Saturday 29th April 2017,
My great Wordpress blog

Regulatory Overaction: From Crisis to Bad Laws

New York Stock Exchange

By Jordan Rosman

Richard Nixon once remarked that the most dangerous period of a crisis “is the aftermath” because “with all his resources spent and his guard down, … an individual must watch out for dulled reactions and faulty judgment.” The same is certainly true for national crises. It’s not difficult to conjure up frightening images of crises in history that seemed like existential threats to the United States: the Black Tuesday stock market crash of 1929, the attack on Pearl Harbor, 9/11, and in most recent times the financial crisis of 2008. What is harder to recall is the damage caused by public policies that followed such crises. The victims of Pearl Harbor not only include the 2,400 American navy- men but also the thousands of Japanese- Americans sentenced to concentration camps by President Roosevelt. The stock market crash of 1929 led to irrational and destructive public policy-making on behalf of Congress and the Federal Reserve, having caused the Great Depression. Looking back today, five years after the financial crisis of 2008, it is highly likely lawmakers have overreacted in a similar way, shape, or form.

It would be naïve to believe that U.S lawmakers could have mitigated the consequences of the financial crisis in a state of reason and rationality, isolated from the passions and emotions of the American public. Of course, in a nation governed by the people and for the people, lawmakers lay vulnerable to the zeal of the citizenry in times of crisis. Thus, what followed the collapse of our banking system, like other national catastrophes, were irrational public policy responses and decisions guided by biases and emotions. The art of crisis- politics is not just how to react, but how not to overreact.

In the five years since the crisis, many lawmakers, guided by frenzied public sentiment, have misunderstood the causes of and solutions to the financial meltdown. After all, our lawmakers were summoned to repair our banking system only after the crisis occurred. That is, with pressure from the American public, much of the regulatory undertakings were spearheaded in the beginning of 2009, only several months after the banking system had collapsed, a time in which few – if any – people fully understood the causes of the crisis. What began afterwards was an attempt by Congress, led most notably by Congressman Barney Frank (D-Massachusetts), to pass financial regulatory reform. This finally became known as the Dodd-Frank Wall Street Reform and Consumer Protection Act. It is extremely difficult to determine how the 800-page Dodd-Frank statute will affect our economy—even the nations largest banks do not know how it will play out. However, any regulation passed in aftermath of any crisis will probably be mired with provisions guided by irrationality and emotion.

When crises or catastrophes occur, the public yearns for clear-cut answers and solutions. Painting pictures as complex and multi-faceted following national emergencies rarely succeeds in the political arena. Thus, lawmakers pitched a simplified narrative to the American public after the financial crisis: before 2008, we had a Gatsby-esque-high- flying-deregulated-banking system— thus, we need more regulation. Nearly everyone can agree that this was true to some extent. Economists and lawmakers from all over the spectrum agreed that we needed some sort of better regulation. Alan Greenspan, former chairman of the Federal Reserve, called for stricter capital requirements while Columbia economist Joseph Stiglitz called for stronger anti- trust law enforcement.

The problem with the narrative pitched by Congress was not its content, but rather its simplicity. To quote Nobel laureate and behavioral economist Daniel Kahneman: “After a crisis we tell ourselves we understand why it happened and maintain the illusion that the world is understandable. In fact, we should accept the world is incomprehensible much of the time.” The narrative was undoubtedly more complex than how it was painted; the crisis was not caused solely by deregulation but also by bad regulation and in some cases, even by too much regulation. When we construct clear-cut narratives that do not exist, we leave ourselves susceptible to the causation fallacy in which we mistake two correlated variables as having as a simple causal relationship. Probably the most widespread narrative among lawmakers in the wake of the financial crisis was that regulators had to reinstitute provisions of the Glass-Steagall Act of 1933, which was formally repealed in 1999. What Glass-Steagall did was separate the activities of investment banks from those of commercial banks, meaning that commercial banks could not engage in proprietary trading and investment banks cannot accept deposits. The narrative that had been echoed in Washington sounded like this—Glass-Steagall was repealed in 1999, and then we had a financial crisis in 2008–ipso facto, we should bring back Glass-Steagall. It sounds simple and on paper, it makes sense. Of course, it is entirely possible that the repeal of Glass-Steagall was no direct cause of the crisis at all and that its absence could have even mitigated the crisis. One could strongly argue that its repeal was instead correlated with an era in which Washington aggressively deregulated many other sectors of the financial system. In 1995, Congress loosened lending standards to low-income households by rewriting the Community Reinvestment Act, a statute originally passed in 1977. In 2000, President Clinton signed into law the Commodity Futures Modernization, which “modernized” (a euphemism for exempted) the regulation of credit-defaults swaps and other over- the-counter derivatives, products that Warren Buffet called in 2003 “weapons of mass destruction.” Thus, looking back at the causes of the financial crisis, we must be careful not to find relationships where they do not exist and instead take a more guided, detailed approach to solving financial-public policy issues.

Senator Warren of Massachusetts, one of the most influential senators in Washington with respect to financial policy, admitted that she was pushing to reinstate Glass-Steagall: “It is an easy issue for the public to understand and you can build public attention behind.” Thus, lawmakers and regulators pushed for what is known today as the Volcker Rule, named after the eminent Federal Reserve Chairman in the early 1980’s, Paul Volcker. Essentially, the Volcker rule attempts to achieve what Glass- Steagall did from 1933 to 1999, to separate federally insured deposits from proprietary trading, a seemingly simple goal. In fact, attesting to the complexity of financial regulation, the final rule clocked in at a massive 900 pages. Last December, five regulatory agencies approved the rule, and it will be implemented on April 1st of 2014.

Like Dodd-Frank, it is very difficult to estimate the net benefit/damage the Volcker Rule will generate in our economy. The causes and solutions to any crisis are often far more complicated than any politicians spells it out to be. As Nobel laureate Paul Samuelson has said, “What we know about the global financial crisis is that we don’t know very much.”

This article originally appeared in the Summer 2014 edition of PPR.

Image (Attribution License) courtesy of Peter Kaminski on Flickr.

Like this Article? Share it!

Leave A Response