Financial Regulation Won't Eliminate Boom Bust Cycle (and the government shouldn't try)

Posted on July 7, 2009 by David Laidlaw 

Market booms and busts have occurred throughout history as rapid advances lead to manic price increases followed by contractions that often destroy all of the wealth created during the expansions. In the wake of these cycles, governments frequently pass sweeping reforms to try to prevent future market crashes. Politicians want to be viewed as decisive leaders responding forcefully to the problems at hand. Following course, the current Congress and Obama Administration are crafting legislation that will solidify the regulatory infrastructure to smooth future investment cycles and stabilize the system.

As with past changes, some of the changes are salutary; however, the vast majority of new proposals will increase costs without helping investors or society as a whole. The main proposal in the new regulatory paradigm is to turn the Federal Reserve into a Systemic Risk Regulator. As envisioned, the Fed’s role would be to oversee the complete financial system, fix weaknesses in the system and possibly to prick bubbles in their early stages before they cause damage to the wider markets and economy.

There doesn’t appear to be any solid evidence that this would work. As regulator in chief of the banking system, the Federal Reserve did not do anything to head off problems with the largest banks in its network. Citi and Bank of America were two of the main culprits in bringing our banking system to the brink of collapse through their insolvency. During the boom, both banks increased their lending to borrowers that could not repay their loans. Both banks also borrowed way more than they could repay without tremendous taxpayer capital injections and subsidies. Finally, both banks maintained toxic assets on their balance sheets that either they created or bought from other banks which eroded their capital bases. The Federal Reserve was already regulating Citi and Bank of America, so how would this type of risk be prevented if the Fed had the power to oversee the whole financial sector when it could not police the largest companies in its own back yard?

Many European countries already use a systemic risk regulator similar to the role envisioned for the Federal Reserve. The United Kingdom’s Financial Services Authority(FSA) already acts in this capacity, yet, it was not able to intervene before Northern Rocks’ failure or before the point when the Royal Bank of Scotland required tens of billions of pounds and was nationalized last year. We believe a Federal Reserve with expanded powers would be no more successful than its European cousins.

Serving as a systemic risk regulator would also confuse the Federal Reserve’s current role to prevent inflation and increase stimulus when economic growth slows. Conflicts of interest could arise if, for instance, a bank deemed “too big to fail” needed low rates to avoid insolvency. However, if the Federal Reserve noticed that low rates were causing inflation, which evil would it chose: raise rates and possibly cause the bank to fail or lower rates and cause inflation?

Philosophically, we do not believe that it makes sense to even try to eliminate booms and busts. Market participants are humans and subject to emotional swings which have great impacts on the markets. The net results of market manias and crashes are often positive and lead to innovations and progress that might not be possible in a more “controlled” economy. For example, during the Technology driven boom, Alan Greenspan opined that the market was “irrationally exuberant” in 1997. If the Federal Reserve had raised rates dramatically at that time to stop stock market increases, it may have choked off the future funding of revolutionary companies such as Google or the build-out of the Internet which has made our economy much more productive and all of our lives richer.

Innovation within the financial sector has led to well-documented problems as far as the risks posed by instruments such as Credit Default Swaps. However, many aspects of our financial lives are better and easier. For example, stock trades are competitive and brokerage costs have steadily decreased since the regulated commission structure was abandoned 30 years ago. Incredible quantities of information are now freely available to anyone with an Internet connection; whereas, in the past, less comprehensive data was only available through information services which cost thousands of dollars per month. Additionally, financial practices have evolved so it is now possible to perform such chores as refinancing one’s home in an afternoon due to streamlined procedures which took much longer in the past.

Some of the regulations which propose to increase transparency are sensible and would help investors and markets uncover problems and thus decrease systemic risk. For example, forcing Credit Default Swaps to trade on exchanges would limit the likelihood of future defaults since the exchanges would eliminate the counter-party risk of having a trading partner default. Simpler credit card sales practices and disclosures would also limit the gimmickry and likelihood that consumers were tricked into entering contracts that they didn’t understand or couldn’t afford. However, a super regulator with wider powers would not be guaranteed to be more effective and would most likely slow positive developments in the financial sector and the economy as a whole.