Published in the Western Standard (www.westernstandard.ca), June 24, 2009
Obama's Reform: Systemic Danger Once Again
by
Pierre Lemieux
Transactions in securities “are affected with a national public interest which makes it necessary to provide for regulation and control... and to impose requirements necessary to make such regulation and control reasonably complete and effective... in order to... insure the maintenance of fair and honest markets”. The text explains how such intervention is required to face “[n]ational emergencies, which produce widespread unemployment and dislocation of trade... and adversely affect the general welfare”.
Last week, U.S. president Barak Obama presented his plan for financial regulatory reform, but the quotes above are not taken from there. Instead, they come from section 2 of the Securities Exchange Act of 1934, under Franklin D. Roosevelt’s administration. Seventy-five years later, Obama appears to have a similar approach in proposing (and here I quote Obama) “a set of reforms that require regulators to look not only at the safety and soundness of individual institutions, but also -- for the first time -- at the stability of the financial system as a whole”.
This is not the first time a systemic regulatory reform is introduced, we have gone through this before.
The Great Depression started in 1929 and bottomed out in 1933, but economic activity did not return to its pre-depression levels until the Second World War. Government intervention deepened the recession in many ways, whether under President Herbert Hoover or his successor Franklin D. Roosevelt, who arrived in the White House in early 1933. The protectionist Smoot-Hawley Act of 1930 is widely blamed for worsening what could have been an ordinary recession. The U.S. federal government increased taxes in 1932, with similar effects. The same year, it created the Reconstruction Finance Corporation – the Troubled Assets Relief Program (TARP) of the times. It bullied large companies into not reducing wages, thereby worsening and hiding unemployment. A host of controls – in agriculture, finance, etc. – as well as pro-union legislation slowed the rapid economic adjustments that would have been required to escape the recession. And the Federal Reserve System made everything worse by reducing the money supply, as the path-breaking work of Milton Friedman and Anna Schwartz has showed. You have there all the ingredients for transforming a recession into a deep depression.
In fact, Hoover had started the “New Deal” even before Roosevelt coined the term. Just as today, Hoover believed in “ample supply of credit at low interest rates” (although the Fed apparently did not follow), and in stimulus through public works. He boasted that he had “met the situation with the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic.”
The late Murray Rothbard argued that the recession itself was a product of the reckless increase of the money supply in the 1920s. Whether this is true or not, it is difficult to deny that government intervention had much advanced since the beginning of the 20th century. The creation of the Federal Reserve System in 1913 is symbolic of a phenomenon that was everywhere apparent. Between 1901 and 1928, federal expenditures were multiplied more than fivefold.
Herbert Hoover's and Franklin D. Roosevelt’s policies more than doubled federal expenditures between 1928 and 1938. Many of the laws and institutions involved in the housing and mortgage market that started the current mess were created as part of the New Deal, including the Federal Home Loan Bank Act of 1932, Fannie Mae in 1934, and the 1938 amendments to the National Housing Act. Americans (and subjects of other states who have followed American regulatory fashions) are labouring under the Securities Act of 1933, the Securities Exchange Act of 1934, and their constant expansion over time. For example, the Securities Exchange Act has gone from its original 30 pages to 259 pages in 2004.
Note that all this growth in government power did not prevent the current crash.
An urban legend claims that finance and banking have been deregulated over the past few decades. Two American think tanks, the Mercatus Center and the Weidenbaum Center, have been documenting the evolution of federal regulatory budgets since 1960 (see their latest report, edited by Véronique de Rugy and Melinda Warren). Over these five decades – and not counting the current rush to regulation – regulatory expenditures on finance and banking have been multiplied by 12 in constant dollars. Even during the 1980s, the Reagan decade, these expenditures more than doubled.
Two other sorts of government intervention have contributed to the perfect storm at the origin of the current crisis. First, just look at the crime scene: the housing and mortgage market. The past decades have witnessed the continuous stimulation of the residential mortgage market by the U.S. federal government through its mortgage guarantees, its government-sponsored enterprises (like Fannie Mae) which monopolized about half the market, and its legislative encouragement of subprime mortgages for the poor. These policies fuelled risky mortgage securitization by both private and public organizations.
Second, monetary policy probably contributed to the low interest rates until 2004 and, thus, to the housing and mortgage bubble, which was a catastrophe waiting to happen. The growing economic consensus on this is tempered by those who (like David Henderson and Jeffrey Hummel) argue that other factors played a role in the low interest rates.
The disorderly U.S. government intervention after the recession deepened last autumn was not more commendable. TARP, which was originally meant only for banks healthy enough to lend, drifted into a general subsidy bonanza, soon to be buried under a new stimulus program. The initial rescue of AIG was modified three times, until the insurance company was nationalized.
Talking about the current situation, John B. Taylor, of Stanford University, writes that “government actions and interventions caused, prolonged, and worsened the financial crisis.” Milton Friedman, recalls Taylor, is often quoted as saying that “[t]he Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy.” Does that statement apply to the current financial crisis? asks Taylor. He answers, “Yes”.
Why is government intervention so expectedly inefficient in promoting economic growth and stability? The short answer is two-pronged. First, politicians and bureaucrats don’t have the incentives to fix, or not to break, the economy. Second, there is an insuperable information problem, which Nobel laureate Friedrich Hayek’s work put in clear focus: the state (the whole apparatus of government) simply does not have the information necessary to intervene efficiently. The business cycle is a complex phenomenon on which generations of brilliant economists still don’t agree. How could we expect that campaigning politicians and bureaucrats in committees will resolve the problem? How could they, as the 89-page Financial Regulatory Reform document states, get “a focus on identifying whether new trends might be creating risks that would otherwise go unseen”?
Another, more mundane, information problem lurks – this one between government and the citizens. By creating “a new and powerful agency,” Obama wants to help the “millions of Americans who signed contracts they didn’t always understand offered by lenders who didn’t always tell the truth.” Perhaps. Yet, the implicit “social contract” that binds citizens and governments is certainly more difficult to read and understand than any credit card contract. And governments certainly lie at least much as financial firms.
“It is an indisputable fact,” claimed President Obama in presenting his regulatory reform plan, “that one of the most significant contributors to our economic downturn was... the lack of adequate regulatory structure to prevent abuse and excess.” The truth is that a heavy regulatory structure and continuing government interventions existed before the onset of the current economic crisis. Obama also claimed that hedge funds “operate outside of the regulatory system altogether.” This is clearly false. Although hedge funds are less regulated than other investment vehicles regarding registration and disclosure requirements, they are subject to most direct and indirect regulations that constrain trading on stock exchanges, define fraud more and more widely, and govern relations with banks and other financial intermediaries.
“Over the past two decades”, said Obama, “we’ve seen time and again, cycles of precipitous booms and busts.” This is only a half lie, as two mild recessions have occurred between 1982 and 2007, a relatively stable period that has been called “the Great Moderation.” The President’s apparent desire to regulate the business cycle out of existence points to the sort of hubris that Friedrich Hayek feared might destroy civilization: this idea that government can understand and control everything, including complex phenomena like the business cycle.
Obama’s financial regulation plan is mistaken if only for one reason: it has been tried before and it did not work. Obama’s “free and fair markets” are not much different from Roosevelt’s “fair and honest markets”: both expressions are empty words to justify more government intervention. Economic theory suggests, and history illustrates, that the worst systemic risk we face is the state itself.