New Rules Aren't Enough

The Obama administration's proposal for reforming financial regulation
has many useful features. In particular, the proposed consumer
financial protection agency likely would have prevented many of the
worst abuses in the subprime market over the last decade, as well as in
other areas of consumer lending.

Other measures, like requiring
that standardised derivatives be traded as clearing houses and that
hedge funds register their interests with the Securities and Exchange
Commission are positive steps towards modernising regulation, although
they do not go far enough.

The
US Treasury should be trying to standardise all derivatives and have
them exchange traded to maximise transparency. There also should be
increased public disclosure of hedge fund dealings. But, these are not
the biggest flaw in the administration's regulatory proposals. The
biggest flaw is that they help to support the view that the main
problem was inadequate regulations, rather than failed regulators.

The
basic story of this crisis was not that the regulatory authorities
lacked the ability to rein in this disaster before it was too late.
Rather, the regulators - most importantly the Fed - opted not to use
their power to rein in the housing bubble.

The Fed had ample
tools at its disposal to burst the housing bubble before it expanded to
such a dangerous size. To start, the Fed could have tried just
providing information. First, Alan Greenspan could have devoted his congressional testimonies and other public appearances to warning about the housing bubble.

These
warnings would include both a careful description of the evidence for
the bubble (with tables and charts) and a detailed account of the
damage that would be caused to both the economy and the financial
sector from its collapse. The Fed could have also committed its staff
of thousands of economists to detailing the case for a housing bubble
and drawing out the implications for various regions and sectors of its
collapse.

If Greenspan had followed this route, rather than
insisting that there was no bubble, it is likely that it would have
been sufficient by itself to burst the bubble. No major financial
institution can simply ignore the Fed, and there was no plausible
response to the argument showing the existence of a housing bubble.

If
talk proved insufficient, the Fed should have used its regulatory
authority to clamp down on many of the bad loans that were feeding the
bubble. It eventually did issue guidelines that would have precluded
many of these loans, but not until the middle of 2008.

Finally,
if necessary, the Fed should have raised interest rates until the
bubble burst. This would have been undesirable, since it would slow
growth and raise unemployment, but it still would have been better than
letting the bubble grow and create the basis for even more pain later.
And the story of the crisis is the story of a collapsed housing bubble.

The discussion of financial issues has largely worked to hide
the centrality of the housing bubble to the crisis. If there had been
no credit default swaps, collateralised debt obligations or subprime
and Alt-A mortgages but the housing bubble had still grown to $8tn, we
would be in pretty much the same economic situation that we are in
today.

Residential construction would have collapsed due to a
huge glut in the housing market, and consumption would have plunged as
a result of the loss of $8tn in household wealth. The financial
problems created by failed regulation do complicate the picture, but
the fundamental picture is a very simple one of a collapsed bubble
causing demand to plummet.

Politicians and regulators have a
direct interest in portraying the crisis as being the result of an
inadequate regulatory apparatus rather than failed regulators, because
failed regulators should get fired. However, by not holding failed
regulators accountable, this reform proposal is setting the grounds for
the next crisis.

Even a perfect regulatory structure will not
work if the regulators do not do their job. They will not have an
incentive to do their job if there are no consequences for failure.

In
this case, we have seen the most disastrous possible regulatory
failure. This is like a drunken school bus driver who gets all his
passengers killed driving into oncoming traffic, and no one is held
accountable. The message to future regulators is, therefore, to simply
go along with the powers that be (ie the financial industry), and you
will never suffer any negative consequences.