May 18, 2010
FINANCIAL REGULATION AND HISTORICAL RHYMES
Every financial crisis brings cries of more regulation. True in centuries past, true today. But more regulation isn’t always better regulation. And sometimes the knee-jerk reaction to do something, anything (if only to look politically astute) is a step backward.
"Governments know that the public believes that ‘something must be done’ after a crisis, but all too often through history governments have done the wrong thing," argue the authors of the recently published The Road from Ruin: How to Revive Capitalism and Put America Back on Top. In making their point, Michael Bishop and Michael Green recount a bit of 18th century financial history...
In the same year as Britain’s South Sea Bubble, France had its own financial crisis, following the newfangled financial innovation of paper money. France responded to the Law Panic of 1720— named after the Scotsman John Law, who was behind the new economic plan— by abandoning paper money entirely, which stalled its economic development. Similarly, strict regulation of the financial sector was a central plank of President Roosevelt’s New Deal reforms to tackle the Great Depression, yet many of these regulations proved to be wide of the mark. Some reforms, such as trying to stabilize the banks by forcing them to hold much more capital, made the Depression worse; others, such as splitting up the banking sector into separate investment and retail banks, imposing arbitrary caps on interest rates, and tightly regulating the stock market, hobbled the U.S. economy for nearly half a century.
It would be a mistake to argue against rethinking some, if not most of the existing financial regulation in the wake of the 2008 crisis and the Great Recession. The challenge is figuring out what to fix, what to leave alone, and generally what’s required to promote stability and entrepreneurship without creating new hazards in the process. Considering the mounting efforts in Congress to introduce a maze of new financial regulations, Andrew Lo, a finance professor at the Massachusetts Institute of Technology warned earlier this month: "Until we understand what the causes were, we may be implementing ineffective and even counterproductive reforms. I understand the need for action. I understand the need for something to be done. But what I expect from political leaders is for them to demonstrate leadership in telling the public that we need to proceed about this in a much more deliberate and rational and thoughtful way."
Nonetheless, it’s fair to say that the general demand for more regulation runs hot these days. That includes the residential real estate market, which in many ways was ground zero for the economic ills of recent vintage. In his 2009 book A Failure of Capitalism, Richard Posner speaks for many when he writes: "The housing bubble and the risky lending practices could have been prevented by more aggressive regulation and the elimination of tax benefits for homeowners."
Perhaps, although the messy details of minting new regulations are upon us as the end game for financial reform legislation unfolds in the Senate. As usual, you can find a rainbow of views on what’s shaping up to be a rather large bill, and one that’s reportedly likely to pass, for good or ill.
As we ponder a new chapter of financial reform in American history we might want to pause a moment and consider if any of the recent troubles were caused by previous reform efforts gone awry. A new study published by the Philadelphia Fed offers some evidence for thinking that such worries are more than political provocation. "The U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession," according to the new research study: Did Bankruptcy Reform Cause Mortgage Default Rates to Rise? The paper’s abstract answers in the affirmative, explaining...
When debtors file for bankruptcy, credit card debt and other types of debt are discharged — thus loosening debtors’ budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. We argue that an unintended consequence of the reform was to cause mortgage default rates to rise. Using a large dataset of individual mortgages, we estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage default rates to rise. Our major result is that prime and subprime mortgage default rates rose by 14% and 16%, respectively, after bankruptcy reform. We also use difference-in-difference to examine the effects of three provisions of bankruptcy reform that particularly harmed homeowners with high incomes and/or high assets and find that the default rates of affected homeowners rose even more. Overall, we calculate that bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 per year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.
To be sure, mortgage defaults were but one piece of a very large calamity. Nonetheless, the paper brings to mind a couple of famous quotes. The first, from Santayana, is the ever pertinent gem about how those who ignore history are doomed to repeat it. Finally, there’s the dean of American letters, Mark Twain, who wisely observed that while history doesn’t repeat, it does rhyme.
Posted by jp at May 18, 2010 4:38 PM
What puzzles me to no end is why those who keep calling for more government regulation never discuss the foibles of regulators themselves. They don't even mention public choice theory--and this is most peculiar when it comes to Richard Posner, who must know that school--which rests on the pretty common sensical assumption that regulators are, like other human beings, motivated by agendas of their own. If you add to this the near impossibility of identifying the public good or interest which regulators are urged to promote, the result is nothing less than the transfer of power from one group of blokes to another. But this other group is even more likely to engage in malpractice since they have sovereign immunity--they cannot be sued for any wrongdoing.
Posted by: Tibor Machan at May 19, 2010 2:01 PM