Did Lack of Regulation Cause the Financial Crisis?

Bill Moyers recently interviewed William Black (ht Glenn Greenwald), who is a regulator who came to fame for exposing the "Keating 5" Senators for their misdeeds during the Savings & Loan crisis and wrote a book based on that experience called The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry. The interview mostly covers our current financial crisis and is well worth watching.

You may recall that as the crisis initially unfolded, there was a reflexive reaction on the part of many to blame deregulation, without presenting any evidence for that position. Black makes numerous references to a lack of regulation as being responsible for the mess, but does bring up specific examples. Black quite naturally brings with him the bias of a regulator, so it is necessary to examine what he says in order to evaluate his assertions. I have summarized some of his key points below, in the order in which they surfaced in the interview, while adding my own thoughts after each.

  • This crisis was driven by fraud … on the part of mortgage loan originators, rating agencies, investment banks, and AIG.
    • Black attributes the collapse to fraud and equates this with a lack of regulation. However, as Sheldon Richman pointed out in connection with the Madoff scandal, this is a false equivalence. "Dear Ms. Maddow: Why do you call the government's failure to pursue fraud allegations in the Madoff case "deregulation"? Laws against fraud — that is, against the acquisition of someone else's property by deceitful means — have never been regarded as "regulation" or limits on free-market activity. They were simply part of the free market's common-law prohibition against violating person and property. Regulation, on the other hand, consists of government interference with private parties setting their own nonfraudulent terms of exchange in the market. By equating abstention from investigating fraud with laissez faire, you have allowed your ideology to blind you. Maybe this would be a good topic for discussion on your program." In other words, failure to investigate and prosecute fraud is a fundamental breakdown in the rule of law, much as it would be to do likewise for cases of murder or conventional robbery. It is not a characteristic of a free market. If we want to get to the bottom of the problems, as I believe Black sincerely does, we need to be very careful about diagnosing the problems correctly and a prerequisite for doing so is using accurate language. This is not mere quibbling about semantics.
    • It is worth noting that Black emphasizes the malfeasance of the above players, but completely ignores the roles played by the Fed's monetary policy, Fannie, Freddie, and the Community Reinvestment Act. I won't cover them here, as they are well documented by Thomas Woods in his book Meltdown, but will only point out here that they played a crucial role in precipitating this crisis. I am inclined to believe that this represents a blind spot in Black's perspective.
  • The FBI put out a public warning in September 2004 that there was an epidemic of mortgage fraud, which if it were to continue, would produce losses at least as large as the S&L debacle. However, there was a lack of regulation because after 9/11 the Justice Department transferred 500 white-collar specialists in the FBI to national terrorism and didn't replace them. Thus there are now 1/5th as many such agents working on these issues for a calamity which is at least 100 times as big as the S&L crisis.
    • This is clearly a problem but what does it tell us? It tells us that in government, resources will always be allocated on a political basis. After 9/11, it was politically expedient to divert resources being used for investigating bank fraud to fight terrorism instead.
    • Government will always be preparing to "fight the last war." After the Enron debacle, the Sarbanes Oxley Law was instituted at great expense, yet those rules did nothing to prevent the current breakdown. Maybe there is something more fundamentally wrong than simply an administration asleep at the wheel.
  • In 1999, Congress got rid of the provision of the Glass Steagall Act (a post-1929 Crash law) which separated commercial and investment banking, a measure which enjoyed bipartisan support.
    • This certainly constitutes deregulation, but Black does not go on to demonstrate that this development did in fact contribute to the current breakdown. Sheldon Richman has indicated that it did not and I have yet to come across someone who could show that it did.
  • Chairperson of the CFTC (Commodity Futures Trading Commission) Bern attempted to acquire authority for the CFTC to regulate Credit Default Swaps (CDS, the instrument which was the undoing of AIG) but was blocked from doing so by Congress, others.
    • This is as close to a deregulation smoking gun as Black gets. I would concede that some of the problems with CDS might have been mitigated to some degree if the CFTC were given the requested authority. Whether this would have materially impacted the course of events, I am not so sure.
    • That said, the whole incident calls into question the whole premise of the regulatory model. If the regulated industry can control the course of the development of the rules, as was clearly the case here, how can we ever come to rely upon the regulators to act in "the public interest"? This is the whole topic of regulatory capture, or in more colloquial terms, the fox guarding the hen house. And regulatory capture is really a subset of the larger problem we face today, which is government capture.
  • The government did not enforce the Prompt Corrective Action Law, a measure passed after the S&L crisis which mandated closing failed banks. During Japan's financial crisis, our government repeatedly told Japan to use these processes, but Japan did not and had a "lost decade."
    • More government failure. Even when government appears to learn from earlier crises, whether or not those tools will be employed is at the discretion of subsequent administrations. And political considerations will decide this.
  • There needs to be a Congressional investigation to get to the bottom of what happened. Executives from the failed banks need to be replaced and successful regulators need to be appointed, not the same people who got us into this mess.
    • Sure, this is what ought to happen, but it won't unless an angry mob descends upon Washington demanding that they do these things.
    • More likely, to placate us we would get a "Blue Ribbon Panel" appointed by our rulers who will tell us what they want us to hear and will give a slap on the wrist to some of the "bad apples" responsible for this mess while discounting if not entirely ignoring many of the most serious criminals. When all is said and done, they will recommend sweeping new governmental powers to “ensure that a catastrophic financial breakdown will not recur.”
  • These problems were a result of ideologies which swept away regulation. Regulation and law enforcement mean that cheaters don't prosper and allow capitalism to function properly and honest purveyors to succeed.
    • As discussed earlier, free markets DO punish fraud, so if there was an ideology that was responsible for the non-punishment of fraud, it is not a free market one.
    • Free markets also punish reckless behavior by allowing companies and individuals to endure the consequences of their actions, not get bailed out. This is another way that they allow honest and prudent people to succeed.
    • Free markets also allow for open competition which over time will produce better businesses. On the other hand, for example, giving regulatory preferences to certain rating agencies will create a cartel instead, making it more likely for the poor performance of said companies noted after the crash of the Technology Bubble to continue.
  • There is a Dutch saying that it is not necessary to hope in order to persevere.
    • This much I think we can agree on. If more Americans felt this way, we would have President Paul right now, rather than President Obama.
    • While I have criticized some of Black's conclusions, I admire his honesty, courage and dedication.
    • I would love to include Black on a Blue Ribbon Panel to investigate the causes of the crisis and to make policy recommendations, along with others like Ron Paul, Tom Woods, Sheldon Richman, etc. Uh oh, I guess I have fallen back into "Hope" mode.

April 9, 2009

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