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Brooks Wilson's Economics Blog: The Crisis Paradox and Taylor's Assessment of Financial Regulatory Reform

Tuesday, July 6, 2010

The Crisis Paradox and Taylor's Assessment of Financial Regulatory Reform

Like so many news stories and commentaries, John B. Taylor's article in the Wall Street Journal, "The Dodd-Frank Financial Fiasco," brings to mind what I called the Crisis Paradox: crisis is the best time politically and the worst time economically to enact fundamental economic reform.  While I coined the phrase, it is Robert Higgs' work that laid its foundation.  He offered the "Crisis Hypothesis," that the supply of and demand for government oversight and control of a market economy increases in times of crisis, in "Crisis and Leviathan," and the uncertainty hypothesis that increased government oversight and control during the Great Depression dampened investment in "Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War" (The Independent Review, Vol. 1, No. 4, Spring 1997),(see also, "Depression, War, and Cold War").

Taylor believes that the Dodd-Frank financial reform bill's complexity is a risk to economic growth.  This is the Uncertainty Hypothesis.  He also observed that the bill misdiagnosed the causes of the financial crisis, perhaps because it was passed before the congressionally mandated Financial Crisis Inquiry Commission finished its work.  Simply put, Congress struck while the iron was hot to pass reform some legislators sought prior to the financial crisis.  This is the Crisis Hypothesis.   
The sheer complexity of the 2,319-page Dodd-Frank financial reform bill is certainly a threat to future economic growth. But if you sift through the many sections and subsections, you find much more than complexity to worry about.

The main problem with the bill is that it is based on a misdiagnosis of the causes of the financial crisis, which is not surprising since the bill was rolled out before the congressionally mandated Financial Crisis Inquiry Commission finished its diagnosis.

The biggest misdiagnosis is the presumption that the government did not have enough power to avoid the crisis. But the Federal Reserve had the power to avoid the monetary excesses that accelerated the housing boom that went bust in 2007. The New York Fed had the power to stop Citigroup's questionable lending and trading decisions and, with hundreds of regulators on the premises of such large banks, should have had the information to do so. The Securities and Exchange Commission (SEC) could have insisted on reasonable liquidity rules to prevent investment banks from relying so much on short-term borrowing through repurchase agreements to fund long-term investments. And the Treasury working with the Fed had the power to intervene with troubled financial firms, and in fact used this power in a highly discretionary way to create an on-again off-again bailout policy that spooked the markets and led to the panic in the fall of 2008.
Taylor's intent was not to offer support for Higgs' work but to describe false remedies the 2,319 page bill mandates and his criticism that it increases the power of the government in areas unrelated to the financial crisis should be addressed.  The bill creates "orderly liquidation" authority for the Federal Deposit Insurance Corporation that implicitly supports the "too big to fail" policy strengthening the moral hazard caused by the socialization of losses.  The bill does not reform Fannie Mae and Freddy Mac, the two government sponsored entities that underwrote or purchased a large percentage of subprime loans, nor does it reform the bankruptcy code to allow large, complex financial firms to go through an orderly liquidation.  Those interested in reform of the financial sector should anxiously read the article.    

1 comment:

  1. People feel most threatened and vulnerable when their assets and financial possessions are potentially at risk. During these times of economic turmoil, people seek out the quickest route for a solution and subsequently turn to politicians and people in positions of power as a path for escape. It is then, when the ball is in the politicians' court, that they have complete power to spin any bill or idea to an easily impressionable public and quickly gain support regardless of the true validity for the newly proposed idea.
    This "crisis paradox" can lead to misinterpretations of certain new ideas and then the passing of legislation that may or may not have been correctly offered, but in times of panic, human nature is known for leaping to conclusions, no matter how incorrect they may be.