barnacles, impeding economic progress." Because regulations are so often rooted in biases and prejudices, "regulatory responses to perceived problems will often be ineffective."

And speaking of irrationality ... No matter how correct Professors White, Lemieux and Cowen are about the absence of deregulation in recent years and the culpability of bad and excessive regulation, their efforts to defend economic liberty may have little benefit. Hirshleifer adds that prejudices and biases often result in "drastic increases in regulation" in response to market downturns.



Blogger dalmazio said...

Excellent analysis! I must commend you on being able to do what few others have done: seeing past the rabble of hype and cries for more regulation!


March 18, 2009 10:46 AM  

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