Monday, March 31, 2008

Bad Economic Policy Leads to Greater Financial Regulation

A case can be made for more regulation of the United States Financial system. With the Federal Reserve now involved with more financial institutions than just the commercial banking system, more tax payer dollars seem at risk and if this is, in fact the case, then rules and regulations should be extended to a wider range of institutions than they have been in the past. Furthermore, the financial environment has changed. The reality of this statement is underscored by the innovations the Federal Reserve has had to introduce over the past six to nine months. An ‘out-of-date’ financial system needs to have its rules and regulations updated.


a question needs to be asked about the role that bad economic policy has played in the financial distress that has appeared over the last eighteen months. The government’s economic policy creates the environment in which the financial system…and the economy…have to perform. A government’s economic policy sets up the incentives that institutions respond to and, therefore, the behavior of the institutions are not entirely their own fault.

People and organizations do respond to the incentive system in place! It is a very competitive world and if you do not respond to the incentives that are ‘out there’ then your competition outperforms you and you lose your position in the marketplace. One can always say that they maintained their discipline within, say, an inflationary environment, but, it is harder and harder to maintain that discipline when others are surpassing you by following policies that are rewarded within an economy that is experiencing inflation. For example, increasing financial leverage tends to benefit companies within an economy that is going through a period of rising inflation.

The economic policy of the George W. Bush Administration created an environment that was not conducive to disciplined financial behavior. And, why should other organizations be disciplined when the Federal Government that does so much to determine the economic environment that everyone else works within is acting in an irresponsible way with respect to its own financial affairs? If the Bush Administration is creating incentives for undisciplined behavior, it is not beneficial, at least in the short run, for others to act in a restrained way.

I would strongly argue that this is not just my conclusion on the consequences of the Bush Administration. Strong evidence that others believed this to be the case comes from the foreign exchange markets. The value of the United States dollar has declined almost continuously over the past six years or so. It is usually the case that the value of a country’s currency declines when market participants believe that the economic policy of the government of that country is irresponsible and can lead to excessive amounts of inflation in the future.

The environment in which this decline in the value of the dollar took place was one of tax cuts that moved the budget of the United States government from surplus to deficit. These tax cuts were followed by a ‘war on terror’ that was not really planned for and that exacerbated the trend to larger and larger budget deficits. Furthermore, the absence of an effective energy policy contributed to the accumulation of wealth in nations and governments around the world. Large holdings of dollars were gathered by other hands that would not always act in the best interest of the United States. Finally, the Federal Reserve System, under the leadership of Alan Greenspan, kept short term interest rates excessively low for approximately three years, thereby helping to underwrite the large and growing Federal deficits.

The international banking community knew that imbalances were growing in the United States economy, but the United States government did nothing about them. The Bush Administration talked about a ‘strong dollar’ but never backed up the talk with actions. Participants in international financial markets became very cynical about the intent of the U. S. President and his administration.

Seven years of such an environment got built into the financial institutions that operated within the United States financial community. It was an environment that did not stress discipline in risk taking and that encouraged being ‘out-on-the-edge’ when it came to financial innovation and competition. The previous thirty years or so had been a vibrant period of creation in the United States and one could argue that because of this innovation, the financial markets became more efficient and served more areas of the economy than ever more. However, as the environment changed, the financial system responded, emulating the undisciplined behavior of the fiscal and monetary policies that were setting the tone for the whole market.

Now, this period in which there was a lack of discipline has ended. The consequences of the incentives created during this time are being felt, not only throughout the United States, but throughout the world. However, the thing that we must be aware of going forward into a new age of regulation is that the financial institutions themselves are not completely at fault. If the ‘bill’ for saving the financial system is a large one that must be assumed by the American people, it is right that they pay this bill for they were the ones that put the Bush administration into office. That is, the legacy of the economic policies of the past seven years will be not only higher taxes, but also a new administration that is ‘strapped’ in what it can do for there will be no room for new programs as an attempt to re-establish fiscal and monetary discipline so that as to bring the financial system back into order. My next post will discuss more fully some of the issues surrounding the potential new regulations that are coming to the United States financial system.
Should the American people have been aware of this lack of discipline? Well, most people I know were continually being shocked by the exchange rates they were faced with when they traveled internationally. “What,” they would say, “I have to pay two dollars to get one British pound? Ridiculous!” And, yet that was the case. Still, little or no concern was raised at the national level about this lack of fiscal and monetary discipline. Maybe the lesson is now being learned…even the United States cannot conduct its economic policy independently of the rest of the world! Let’s hope so!

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