Congress, Bernanke Should Know That Regulators Aren’t Soothsayers
Speaking to economists earlier this week, Federal Reserve Chairman Ben Bernanke rebutted the argument that easy money caused the housing bubble. “The best response to the housing bubble would have been regulatory, not monetary,” Bernanke concluded.
Fair enough — but the regulatory philosophy that Congress is following, with Fed support, is the same line of thinking that got us into this mess: the idea that regulators can prevent financial failures by assessing risk from the top down.
Instead, regulators should make the economy better able to withstand impossible-to-predict financial failures. Then, market participants will judge risk from the bottom up — knowing they won’t get a bailout if they’re wrong, because the economy can survive their failure.
We learned in the 1920s what Bernanke is saying now: that monetary policy is no substitute for financial regulation. Back then, the government had just one way to dampen financial excess: the Fed. But when the Fed tried to quench a stock fever in 1928, it had to raise interest rates for everyone, harming the economy and still failing to cool overheated stock investors.
That experience showed that there is no such thing as a Goldilocks interest rate — one that’s low enough to encourage healthy lending but high enough to discourage excessive speculation.
In the Depression’s aftermath, President Roosevelt and Congress understood a truth that Bernanke repeated on Sunday: “Monetary policy is ... a blunt tool, and interest-rate increases ... sufficient to constrain the bubble could have seriously weakened the economy.”
So FDR and lawmakers armed regulators — the Fed and the new Securities and Exchange Commission — with more delicate instruments, including the power to impose clear, consistent limits on speculative borrowing. These limits rightly didn’t prevent investors from making colossal mistakes, but they did cushion the economy from the effects of such mistakes.
The borrowing limits meant that investors in stocks and other financial instruments, while free to take risks, were not free to borrow so much that their errors would bankrupt the financial system. Regulators also won the power to impose disclosure rules on financial-instrument trading, so that people had a fair idea of where risks lay, muting panic in a crisis.
These rules worked then and still work today. When the tech bubble burst in 2000, people lost money on stocks, but they didn’t leave behind so much debt that they bankrupted the lending system.
And when the investment bank Barings bankrupted itself in 1995, it didn’t take the rest of the financial industry with it. Global investors knew that Barings’ derivatives trades had been subject to rules and debt limits that protected the economy from its failure.
Applying the same old principles to new institutions would have averted the worst consequence of the current credit crisis: the bailouts that threaten public faith in free markets.
Requiring homebuyers to make a 10% or 20% down payment to purchase a house, for starters, would have had the same effect as margin requirements do for stocks. Buyers wouldn’t have had enough cash in hand to keep up with bubble prices; the result would have been a smaller bubble.
And when that bubble burst, homeowners would have had their own money in the game, reducing their incentive to walk away from their homes and bankrupt their lenders. If such rules had been in place, the Fed would not have to agonize, as Bernanke did in his remarks, over why its efforts to rein in instruments such as adjustable-rate mortgages “came too late.”
Fancy mortgage structures were not the problem but the symptom. The world’s most highly educated, highly paid financial minds devised them to help insanely indebted borrowers pretend, even for just a few months, that they could afford their mortgages. The true problem was that people were borrowing so much to speculate on their own homes.
The principle holds not just for homebuyers but for financiers. If regulators had properly governed derivatives such as credit-default swaps, AIG couldn’t have made $500 billion in promises without putting consistent cash down and clearing its trades on exchanges.
AIG could have failed, because its failure wouldn’t have endangered the rest of the economy. Investors would have known where the risk lay, and known, too, that there was a set level of cash down to cover some losses. They wouldn’t have panicked and pulled their funds indiscriminately from the financial system, necessitating a bailout.
Though Bernanke understands that regulatory, not monetary, policy can help us avoid another crisis, he still hasn’t embraced the correct approach. Instead, the chairman says we need “smarter, better” regulators, and supports lawmakers’ current efforts to create a “systemic-risk regulator.”
Bernanke voices the new Washington-and-Wall-Street conventional wisdom: that the crisis happened because regulators were responsible for monitoring individual companies and markets, not the entire financial system. Bernanke and Congress are confusing “systemic” with “omniscient.”
The financial system failed not because regulators were stupid or because they lacked discretion to act — and if the Fed wasn’t thinking about how things like trillions of dollars in mortgages could affect the entire economy, it should have been.
The system failed because regulators thought they — and the industry wizards they oversaw — were so smart that they could predict the future, and regulators enjoyed discretion to act on that belief.
Regulators thought that Washington could exempt new speculative markets from old limits. In 2000, the Fed willingly surrendered its power to regulate credit-default swaps. Global regulators also decided for themselves which investments were perfectly safe v AAA-rated mortgage securities — and which weren’t.
They based their borrowing limits on these subjective assessments, making the economy vulnerable to a colossal central-planning error. Since an unforeseen mistake seemed inconceivable, no consistent rules were necessary to protect the economy from such an event.
Only by returning to a regulatory philosophy that allows for the unforeseen can Washington reintroduce the only systemic-risk regulator that matters: market discipline. Millions of investors can monitor the financial system better than Washington can, but only if they operate under the credible threat of failure.
Such discipline is lacking now. Lenders know that big or complex financial companies are “too big to fail,” largely because the firms and their customers face no consistent constraints on speculation.
Bernanke — and Congress — should understand that creating a systemic-risk regulator would do the opposite of introducing market discipline. It would maintain the illusion that big government and big finance can predict and prevent the unexpected.
This piece originally appeared in Investor's Business Daily
This piece originally appeared in Investor's Business Daily