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Parsing Obama’s Financial Regulation Speech

Barack Obama today gave a major speech on financial regulation. It’s interesting. It looks erudite and learned, at least at first glance. Unfortunately, it’s also worrisome in many respects.

Let’s take a closer look.

The speech begins with a bow to “extraordinary” NYC Mayor Michael Bloomberg, who introduced Obama. This has triggered speculation of a possible Obama-Bloomberg ticket:

The First Read gang is all a-buzz at the Obama-Needs-A-Jew-On-The-Ticket-Angle, but I think the best way to look at an Obama-Bloomberg ticket is by noticing their complimentary traits. Obama isn’t much of an administrator or a details guy by his own admission, while Bloomberg is so concerned about Your Health and Welfare that he studies intently the ins and outs of congestion pricing and trans-fats. He’s a prime minister-type—although he brings an outsider’s sense of efficiency to the bureaucracy. Let Obama be the vision guy; Bloomberg could be the brass-tacks administrator.

The speech then segues to a history lesson on the debate between Alexander Hamilton and Thomas Jefferson, positing that we continue to struggle “to balance the same forces that confronted Hamilton and Jefferson – self-interest and community; markets and democracy; the concentration of wealth and power, and the necessity of transparency and opportunity for each and every citizen.” The requisite nod to free markets follows.

This is the sort of thing at which Obama excels and, I think, explains a large part of his appeal to the intellegensia. Obama’s speeches frequently include passages that flatter their listeners who aren’t quite intelligent enough to realize how shallow his thinking actually is into thinking that they are more intelligent than they are. (I’m paraphrasing something Henry Farrell wrote about the Economist here, because it fits so nicely.)

Next comes the opening in a series of populist moves:

As I said at NASDAQ last September: the core of our economic success is the fundamental truth that each American does better when all Americans do better; that the well being of American business, its capital markets, and the American people are aligned. 

I think all of us here today would acknowledge that we’ve lost that sense of shared prosperity

This loss has not happened by accident. It’s because of decisions made in boardrooms, on trading floors and in Washington. Under Republican and Democratic Administrations, we failed to guard against practices that all too often rewarded financial manipulation instead of productivity and sound business practices. We let the special interests put their thumbs on the economic scales.  The result has been a distorted market that creates bubbles instead of steady, sustainable growth; a market that favors Wall Street over Main Street, but ends up hurting both.

Note the underlined passage. I see a subtle suggestion that finance is all smoke and mirrors, while manufacturing, farming, and the like (hence, the code word productivity) are real sources of wealth. The appeal here is to guys who think like Carl Fox, who told Bud to “Stop going for the easy buck and start producing something with your life. Create, instead of living off the buying and selling of others.” The implication is that financiers, like Gordon Gekko, “create nothing.”

Now note the italicized passage. In the first place, it perpetuates a basic myth about “bubbles.” Go read Syracuse law professor Chris Day’s paper on market exuberance, which tells a contrarian story of some famous bubbles:

Markets are sometimes accused of “irrational exuberance.” Some distrust stock markets because of “predatory” behavior by speculators. Three fantastic bubbles - Tulip mania, the Mississippi Company and the South Sea Company are held out as horrid examples of market excess and malfunction by the public and sophisticated commentators alike.

Tulip mania never occurred and was, instead, a rational attempt to organize markets for rare commodities in a primitive futures market. The Mississippi Company collapse and the loss of liquidity in France are linked to the South Sea Bubble. Both the Mississippi Company and South Sea Company were spectacular investments with major structural flaws. But they were not morality tales.

This paper delves into the economics, finance, psychology, legality and morality of these bubbles. It demonstrates that the markets often worked rationally and efficiently, that the investments were not wildly unsound, and that exogenous factors (the Plague in Holland) and politics and illegality in France may have played major roles in these “disasters.” The paper concludes that markets got it right and that popular wisdom has failed to appreciate the market’s wisdom.

If you can find a copy on line (I can’t find one other than on Lexis or Westlaw), you should also go read Larry Ribstein’s article Bubble Laws, 40 Houston Law Review 77 (2003), in which Larry argues that bursting of bubbles inevitably leads to “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. ... [After each major bubble, going back to the South Sea Bubble,] regulation was passed without due consideration either to the benefits or costs of regulation, and it likely constrained the market’s recovery from the crash.

I posted earlier today on the buyers’ regret experienced by some of the Sarbanes-Oxley Act’s original proponents. The lesson of the Day and Ribstein papers, which is confirmed by our experience with SOX, is that letting the market shake itself out is often (always?) prefereable to a regulatory fix. Markets work, at least in the long run. Politicians all too often either panic and/or respond to interest groups rather than the public good.

Speaking of Sarbanes-Oxley, Obama really went off the rails when he described Enron and Worldcom as being the product of “industry lobbyists tilting the playing field in Washington, an accounting industry that had developed powerful conflicts of interest, and a financial sector that fueled over-investment,” without once acknowledging the debacle that was—and still is—the Sarbanes-Oxley Act. I presume this is a deliberate omission, as acknowledging the point would remind his more thoughtful listeners that regulatory medicine is often worse for the patient than the economic bug.

To be sure, Obama emphasized the need to create a “21st-century regulatory framework,” rather than turning “back the clock to an older era of regulation.” In particular, he is to be commended for apparently dispatching the idea, advanced by some of the more wild eyed commentators, of bringing back some version of Glass-Steagall.

Yet, in his speech, while recognizing that regulatory reform in the 1990s was appropriate, Obama complains that “campaign money all too often shaped policy and watered down oversight.” He repeatedly refers to the baleful influence of lobbyists on prior regulatory reform efforts. Obama nevertheless wants us to believe that he can achieve an aggressive set of financial market regulatory changes that will not be twisted by interest group politics. This is either hopelessly naïve or deeply cynical. Either he knows it’s not true or he’s succumbed to the messianic views of his candidacy held in some quarters. I’m sorry but a constant mantra of “change we can believe in” is not going to change the basic fact that, as a famous Democrat once put it, money is the mother’s milk of politics.

While we’re on the subject of the messianic undercurrent in the Obama campaign, I find his suggestion that the government can somehow prevent the “cycle of bubble and bust” troubling. Even if you don’t buy Day’s contrarian theory about the nature of bubbles, it’s worth remembering that what we call bubbles and busts are an inherent attribute of the process of creative destruction that lies at the heart of capitalism. Striving to eliminate the risk of occasional market blips risks eliminating the space within which creative entrepreneurs function. Think of a child so swaddled in protective gear that they cannot even play. Put another way, there is both an economic and ethical case to be made for a limited social safety net. Attempting to drape a safety net under the entire economy, however, turns the federal government into an insurer of the entire economy and, as such, carries a serious moral hazard problem.

So what does Obama propose?

To stabilize the housing market and help bring the foreclosure crisis to an end, I have sponsored Senator Chris Dodd’s legislation creating a new FHA Housing Security Program, which will provide meaningful incentives for lenders to buy or refinance existing mortgages. This will allow Americans facing foreclosure to keep their homes at rates they can afford.  ...

For homeowners who were victims of fraud, I’ve also proposed a $10 billion Foreclosure Prevention Fund that would help them sell a home that is beyond their means, or modify their loan to avoid foreclosure or bankruptcy. It’s also time to amend our bankruptcy laws, so families aren’t forced to stick to the terms of a home loan that was predatory or unfair.

In the first place, despite Obama’s denials, John McCain is right. The Dodd bill amounts to a federal bailout of lenders who made bad lending decisions and homeowners who made bad borrowing decisions.

The reason Obama is going to insist this bailout plan isn’t really a bailout - even though taxpayers would end up covering the costs of every refinanced loan that defaulted- is because the actual details of the plan would be phenomenally unpopular. Rasmussen recently reported, “Fifty-three percent (53%) of Americans say that the federal government should not help out homeowners who borrowed more than they could afford. A Rasmussen Reports national telephone survey found that 29% disagreed and believed that federal action is appropriate. Seventeen percent (17%) are not sure.”

The basic problem in the subprime mortgage market was not actual fraud, but rather the fact that lenders made loans to risky borrowers and borrowers accepted loans without understanding the terms of the deal. When you bail out people who make bad decisions, such that they do not feel the full economic consequence of those decisions, you are subsidizing bad decision making. You are also creating an expectation in the public at large that bad decision making will always be bailed out at taxpayer expense.

Indeed, I would argue that the present problem is an indirect consequence of the government bailout of the savings and loan industry back in the late 1980s and early 1990s. Savings and loans historically had paid very low interest rates on deposits and, as a result, were increasingly unable in the 1970s and 1980s to compete with money market mutual funds and even regular banks. The S&L industry went to Congress and the administration to get new regulations allowing them to invest their assets in high-yield junk bonds. When the junk bond market had one of its regular major hiccups, the S&L industry found itself in a liquidity crisis that could have resulted in massive bank failures. The government stepped in to bail the industry out. Along with other government bailouts, such as the Chrysler bailout in the 1970s, the impression is created that some industries and even some companies (for example, Bear Stearns) are too big to let fail. Instead, the assumption in the economy is that the taxpayer will foot the bill went bad decision making by such industries or firms leads to a market failure. If we now bail out the subprime mortgage industry, 10 years from now some other industry will assume that it can take excessive risks because the taxpayer will bail them out if those risks turn out badly.

The same thing is true with respect to homeowners. In the S&L crisis, depositors were protected by FSLIC—the S&L equivalent of the FDIC—deposit insurance. As a result, depositors basically suffered very little for having made uninformed decisions about where to invest their money. Just so, subprime mortgage homeowners blithely made uninformed decisions. Bailing people out repeatedly creates no incentive for people to make better decisions in the future.

No bailouts for the Bear Stearns of the world and no bailouts for individuals either. As John McCain aptly put it, “it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers.”

Obama also posits that:

We must develop and rigorously manage liquidity risk.

We who? Some Washington bureaucrat? Enormous amounts of real wealth have been created by innovative financial instruments and transactions. Inevitably, those transactions pose some degree of liquidity risk. Are we to cut financial entrepreneurs off at the knees?

I also don’t buy Obama’s proposal that:

… we need to regulate institutions for what they do, not what they are. Over the last few years, commercial banks and thrift institutions were subject to guidelines on subprime mortgages that did not apply to mortgage brokers and companies. It makes no sense for the Fed to tighten mortgage guidelines for banks when two-thirds of subprime mortgages don’t originate from banks.  This regulatory framework has failed to protect homeowners, and it is now clear that it made no sense for our financial system. When it comes to protecting the American people, it should make no difference what kind of institution they are dealing with.

This reflects a fundamental misunderstanding of the purpose of financial regulation. Financial regulation has two basic goals. First, as to those institutions for whom the Federal Reserve system serves as a wonder of last resort, regulation is justified because the Fed is, in effect, acting as an insurer. Just as a private insurer regulates what its insureds do, so the Fed regulates what its banks do. Second, as to those institutions covered by deposit insurance, regulation is justified because of the moral hazard inherent in such insurance. Hence, for example, the whole point of mortgage guidelines is not to protect homeowners to protect the Fed and FDIC from banks that make bad lending decisions. Mortgage brokers and other institutions that are neither eligible for Fed bailouts (as Bear Stearns should not have been eligible) nor covered by deposit insurance should be free of the financial regulations that come with such eligibility.

Finally, the end of the speech reflects Obama’s generally muddleheaded approach to economics. He claims that his policies “will foster economic growth from the bottom up, and not just from the top down.” Hence, for example, he proposes that:

To reward work and make retirement secure, we’ll provide an income tax cut of up to $1000 for a working family, and eliminate income taxes altogether for any retiree making less than $50,000 per year.

The bit about retirees strikes me as privileging the grasshopper over the ant.  Interestingly, Paul Caron points out a “curious fact about Barack Obama’s tax returns:  despite over $1.6 million in Schedule C income, most of it from royalties on his book, he did not take the elemental tax planning step of establishing a SEP-IRA.  The tax magic is that you can shelter up to 25% of your self-employment income (up to $180,000 in 2007), and the investment earnings accumlate tax-free until withdrawn at retirement.” The same observation prompted Greg Mankiw to speculate that:

Maybe he is getting bad tax advice. Or maybe he is expecting vastly higher tax rates in the future when the accumulated savings will need to be withdrawn and taxed. As Obama economic adviser Austan Goolsbee has written, “Future increases in tax rates potentially threaten to significantly reduce the value of your retirement savings and may even mean that you should not save in 401(k) accounts at all.”

In any case, whether there are economic justifications for these proposals, I freely admit that there are moral ones. As a Catholic, I am conscious of the preferential option for the poor, which might well be cited as a justification for such proposals. Having said that, however, what do these proposals have to do with economic growth? With all due deference to working families and retirees, a tax cut for them creates no new wealth nor does it incentivize activities that create new wealth. Economic growth comes from incentivizing entrepreneurs to develop new or better goods and services. Jobs are created when such entrepreneurs start new businesses, not when working families or retirees spend a few bucks they got from a tax cut.

By planning to raise taxes on upper income individuals, moreover, Obama further underrmines his hope for economic growth by penalizing the very people he should be incentivizing. Obama’s proposing to raise the capital gains tax from 15% to anywhere between 25 and 28%, for example, which may not worry Warren Buffet but may well affect the decision making of some striving start up entrepreneur thinking about leaving his job to start a new business.

Having said all this, there are some things in Obama’s speech with which I find myself in substantial agreement. For example:

The Federal Reserve should have basic supervisory authority over any institution to which it may make credit available as a lender of last resort. When the Fed steps in, it is providing lenders an insurance policy underwritten by the American taxpayer. In return, taxpayers have every right to expect that these institutions are not taking excessive risks.

The lender of last resort is, in effect, an insurer. Because insurance inherently raises problems of moral hazard, every insurer, whether public or private, has an interest in the amount of risk the the insured takes on. Here, however, we can still look to market-like solutions. Ideally, Fed regulation ought to replicate the same kind of creditor protections that depositors would want if they were not protected by deposit insurance. Unfortunately, much banking regulation historically has gone far beyond what a private creditor would insist upon. Instead, much banking regulation was designed to protect certain interest groups from competition. The Glass-Steagall act for example served mainly to protect securities underwriters from competition by commercial banks.

It’s also worth stressing that the Fed should not become the universal lender of last resort. Not every industry that runs into financial difficulty should have access to the Fed’s lending window. Not even every sector of the financial industry.

Finally, I agree with his proposition that:

… we need to streamline a framework of overlapping and competing regulatory agencies.  Reshuffling bureaucracies should not be an end in itself. But the large, complex institutions that dominate the financial landscape do not fit into categories created decades ago.  Different institutions compete in multiple markets – our regulatory system should not pretend otherwise. A streamlined system will provide better oversight, and be less costly for regulated institutions.

The alphabet soup of financial regulators is problematic at any number of levels. Agencies with a relatively small area of responsibility are more subject to capture by the regulated industry than are agencies with many constituencies. Multiple agencies can lead to overlapping regulatory regimes applicable to a single company. Hence, Obama is quite correct that there is a case to be made for streamlining regulatory agencies. Having said that, however, now is not the time to do so. The current crisis atmosphere simply does not lend itself to the kind of calm and measured thought that must go into any such proposal.

In sum, there’s merit in a few of Obama’s proposals. It would be unfair to say otherwise. On balance, however, I found much more here worthy of criticism than praise.