Friday, December 17, 2010

America Must Start Again On Financial Regulation

Henry Kaufman, the Wall Street economist who formerly worked and gained his reputation as “Dr. Doom” at Salomon Brothers, Inc., has an op-ed piece in the Financial Times that raises a point that should be considered. The title of the article: “America Must Start Again On Financial Regulation.” (

Kaufmann’s basic point is that the Dodd-Frank Act “enshrined” the domination of big institutions in our financial system.

That is, the Dodd-Frank Act achieved just about everything it didn’t want to happen.

But, to be fair, the Obama administration efforts, not just in regulation, but also in its conduct of monetary and fiscal policy, has done about everything it can to achieve just the opposite of what it wanted to do.

And, as Ben Bernanke, the chief economic spokesman for the Obama administration has pointed out, the focus is still on unemployment and the means to bring unemployment down. The beat goes on, or the image Charles “Chuck” Prince, the former CEO and chairman of Citigroup, gave us was that “the music must keep on playing.”

For almost 65 years, the United States government has attempted to achieve something that it cannot achieve, “full employment.” This objective of the United States government was written into law, first in the full employment act of 1946 and then in the Humphrey-Hawkins full employment act of 1978.

In 1968, the economist Milton Friedman showed us that the government’s fiscal and monetary policy cannot achieve full employment. Friedman’s work, along with that of Edmund Phelps, another Nobel-prize winning economist from Columbia University, highlighted the insight that a government that brings about greater inflation cannot permanently reduce unemployment below a “natural rate of unemployment” by doing so. Unemployment may be temporarily lower than this “natural rate”, if the inflation is a surprise, but in the long run unemployment will be determined by the frictions and imperfections of the labor market.

Still, the Federal Reserve and other governmental agencies seem to act as if there is a trade-off between inflation and unemployment, a trade-off commonly called the “Phillips Curve.” Former Federal Reserve economist Ethan Harris confirms the use of the Phillips Curve in current analysis within the Fed in his book “Ben Bernanke’s Fed: The Federal Reserve after Greenspan.”

As a consequence, the United States government has followed an explicit policy of credit inflation since the early 1960s. The gross debt of the United States government has increased by more than a 7 percent compound rate of growth since 1960. This, and the accompanying monetary policy, has resulted in a massive increase of debt in the private sector accompanied by a substantial increase in risk taking. The environment has been optimal for the production of financial innovation and the massive growth of the financial industry and financial institutions.

And, everything that the federal government seems to do just further contributes to the growth of financial institutions and the growth of federal debt.

The question needs to be asked, “Why do the financial giants on Wall Street need to lobby the federal government?” One could make the argument that the federal government has basically been under-writing the growth of the financial industry and the proliferation of financial innovation for much of the last fifty years.

Maybe the efforts of the financial giants on Wall Street to “cry wolf” every time the federal government talks about regulating or re-regulating the finance industry and further lobby the federal government is just a cover.

The biggest financial institutions are doing just fine, thank you. But, they don’t want you to know it.

Many of my posts over the last year and one half have discussed the fact that the “movers and shakers” in the financial industry have come out just fine. As Kaufman asks in the above mentioned article, what happens when a large financial institution gets into trouble? The answer he gives: the only institutions that can absorb a large, troubled financial institution is another large financial institution. If Bear Stearns goes down, JPMorgan Chase picks it up. If Merrill Lynch goes down, Bank of America picks it up. The large financial institutions just get larger.

Regulation is not useless, but the misled efforts of the Congress to regulate the financial industry often overshadow the good that regulation can do. Unfortunately, Congress, in attempting to re-regulate the finance is primarily fighting the “last war”. This is always the “wrong war”.

The new regulatory environment is basically “out-of-date” on arrival. I have argued in post-after-post that the Dodd-Frank Act is a bill that is, by-in-large, irrelevant because the largest commercial banks had moved well beyond the legislation by the time that the legislation passed.

To me, the federal government needs to focus on three things going forward with respect to economic policy and financial regulation. First, the federal government needs to get its focus off of short run efforts to achieve full employment in the economy. It cannot be done and the credit inflation that follows only creates problems that must be dealt with later, as we have been dealing with the aftermath of fifty years or so of credit inflation. To reduce un-employment and under-employment, policies must be put in place that take a longer time to achieve desired results, but the results are longer lasting and more consistent with current market needs. However, this is hard for politicians to do.

Second, the government must work to obtain greater openness and transparency in the financial markets. In this information age, more and more information is readily available and should be available on a timely basis. If the Wikileaks episode shows us anything it is that in most cases it is very difficult to keep information. One would think that organizations, including financial institutions, would want to get out “ahead of the curve” with respect to providing information to the world by advocating more and more openness and transparency of their own data. If they don’t, the message is that someone else will provide the openness and transparency. Let’s “open up” in a voluntary and well-thought out way.

Third, create regulatory efforts that use market based early warning systems, like the one proposed by Oliver Hart and Luigi Zingales. (See my post In this information age, old-style regulation is ineffective if it is of much use at all. A lot of people are really going to have to re-think the whole regulatory environment.

The bottom line is that it appears as if we are getting “more of the same.” The only thing Bernanke knows is how to throw spaghetti against the wall. (See But, more of the same is more and more emphasis on unemployment and the provision of liquidity to the banking system. This is the short-sightedness that Milton Friedman warned us all about. I guess fifty years of economic policy failure is not enough of a lesson.

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