Some Call It ObamaCare for the Financial Sector | HughHewitt.com | 04.05.10

Having taken over the auto industry and the health care industry, last week Washington turned its attention to securing its grip on the full sweep of American financial institutions.

Last year’s and this year’s bailouts had given the government a stake – supposedly passing – in a number of commercial banks.  The reforms that Congress is now considering would give the regulators arbitrary sway over all large financial service firms – not just commercial banks but investment banks, insurance companies, hedge funds, everything.

The reason given, of course, is to protect against so-called systemic risk.   If the government deems a major financial institution “too big to fail” and regards its condition as inviting failure, it will have the option of breaking up the offending giant.

American Enterprise Institute senior fellow Peter Wallison (he was also White House counsel to President Reagan) has noted that this legislation will signal to the markets that the government stands behind these firms.  The result will be favorable rates of borrowing, giving America’s largest banks a government subsidized price advantage over smaller ones.

It takes little sophistication to see that the advantage will come at a cost.  The banks will have to accept the policy priorities of the White House and leaders in Congress, particularly of the oversight committees.  In recent years, these quarters have favored – actually demanded – bank lending to the housing sector.  Despite the crisis, they still do.  In future years, their fancy could turn to dying industries like automobile manufacturing, or to the high tech flavor of the day, or to major contributors to their campaigns, or to those that play ball with preferred constituencies, such as the unions, to the detriment of those who don’t.

Yet as Mr. Wallison points out, the rationale for this overhaul is mistaken, or put less politely, bogus.  The idea was that the financial crisis had been “caused by deregulation.” But, he says, “The banks, which were [the institutions] in the most trouble, are the most heavily regulated sector of the economy….”

And what evidence is there that more regulation can actually improve things?  As Mr. Wallison notes, “[T]he central element of the administration’s reforms was to give more power to the Federal Reserve…. The Fed had been regulating the largest banks and holding companies for 50 years… yet it failed to see the risks they were taking or the impending danger.”

Any number of economists has concluded that the heart of the problem was the government, not the nation’s financial institutions.  The crisis was the almost inevitable product of the framework of mandates and incentives that the government imposed on the banks (specifically the demand for subprime lending and Fannie Mae and Freddie Mac’s readiness to pick up the paper), together with lurching Federal Reserve policy that, as Stanford and Hoover scholar John Taylor has argued, went from too loose for too long to too tight too quickly.

Whose idea was it anyway that regulators will see the next panic coming any better than they saw the last one?   The so-called government experts went to the same schools as the bankers and other private players, look at the same data, and employ the same analytical tools.

There will always be outliers, those who had a moment of insight or luck and predicted the market swing correctly, but it is unlikely they will be in the government, or if they are there, that they will be heard.  Government operates – must operate –by consensus.  But the need to work by consensus is one reason no central bank and no regulator anywhere in the world anticipated the crisis.  If Washington takes responsibility for avoiding systemic crises, the agencies involved will necessarily go to where they sense the consensus, which will be to resist the new, the different, the innovative.  It is hard to imagine any move more fatal to our financial sector.

But even if agency incentives and organizational structures and norms were perfectly suited for the task, identifying systemic risk would remain a fool’s errand.  I was forced to face this truth several weeks ago, while attending a conference that the Pacific Research Institute organized in Newport Beach.  The question of the day was “How to Put the Gold Back In the Golden State,” in other words, how to fix California and its government.  The presentations were impressive.  But the biggest surprise of the day revolved around the impact of local land use regulations on the national and global economies.

California, parts of the Northeast, the Northwest, and Florida have long had highly restrictive – so-called “smart use” – regulations, restricting the building of new homes. Virtually all the rocketing up and crashing down in American real estate values was confined to “smart use” markets.  National monetary and regulatory policy combined with these regulations to fuel a number of local housing bubbles that, thanks to the global financing of the US housing sector, almost destroyed the international economy.  [a summary of this dynamic is here ]

Both Paul Krugman on the Left to Thomas Sowell on the Right have made this point, but how likely is it, how plausible that any players – regulators, central bankers, or private l=players of any stripe would see in advance the catastrophic capacity of local regulations virtually invisible to all but those who are looking for them?

The will to power is running strong in Washington these days.  Foolish hubris is in the saddle as rarely before in our history. Peter Wallison has called the financial regulatory overhaul legislation “Obamacare for the financial system.” He was being way too kind.