Fixing the financial system so that it doesnt blow up the economy again isnt hard. But complex solutions help Washington and the “too-big-to-fail” financial firms maintain the status quo -- and make future problems worse.
The administration and lawmakers are giving us pretend ways to fix finance. The latest came Tuesday from Senate Banking Committee Chairman Chris Dodd -- a 1,136-page plan for bureaucratic “reform,” plus new bureaucracy.
Wed get a “Consumer Financial Protection Agency” to police things like mortgages. Wed get an “Agency for Financial Stability,” which would supposedly stop catastrophic risks, like AAA-rated mortgage securities, before they explode.
Yet these “solutions” dont address what went wrong leading up to the crisis. That diagnosis is simple: Over 25 years, finance became immune to market discipline -- starting with the first too-big-to-fail bank bailout in 1984.
Lenders to big banks -- and, later, to smaller firms -- could expect government bailouts. So the lenders lent huge amounts without caring what the banks did with the money -- mostly, lending it in turn (via various complicated structures) to anyone with a pulse.
Why did lenders think that they could rely on bailouts? Because financial firms, with government help, made the system unable to withstand the inevitable failure of individual firms, so that government bailouts were necessary.
But we know how to create a system that can withstand individual failures; we did it during the Depression.
First, limit debt. Depression-era rules forbade anyone, whether a bank or a person, from borrowing more than half the price of a stock purchase. This keeps bubbles from getting too out of control -- because as prices rise, people wont have enough to pay the cash portion, limiting demand.
Second, force financial instruments to trade on exchanges, which have to report information on trades regularly, and which also keep cash in reserve to insulate against risk.
This way, when something goes wrong, everyone knows where the risk lies -- at the exchanges clearinghouse, which has taken steps to protect itself.
We followed these rules for 50 years. But starting in the 80s, the financial industry got around them.
* Firms got around debt limits by structuring securities so that they got AAA ratings. The government, seeing no risk, let the firms borrow more.
* The industry also created trillions of dollars worth of exotic “derivatives” that got around debt limits because they didnt trade on exchanges.
* And we stopped requiring people to put down cash to buy a house.
Fixing this is easy -- apply old principles, which worked well for decades, to new firms and markets.
The government should require financial firms to hold a consistent percentage of nonborrowed money behind all similar investments, including houses and all derivatives. And regulators should force firms to trade common financial instruments -- and those that become common -- on exchanges.
Then, the financial system will be able to withstand individual failures -- so markets can do much of the rest of the work.
Congress “fixes” touch on everything except these reforms. (A bill to push exotic trading onto exchanges, for example, has gotten lost amid the lobbyists.)
Dodds “Agency for Financial Stability” would do what other regulators did for 25 years: Give false confidence that certain investments are safe, allowing more borrowing, since, hey, what can go wrong? If this agency had existed five years ago, it wouldve said that the securities that triggered the meltdown were fine.
Plus, because it would give special attention to big banks, it would institutionalize “too big to fail”: The market would see failure as the governments fault.
Meanwhile, Dodds Consumer Financial Protection Agency (an idea the president also likes) would allow people to borrow more than the economy can stand, as long as financial firms jumped through hoops. Remember, adjustable-rate mortgages werent the problem -- they were the symptom of unaffordable debt levels.
These regulatory “fixes” would set the stage for the next disaster. Next time, though, the US government might not have the resources to rescue the economy.
In the meanwhile, new bureaucracies would allow well-connected financial firms with the best lobbyists to compete on an unfair playing field, also weakening the economy.
Fake fixes are bad for New York, too. They let a government-subsidized financial industry look healthy -- and so allow the local pols to keep spending.
But as the local economy becomes more dependent on an indirect federal subsidy (the “too big to fail” guarantees), it becomes less able to compete without that subsidy. Real innovation, including financial innovation, suffocates.
Neither party has shined in the financial-reform debate. But this is an opportunity for some ambitious politician.
The public hates bailouts. These fixes, wise lawmakers can say, will just cause more of them. Washington isnt helping free markets here -- just maintaining crony capitalism.
Free markets thrive when a financial industry competes with consistent, predictable rules and fear of failure -- something thats easier for voters to understand than a 1,136-page bill.
Original Source: http://www.nypost.com/p/news/opinion/opedcolumnists/phony_fixes_for_the_wall_st_mess_TUl6qy81IAkeE0She4W7CN