Professor Bainbridge...on law, politics, religion, culture & food

Bailout 2.0 Signed, The Over-reaction Comes Next

The bailout bill passed, now the government whose policies brought you this mess is gearing up to bring you a new round of regulatory over-reaction:

Rep. Barney Frank, D-Mass., the Financial Services Committee chairman, said the rescue bill was just the beginning of a much larger task Congress will tackle next year: overhauling housing policy and financial regulation in a legislative effort he compared to the New Deal.

This is just the latest round of boom, bust, and regulatory over-reaction. Larry Ribstein explains that:

A boom encourages unwarranted trust in markets, leading to the speculative frenzy of a bubble and then to the inevitable bust. The bust, in turn, leads first to the disclosure of fraud and then to the mirror image of the bubble—a kind of speculative frenzy in regulation. A political context combining long-standing interest group pressures with panic and populism virtually ensures against a careful balancing of the costs and benefits of regulation. Regulators are more likely to react to past market mistakes than to prevent future mistakes. Even worse, post-bust regulators are likely to ignore the benefits of market flexibility and, therefore, to impede the risk-taking and innovation that will bring the next boom.

It was true of the tech bubble (Sarbanes-Oxley), the 1929 Crash (the New Deal securities laws), and even the South Sea Bubble (the Bubble Act). We all know that SOX was a debacle, but most assume that the New Deal securities laws were a great idea. Wrong. Ribstein explains:

Several studies find little or no effect of the securities laws disclosure requirements. Event studies show that the 1933 Act did not affect securities returns, indicating that the Act did not cause disclosure of valuable new information, as returns would have risen if firms disclosed more negative information after the Act.

On the other hand, the 1933 Act had the sort of regulatory cost highlighted in this Commentary—discouraging risky ventures—as indicated by evidence that the variance of returns fell after the 1933 Act. ...

In short, lawmakers rushing to regulate following the 1929 crash focused on the supposed defects of markets while failing realistically to assess the costs and benefits of regulation. Accordingly, they reduced the opportunities of precisely the sort of innovative firms that were needed to fuel the next boom. Although there were many reasons why it took a generation for the market to return to the levels of the 1920s, the securities laws are more likely to have delayed than to have advanced the recovery.

Larry’s conclusion seems likely to hold true for this round as well as the earlier ones:

Perhaps the worst harm caused by crash-induced regulation is that it conveys precisely the opposite message—that lawmakers can somehow make the markets safe from fraud and protect investors from themselves.