Monday, March 31, 2008

The "Invisible Hand" sure is looking feeble these days

marjorie says...

From a Wall Street Journal Q&A with Treasury Secretary Henry Paulson, regarding recommendations for addressing the current mortgage lending induced Wall Street crisis:

WSJ: Would this new framework have prevented the current credit-market turmoil?

PAULSON: I don’t mean to imply that we aren’t going to keep having these periods every five to ten years. I don’t think any regulatory system is going to change that. I think we rely very, very heavily on market discipline. Mistakes are made. Having said that, I still think we need a system that is more efficient and gives us a better chance, gives us more tools to try to solve problems.


What we just saw the Fed do was not something that happens every five to ten years. The Fed doesn't periodically bail out Wall Street investment firms that are about to implode due to rampant speculation.

The primary issue, to my mind, is that during the 90's the final nail was put in the coffin of what is called the Glass-Steagull Act. Glass-Steagull was one of the measures stemming from the Great Depression. It separated speculation (underwriting of stocks & bonds) activities from commercial lending to consumers. In other words, commercial banks that hold everyday people's money, and lend to us, were insured through a new agency, the FDIC. These commercial banks could not engage in "brokerage"...so in effect, they had to make a choice. The intention was to ensure the safety and viability of the American banking system, while letting the "free market" go about its speculative business on Wall Street. In the late 90's, this historic separation of commercial banks and brokerage firms was eliminated through an Act of Congress that Bill Clinton signed into law.

In the new era this means, practically speaking, that the federal government insures Wall Street in addition to Commercial banks. And we just saw a great example of this in action. Bear Stearns was bailed out because of the fear of a domino effect since the regulatory separation between banks and investment firms has been eliminated. Think: Citigroup.

Paulson says that we're in a new era, that the old regulatory framework doesn't fit anymore. He's right. But the proposal put forward by the Treasury Department this week doesn't really regulate the new mega-firms that are now mixing it up. Instead, it shifts agencies around, provides for numerous reporting mechanisms (basically bringing greater transparency to licensing and state-based regulation of the mortgage lending industry) and expands the power of the Fed to step in during a crisis, such as what happened with Bear Stearns. Frankly, I want to avoid a crisis. Regulation means that industries are "regulated." They have actual rules they have to follow.

The sub-prime mortgage lending disaster didn't have to happen. Paulson says there are oversight gaps that need to be closed so that these types of situations can be predicted with more accuracy. Well, it seems to me that the average Joe and Janice on the street were able to predict it well in advance. The problem is a lack of regulation. Our system is too complex to spin on a dime. Our ideological splits often require a lot of dialog to reach consensus, and due to the nature of a representative democracy the impetus for real bi-partisan political action often only occurs when there is a real crisis. This is why the time is ripe, right now, to implement real controls on a system that needs it. The feeble "invisible hand" of the market is not enough.