Of Wall Street and Pennsylvania Avenue

Who wants another financial crisis? To hear the advocates of the Administration’s financial regulation bill, anyone who disagrees with them does.

Let us walk past the discussion of others’ motives, important as they might be. Let us, you and I, agree that we do no want another financial crisis. Or, phrased better, let us agree that we would like to reduce the likelihood of another financial crisis and minimize the extent of crisis when it comes. Anyone believe that there will never be another one? Recognizing that crises will occur and that we will be better prepared to face them by acknowledging and preparing for their possibility, let us consider which approach is likely to work to reduce their frequency and their severity.

Which is more likely to be more effective at reducing the risk of financial crises: government regulators or market discipline? Relying upon experience as a reliable guide, the question is soon answered. Government was all over the most recent crisis. In fact, the most recent financial crisis was fomented by government regulations and stimulated into panic by unwise government actions, all of which worked to shield key players from market discipline. Government housing programs and guaranties led people to ignore the risks of mortgage lending—ignored by borrowers and lenders. Credit rating agencies (CRAs) were able to classify risky mortgage securities as nearly risk-free, shielded by the Securities and Exchange Commission from market pressures to identify risks that the CRAs were paid to find.

The crisis was fanned into a panic after the Paulson Treasury Department (1) orchestrated the bailout of the securities firm Bear Stearns, then (2) subjected investors to a big tease with Lehman Brothers which they at last decided not to bail out, (3) bailed out AIG, (4) bailed out bond investors in Fannie Mae and Freddie Mac, and then (5) demanded from Congress $700 billion for the catastrophic Troubled Asset Relief Program (TARP). None of the TARP money was used to buy any troubled assets. A third of it went to bail out banks that were not in trouble (until they took the Treasury’s shilling) while other billions went to auto companies that were.

So why are the Administration and leaders in Congress on the verge of enacting legislation that will give Washington bureaucrats virtual control of any and all of the financial system at their whim? Could it be that these friends of regulation, who control the lawmaking powers this year, are unwilling to admit their mistakes? Or is it that the friends of regulation see the financial crisis—whatever its cause—as a wonderful opportunity to expand regulatory controls? Or maybe it is just that once you tell a story—that Wall Street caused the financial crisis—you have to carry the story on to its conclusion, however wrong that might be. In either case, the friends of regulation control the megaphones and the levers of power. If they have their way, though, Time will surely tell whether it was a good idea for Pennsylvania Avenue to replace Wall Street as the financial center of America.