Thursday, March 18, 2010

The "Dodd" Financial Reform Bill

Well, there finally is a financial reform bill!

Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System seems to be back in the good graces of the political pros. So much for the independence of the Fed!

The only thing Bernanke seems unhappy about at the present time is that he would like to maintain more regulatory influence over banks that are less than $50 billion in asset size. Otherwise, he seems pretty satisfied.

The important thing is that the Fed and the Chairman of the Fed retain, or even increase, their power.

I have written on the future environment of bank regulation and so I don’t intend to go into that again at this time. This series began on January 25, 2010: see my “Financial Regulation in the Information Age: Part A” (http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a) which was followed by Part B and Part C. Let me just say that I believe that the regulatory structure that Dodd and Congress is attempting to construct is aimed at “fighting the last war” and that the financial system, especially the part composed of large financial organizations, has already moved beyond what the politicians are fighting for. So, Congress is already behind the times.

Even more important, however, is the fact that the underlying cause of the growth in finance over the past fifty years or so, the financial innovation that took place, and the evolution of financial institutions into structures that are “too big to fail”, is not even being addressed. And, if this cause is not taken into account, any regulatory structure that Congress constructs will be doubly inadequate to handle the problems of the future.

Debt finance thrives in an inflationary environment! Need I mention again that what a dollar bill could purchase in January 1961 has declined to the point that a 2010 dollar could only buy less than twenty cents worth of the same goods and services today? The purchasing power of the dollar has declined by more than 80% since the early 1960s.

The inflationary environment that began in the early 1960s bore fruit by the early 1970s and only spread from there. The Gross Federal debt had increased by more than 40% during this time period, the largest peace-time increase in the government’s debt in history. Commercial banks had innovated to the extent that they could get-around any federal or state regulations that might limit their geographic or asset expansion by creating the ability to “manage liabilities” and hence grow to any size that they desired. The federal government had created a novel new financial innovation called the mortgage-backed security that would, in fifteen years or so, result in the mortgage market becoming the largest component of the capital markets in the world.

And, by August 1971, inflation became such a problem that President Nixon froze wages and prices in the United States and removed the dollar from the gold standard. In addition, Nixon appointed a Fed Chairman that underwrote his re-election and promoted the most expansive monetary growth in the post-World War II period to date. By the end of the 1970s decade, inflation was the number one problem in the United States. In 1978, Congress passed a second full employment bill that secured in law the “Keynesian” economic philosophy that the federal government had to achieve high levels of employment in the economy. And, as they say, with two short exceptions, the rest is history.

There is no better environment for debt and the creation of financial innovation than one that is grounded in inflation. With no constraint on the size of financial institutions, almost all of them became liability managers, banks and other financial organizations could grow and grow and grow. Where there were constraints, the environment was such that ways could be found around the constraints. And, since the constraints didn’t work in such an inflationary environment, the politicians and the regulators were even willing to remove or lessen the constraints that were still on the books. Good-bye Glass-Steagall.

Inflation, usually measured in terms of flow statistics like the Consumer Price Index, spilled over into the prices of assets, like common stocks, houses, and commercial real estate. The consumer inflation of the period before the 1990s became the “bubble” inflations of the 1990s and 2000s, and, the music continued to play.

My point is, of course, that no regulatory structure is going to withstand an economic environment in which the value of the currency declines by more than 80 percent over a period of fifty years. And, the last fifty years was a period in which the Information Age was just in its infancy. The major point in my series of posts on regulation that appeared in January was that the ability of financial institutions to innovate in the next fifty years is ever so much greater than it was in the past fifty years. Thus, the hope to “rein in” the financial system is like smoke that will just swiftly drift away into the atmosphere.

If Congress and the Obama administration want to keep a lid on the financial system they need to clean up their own house first. The attempts they are making to re-regulate this financial system, to me, are hopeless unless they abandon the fundamental philosophy that is the foundation for their economic policies. The “Keynesian” effort to keep employment at high levels in the short run hasn’t worked and it will not work in the future. The “Keynesian” effort to keep employment at high levels creates an inflationary bias in the economy. An inflationary bias produces an incentive to take on more and more debt and leverage oneself into the future. This bias is the engine that drives the excessive risk-taking that can come from accelerating financial innovation. This is story of what occurred over the past fifty years.

In conclusion, then, financial regulation is more than just controlling the behavior of “greedy” bankers!

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