The biggest cause of the lingering financial trouble and the 2008 financial panic has been bad government policy. The markets did not fail. The markets did just what government policies encouraged them to do, namely over-invest in housing while paying little attention to the risks. That created twin bubbles in house prices and in the ways that building houses and buying houses were financed.
When the bubbles burst, the government leadership panicked, and the markets followed their leadership. Treasury Secretary Hank Paulson predicted imminent disaster, and the Federal Reserve rather than playing an independent steadying and calming hand reinforced those predictions (although without the public “fire in the theater” shouting of the Treasury Secretary).
Perhaps the best that can be said about the federal financial leaders during the financial crisis is that they did the best that they knew how to do. The problem was, that they did not know what to do. Each new memoir or retrospective published by one of these financial leaders reveals that they were acting on insufficient knowledge, insufficient information, and most of all insufficient understanding of what was going on. In other words, none of them knew enough to know what to do, and none of them knows enough now.
No one can ever know enough. The economy is just too big; there is too much for anyone but God to know. In an economy as large and diverse as ours, with billions of economic decisions being made all in the same day, it is impossible for anyone to know enough at any one time—of all that is involved—to be able to make the right decisions to control the economy, even if there were someone wise enough to do it.
That problem is not solved by creating a committee to control the economy. While any one person who serves as decision maker will suffer from lack of knowledge and will wear blinders towards the parts of the economy he either does not understand or is not watching at the moment, a committee of people has its own major shortcomings. Not the least of these is the proclivity of any group to be captured by group think, by the members of the group reinforcing each other to form a consensus and not venturing to upset things by questioning or looking beyond the consensus.
That is usually what happens with economic and financial bubbles. A key idea, usually a wrong idea, captures the group imagination. So many people come to believe this idea—like the odd notion that housing prices rarely if ever decline—that they all act on it, building up artificial values that increasingly depart from reality. When there is no government involvement, these bubbles burst soon enough and are resolved pretty quickly. Government leadership can hasten the formation of group think when an idea is part of official policy, and government policies can help to keep it going. Then, because government officials are slow to admit their own mistakes, government policies slow down the quick and natural adjustments that the market provides when the bubbles burst.
Unfortunately for all of us, the new Dodd-Frank financial regulatory legislation increases the power of new government financial czars to try to control virtually any aspect of the financial system that they choose. That error is not diminished by requiring these financial czars to meet together in committee from time to time, in a new Financial Stability Oversight Council (FSOC).
This last week two of the financial czars testified before a commission created to discover what caused the recent financial trouble and to recommend what to do about it (seems that if people were serious about this commission it would have made sense to pass new legislation only after the commission finished its work). One of the commission’s members, John Thompson, asked this question: “Why should we believe that this Council (the FSOC) is going to be uniquely different and keep us out of trouble?” (Donna Borak, “FCIC Presses Bernanke, Bair: Will Dodd-Frank End Bailouts?”, American Banker, September 3, 2010) Good question, but it got a poor answer, basically the observation that government regulators have more authority now. That is akin to saying that I will improve my aim because now I have more ammunition and a bigger gun.
Federal Reserve Chairman Bernanke admitted that even with all the new power given to the federal financial czars it will take political will to use it. “If there’s a lack of political will, there’s probably no solution that is sustainable.” Even were we to believe beyond all experience that any federal regulators or group of federal regulators could possibly know enough, where is the evidence that there would be the political will to break through the regulatory group think? Where would there have been the political will to bring the housing bonanza to a halt, or even to rein in the politically powerful housing giants Fannie Mae and Freddie Mac (which at least the Federal Reserve was seeking to do, against strong opposition from Congress—the stronger political will opposed needed reform)?
You do not need political will, however, if discipline in the markets is not a political decision. Market solutions do not require any political action or the exercise of political will by some federal financial czar or council of czars. No one needs a federal agency to drive down the stock of a badly managed company. Enron was beaten up by the markets long before Congress got around to it. The financial firms that disregarded risks in the housing bubble were put out of business by the markets—except for the firms that the government decided to prop up.
Which highlights the danger we are now in: today, as a result of the Dodd-Frank Act we have a financial system dependent on the government. Every important financial decision has now become a political question for one or more regulators to chew on and manage. Ready or not, here they come.
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