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Deformed Reforms: The New Financial Regulations

By JLP | July 19, 2010

I emailed Dr. Robert Wright, Nef Family Chair of Political Economy at Augustana College SD, and author of numerous books (see post below), to get his take on the financial reform bill that is about to become law. As you can tell from the title of this post, Dr. Wright is not pleased with the legislation. Please take a few minutes to read Dr. Wright’s thoughts and leave a comment with your thoughts or questions and I’ll see if I can get Dr. Wright to respond.

Thanks for another opportunity to reach out to your audience. The last time I posted on your blog, One Nation Under Debt* was gaining traction as the national debt soared under the strain of numerous Bailouts*. This time, my Fubarnomics* is hot off the presses and the U.S. economy looks as “fouled up” (ahem!) as ever. Our construction, higher education, healthcare, and retirement savings industries are as stagnant as ever, acting like huge millstones around the economy’s neck. Alan Greenspan calls this an economic “pause” but I fear the problems run so deep that we’re headed for a Japanese-style stagnation that could last for decades. And I despair that our policymakers in Washington lack the intelligence, knowledge, and incentives to initiate major improvements. All three are needed and the last two are largely lacking.

For example, the financial reform bill about to become law is, like most post-crisis financial regulation, a problematic piece of legislation. As currently constituted, it will not, and indeed cannot, prevent future financial crises. Like many a failed general, Congress has prepared to fight the last war rather than the next one. The legislation will help incumbents up for election this fall by creating the appearance that Congress is “doing something” and by tossing sops to ideologues, mostly on the Left. It does precious little, however, to address the core cause of financial crises, the ability to take one-sided bets.

Almost every financial crisis in U.S. history was preceded by a bubble where the price of one or more assets – sometimes land, sometimes financial securities, sometimes commodities, sometimes all three – soared well above their fundamental value for an extended period. That isn’t supposed to happen in rational markets but it does anyway for a variety of reasons, including leverage. If speculators can borrow on the collateral of the over-valued asset they will do so with alacrity because it allows them to make one-sided bets. If the price increases, they sell, repay the loan, and keep the difference. If the price drops, they give up the asset and walk away.

The question then becomes why do lenders make loans to speculators on such terms? Why, for example, did banks make non-recourse mortgages, i.e., loans where the collateral (the house) backed the loan but not the borrower’s other assets or future income? The answer is another one-sided bet, this time within lenders. In large financial institutions, most compensation is asymmetric, “performance”-based, and tied to peer benchmarks. In other words, employees get big bonuses for exceeding the numbers put up by competitors but don’t suffer losses when things go bad. During bubbles, therefore, they feel pressure to lend freely even if they have reservations about long-term loan quality.

Lenders’ owners (stockholders, partners) sometimes recognize the risks involved in lending to bubble speculators and decide to proceed anyway. Little can or should be done about that. More often, however, stockholders are not aware of the risks they are being exposed to because managers have incentives to hide them. Remember, managers receive enormous bonuses in big years but do not have to pay those bonuses back during lean ones. They therefore want to take on far more risk than most stockholders do, but under our current, watered-down system of corporate governance stockholders have little say in management and very poor information about company operations.

The financial reform legislation really falls down at this crucial juncture.(Like 99.99999% of the population I haven’t read the entire 1,000+ page bill but rather rely here on the Senate banking committee’s final summary.) Instead of providing stockholders with an indisputable right to decide how their employees will be compensated, the new law gives them only a “say on pay” including the “right to a non-binding vote on executive pay.” Compensation now will be decided by committees composed of “independent directors” empowered to hire compensation consultants. That sounds great on paper but fails to capture the complex realities of corporate boardrooms where manager-directors often dominate or co-opt other directors, rendering them a far cry shy of “independent.” To end the long-lived tyranny of the managers, we should return to early nineteenth century rules: no directors should be in management and stockholders should have the final say on everything.

The balance of the new legislation exhibits typical statist thought and assumptions. “The Madoff scandal,” proclaims the summary, “demonstrated just how desperately the SEC is in need of reform. The SEC has failed to perform aggressive oversight and is unable to understand some of the very companies it is supposed to regulate.” Then why reward it with more powers and a bigger budget? Why not tell investors that they are responsible for their own money? That, combined with the empowerment of stockholders discussed above, would work wonders because to obtain funds securities issuers and institutional investors would have to display much more transparency, at least on a selective basis, than they currently do. Such a commonsense reform won’t come to pass, however, as returning responsibility to individuals wouldn’t increase the size or power of the government, Congress, regulators, or corporate lawyers like most of the new law seems well-designed to do.

The new Consumer Financial Protection Bureau, for instance, is supposed to give “Americans confidence that there is a system in place that works for them” by “protecting American consumers from unfair, deceptive and abusive financial products and practices.” That sounds wonderful, but why will the new bureau prove any more adept than the SEC, the DMV, or any other government agency? The law will make it the “one office accountable for consumer protections” but if “accountability” doesn’t include pinching the wallets of the bureau’s employees when they err why will they work hard and smart? Again, I’m left wondering why the government thinks that it is a better protector of American’s wealth than Americans themselves are. It’s one thing to catch, judge, and imprison thieves and quite another to tell individuals that you can prevent theft.

Finally, while I’ve advocated increasing financial literacy for years, I have always thought it best promoted by private entities, like the Museum of American Finance, Dollars & Sense Education, and numerous similar organizations. My fear is that the new bureau will inculcate a flawed, monolithic view of consumer finance much the way that the agriculture department used to push its nearly indigestible food pyramid down Americans’ throats.

As I argue in Fubarnomics, the financial crisis was not caused by market failures alone. The government also played major roles, largely unaddressed by the new law. It stretches credulity, therefore, to think that it makes the American economy or the median consumer any safer.

My comments:

Thanks, Robert. You eloquently voiced what lots of AFM readers and I have thought.

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Topics: Economics | 2 Comments »


2 Responses to “Deformed Reforms: The New Financial Regulations”

  1. BG Says:
    July 20th, 2010 at 7:30 pm

    It’s as if Dr. Wright has been reading my mind. The only point I disagree on is that the government ‘played a major role’. The only role the government played that I absolutely disagree with was bailing out the gamblers who lost.

    Capitalism (with regulation) will and does work, but when we start bailing out people’s losing bets then it’s not capitalism anymore — it’s some kind of zombie corporatism/nationalism that just doesn’t work. It rewards people who take on extreme risk and fail, and punishes those who are conservative and succeed. We have privatized the gains, and socialized the losses.

    As for stockholder rights — I’m looking to Vanguard/Fidelity and the other massive investment houses that own the majority of shares to step in and clean these corps up.

  2. Robert E. Wright Says:
    July 21st, 2010 at 3:57 pm

    Don’t hold your breath waiting for institutional investors to clean up, BG, as they are legally constrained, though not completely prevented, from doing so.

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