I recently argued that the GOP made a huge mistake in removing cost controls on Medicare. This will make it easier for the medical industrial complex to loot trillions of dollars from the Treasury. Another example of crony capitalism posing as deregulation may be playing out in the financial sector. Here’s Forbes, from an article advocating the removal of Dodd-Frank:
Last year, I included Dodd-Frank in a list of the five costliest financial regulations of the past 20 years. Since 2010, the legislation has undeniably had a negative effect on the banking industry, driving dozens of institutions to ruin and giving borrowers far fewer options. . . .
Support for Dodd-Frank is waning more and more. Both former Federal Reserve chair Alan Greenspan and billionaire investor Warren Buffett have come out strongly against it, with Greenspan saying he’d love to see the 2010 law “disappear.” For his part, Buffett believes that, as a result of the law, the U.S. is less well equipped to handle another financial crisis, as Dodd-Frank stripped the Fed of its ability to act.
Case in point: When now-defunct investment bank Bear Stearns was headed for failure 10 years ago this week, the Fed arranged an emergency loan of nearly $13 billion routed through JPMorgan. It also agreed to purchase $30 billion in Bear assets. But now, because of Dodd-Frank, such assistance is illegal since the law stipulates Fed lending must be broad-based and not directed toward a single institution.
A bit later the article poses this question:
So what lessons can we take away from Bear?
I kept reading, hoping for some recommendations for changes in public policy to avoid a repeat of 2008. After all, surely no one (on either the left or the right) can believe that bailing out big investment banks that have behaved recklessly is a good thing. And yet the article concludes with absolutely no discussion of how public policy could be improved to makes this sort of bailout less likely.
In the end, all we have is a call for “deregulation” (i.e. removal of Dodd-Frank) so that there will be no legal barriers to government bailouts of big investment banks.
Sometimes it seems as though in modern America there are only two choices on offer, statism and crony capitalism. There is no political party advocating actual free market capitalism.
PS. Just to be clear, I’d love to see Dodd-Frank completely abolished, if combined with a policy of removing government protections from the financial system. But as long as we have the GSEs, FDIC, TBTF, FHA, etc., then “deregulation” is often just a cover for crony capitalism.
READER COMMENTS
Mark Z
Apr 7 2018 at 4:36am
It is likely that the author believes that either A) the banks shouldn’t have been bailed out and that the financial sector would’ve recovered or B) that even with TBTF, Dodd-Frank still causes more harm than good. It’s possible (I’d say likely) that deregulation may be a net improvement, even if imperfect.
There’s also only so much political capital to expend at a given time. Statists created the status quo piece by piece, via a gradual fait accompli: throttle markets with regulation and barriers to entry, creating monopolies and oligopolies; then later use the monopolies and oligopolies as justification for price controls. Perhaps the only way to get rid of them is piecemeal as well: get rid of the price controls, and when prices balloon, this will give the impetus to eliminate the regulations creating the perceived need for price controls.
BC
Apr 7 2018 at 8:58am
Are bank bailouts inherently necessary as long as we want to subsidize housing through government guaranteed mortgages? What I mean is there seems to be three policy options for housing: (1) Don’t subsidize housing, (2) Subsidize housing transparently, e.g., cash transfers to home buyers, or (3) Subsidize untransparently, e.g., lower mortgage rates by guaranteeing mortgages. We seem to have chosen (3).
As long as the government wants banks to lend to home buyers at below market interest rates, doesn’t there have to be an implicit or explicit promise to bailout lenders when borrowers default? Why else would lenders agree to lend at below market rates?
MikeP
Apr 7 2018 at 6:11pm
There is an option (4): require 20% down on any below market rate mortgage.
That (a) takes the housing crash risk off the banks and (b) reduces the speculators using below rate mortgages.
And it used to be the implicit rule. It is the removal of this rule that is most responsible for the housing crisis.
Alex
Apr 7 2018 at 7:03pm
“Sometimes it seems as though in modern America there are only two choices on offer, statism and crony capitalism. There is no political party advocating actual free market capitalism.”
But this has always been the case everywhere in the world. The reason is that both statism and crony capitalism concentrate big gains on a small number of people and spread small losses on a big number of people. At least in a democracy there is some limit to this to some extent, but the special interests will always be there looking for an opportunity to milk the system.
Mark Z
Apr 7 2018 at 7:20pm
MikeP,
The political problem there, however, is that the very same people who generally oppose deregulation would also probably oppose such a regulation as the one you propose because it would ‘make housing less affordable.’ And that contradictory mindset is apparent in Dodd-Frank, which simultaneously seeks to punish banks for being too frivolous in lending (by making it easier for borrowers to avoid having to pay back loans on the basis that the bank never should’ve given them in the first place) while at the same time making banks more liable to penalization for *not* approving loans to people who (according to regulators) deserve them.
Kevin Erdmann
Apr 7 2018 at 7:38pm
I just don’t get this focus on the GSEs and FHA. FHA was extremely countercyclical, Ginnie Mae securities were never part of the panic, and the low risk means yields are low, so there is no subsidy to finance. What exactly is the complaint?
The GSEs were also countercyclical, their borrower quality was rising during the boom, if anything. And they were moving into markets in 2007 when we should have wanted them to. And, once the government stopped horsing around with the question of whether they would back GSE securities, they also became a safe haven. If the federal government had only taken advantage of that to encourage mortgage lending through the GSEs in 2008 and after, most of the post-crisis damage would have been averted. And, even the way they were managed pro-cyclically, they have churned out billions of dollars of profit for the federal government. And it was concerns about crony capitalism and public distaste for it that caused the GSEs to be procyclical, in contrast to the FHA, because any countercyclical lending would have benefitted shareholders, and the one question everyone demanded an answer for from Hank Paulson when he was talking about public support of GSE debt was that they wanted assurances that the equity holders would eat it.
The GSEs had much lower default rates than either privately securitized loans or loans held by banks.
And, the benefit to housing amounts to about 0.25% in mortgage rates, which is insignificant compared to other housing subsidies.
I’m as opposed to crony capitalism as anyone, but I don’t think this is a very good case for its problems.
Alan Goldhammer
Apr 8 2018 at 7:40am
I’m in agreement with Kevin Erdmann’s comments on the GSEs and I’m interested in whether Mnuchin and Congress will finally end the ‘illegal’ confiscation of Fannie and Freddie profits that have been going on for several years now (big disclosure: my retirement account holds a mutual fund that has rather large holdings of Fannie and Freddie preferred stock).
The debt to the Government has long since been paid off but both organizations are not being allowed to use the profits to build up capital as they should be doing. Maybe this is a good example of “government run crony capitalism?”
Antischiff
Apr 8 2018 at 9:45am
Dr. Sumner,
Do you think the same principle applies to the recent corporate tax rate cut? I accept most arguments for cutting the rate, but if those arguments apply to cuts, why such a modest cut, in effective tax rate terms? Why not eliminate the corporate income tax?
Am I too cynical in thinking that large companies that currently pay zero income tax due to loopholes want some level of corporate taxation for some of their competitors?
Also, perhaps part of the reason for such a modest rate cut was that Republicans didn’t want the shock of their deficit increases to be quite so bad.
Scott Sumner
Apr 8 2018 at 6:55pm
BC, Of course the problem is that we should not want to encourage home mortgage borrowing.
Mike, Good point.
Kevin, I’m not sure the GSEs were countercyclical–didn’t they cut back in 2009?
In any case, the main concern is not the cyclicality, but the way that moral hazard encourages excessive risk-taking
Alan, I’d abolish the GSEs.
Antischiff, There was some crony capitalism in the recent cut, but also some useful reforms.
Kevin Erdmann
Apr 8 2018 at 8:46pm
The GSEs were countercyclical in 2004-2005. How much of that was due to arbitrary regulatory pressure. But, they lost a ton of market share in 2004 and 2005. They were beginning to grow in 2007, and they took a lot of heat for it.
Then, yes, after conservatorship, credit standards were tightened sharply.
I agree that the private/public setup is awkward, but it just seems strange to make a case of this when the GSEs seem to have been, by far, the least problematic source of disruption in the mortgage market.
I thought the main issue here was that risk-taking supposedly caused the panic and the cyclical disruptions, so they both seem to be parts of the same issue.
I’m not sure what the moral hazard problem is. The basic GSE model uses 20% down payments, which basically create risk-free securities. As far as I know, with any of the public mortgage conduits, any mortgages that don’t meet that standard have to be covered by mortgage insurance or some form of credit protection, so that credit risk has a cost.
Scott Sumner
Apr 8 2018 at 10:25pm
Kevin, It’s not enough to say something is countercyclical during 2004-5. For the term to have any meaning, the time series must be evaluated over many business cycles.
The GSEs were bailed out in 2008–that’s the moral hazard problem
Kevin Erdmann
Apr 9 2018 at 4:37am
The only investor that received additional cash paybacks because of the “bailout” was the federal government.
Scott Sumner
Apr 10 2018 at 9:52am
Kevin, Isn’t that also true of TARP? Was that not a bailout?
Matthew Waters
Apr 10 2018 at 4:26pm
“But as long as we have the GSEs, FDIC, TBTF, FHA, etc., then “deregulation” is often just a cover for crony capitalism.”
Sorry that I harp a bit on it, but the discount window is very much underemphasized here.
Most people would be pretty how much the Fed is antithetical to a true free market. Ron Paul harped on a gold standard, but really the gold standard has little to do with it. The 1913-1933 Fed still boiled down to crony capitalism, even though dollar was convertible to gold and minimum gold reserves were 40%.
At its core, the financial crisis was around a non-Fed banking sector that had risen up. Prime dealer and commercial paper weren’t called bank deposits, but they were bank deposits. Before the Fed, banks would suspend withdrawals. With the 2007-08 shadow banking sector, the Fed had to expand the discount window to commercial paper and provide unlimited deposit insurance for money market funds.
Matthew Waters
Apr 10 2018 at 4:38pm
(Sorry to harp again)
Also, I would really like a true free market (no discount window, no FDIC, GSE’s, etc.) for finance. BUT there has to be robust concrete steppes below the zero-bound.
I would like the concrete steppes to have wide acceptance among at least economists, such as the helicopter money proposal from Bernanke’s helicopter money paper. For Japan, it was unlimited tax cuts financed by QE.
Sorry, I just don’t like the reliance of expectations of Market Monetarism. A truly deregulated financial sector will very well have financial crises, as the pre-Fed Panics showed.
If it’s not commonly accepted that the NGDPLT is robust enough, then the banks can very well come for bailouts. Even if the statutes have absolutely zero framework for bailouts, they could possibly get things passed. Especially if the NGDPLT framework actually *isn’t* robust enough at the zero-bound and banks can credibly say a financial system collapse will lead to large unemployment.
Matthew Waters
Apr 10 2018 at 4:50pm
Kevin,
The GSE’s were bailed out in 2008.
In the 2000’s, the GSE’s benefited a lot from paper profits as they got clearance to “compete” with private mortgage lenders. Freddie Mac got into the non-conforming securitization business. That meant an “inventory” of mortgages being securitized.
It would be interesting to see the costs of conforming loan defaults vs GSE fees for insurance. 2006 and 2007 vintage conforming loans still had a 10% default, probably from people walking away from underwater mortgages. Even with 20% down, prime mortgages are hardly “risk-free” in the event of a large price decline.
https://www.chicagofed.org/~/media/publications/profitwise-news-and-views/2010/pnv-aug2010-reed-final-web-pdf.pdf
Scott Sumner
Apr 10 2018 at 5:50pm
Matthew, You said:
“A truly deregulated financial sector will very well have financial crises, as the pre-Fed Panics showed.”
Just the opposite. The pre-Fed system was heavily regulated, and those regs caused the panics. Canada was less regulated, and far more stable.
Matthew Waters
Apr 10 2018 at 8:37pm
“Just the opposite. The pre-Fed system was heavily regulated, and those regs caused the panics. Canada was less regulated, and far more stable.”
The Canadian government limited the charters though. Canada limited competition going back to the 1800’s, when Bank of Montreal was given a monopoly on promissory notes in early-1800’s.
So Canadian banking doesn’t actually look very deregulated to me. The limited charters worked to limit competition, but the existing competitors also have more reason to not upend the system. That’s why they had private bailouts. Equivalent US clearinghouses did not work as well.
Kevin Erdmann
Apr 10 2018 at 10:35pm
Scott,
The GSE takeover was more like if a solvent firm was in technical violation of a covenant on some bonds and the bondholders forced them into bankruptcy over it.
The opening words of Chapter 1 of Paulson’s book are, “Do they know its coming, Hank?” President Bush asked me.
“Mr. President,” I said, “we’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”
That was how he described the takeover. It was over the objections of management. And, they only broke below their capital limits because the treasury forced them to write down their tax assets, which were reversed a few years later when the GSEs became very profitable again.
The GSEs never needed cash.
Now, at the heart of this issue is the federal guarantee of the bonds. They were always treated as if there was a guarantee because what would the point be of requiring regulatory capital limits if the government isn’t going to back the bonds if the capital limits are triggered? There is no functional way for that setup to work if the government isn’t prepared to cover the bonds if they use a regulatory standard to take them over. So, I suppose there is a counterfactual where the government announced that they would not guarantee the bonds, then spent the next 3 months engaged in horribly destabilizing monetary policy, and followed that up with a decade of hyper-pro-cyclical lending controls. And, in that counterfactual the GSEs might have eventually collapsed so hard that they would have become insolvent.
But, consider that their foreclosure rates were quite low, and when the Fed did tank the economy, long term bond rates declined sharply, so after late 2008, the GSEs had very high interest rate gains on the MBS they held on their books, which they could have sold if they needed cash. So, the counterfactual would have had to have been so bad that a temporary panic in GSE MBSs would have countered a double-digit gain on interest rates.
Matthew Waters
Apr 11 2018 at 4:10pm
Kevin,
The GSE’s today will soon need $5 billion of taxpayer funds soon.
MarketWatch
The 2008 bailout had a lot of cash infusions, with both MBS purchases by the Fed and Treasury and $14 billion of equity purchases by Treasury.
The decline in interest rates itself is also due to failure of monetary policy. So, with the counterfactual of no deep recession, it’s far from clear that the GSE’s would have remained solvent after 2008.
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