Of the Rule of Law and the Separation of Powers

In the 1990s I was part of a congressional delegation to Argentina.  At that time the Argentine economy was growing strongly and steadily, inflation was low, the currency was pegged to the dollar, convertible 1-for-1.  Trade barriers were being lowered, commerce was booming.  I recall asking Argentines what could possibly darken what seemed to be a very bright future.  They were quick to reply:  “Here in Argentina we have no rule of law.  You can have no confidence in getting justice from the courts.”

That reminded me of Washington Irving’s observation on a European judge, from his famous work, The Alhambra:

It could not be denied, however, that he set a high value upon justice, for he sold it at its weight in gold.

Not long after that visit, the politics of income redistribution and confiscation threw the Argentine economy into turmoil, where it has remained.

I recently spoke with an economist friend of mine, who was waxing eloquent about the attractive monetary and tax policies in Bulgaria.  I remarked that this would probably invite foreign investment.  He replied, “No, there is no rule of law there.”

The point is that good economic policy cannot long survive inadequate legal safeguards.  Many businesses that made major investments in China, attracted by a market of a billion people, have learned that the lack of a reliable legal and justice system in China has undermined much of the business value they thought to find.  A similar story has been holding back investment and economic development in Russia.

Bringing that home, I would venture that concern for changing rules (or even lack of rules)—the substitution of arbitrary bureaucratic powers in Washington over objective rule of law—has been inhibiting more robust investment in the United States, a major cause for our current anemic economic recovery.

An ancient king in the Western Hemisphere, named Mosiah, warned, “because all men are not just it is not expedient that ye should have a king or kings to rule over you.” (Mosiah 29:16)  Because men are not consistently just, freedom has historically rested upon rule by law rather than rule by men.

Fundamentally, that was the very reason for the American Revolution.  Our revolution was based on the rule of law, an assertion of the rule of law, a response to violations of the rule of law by the English king and parliament.  Most of the Declaration of Independence is a lengthy litany of violations of law by the English rulers.  The Revolution was designed to take power away from man and men and rest it upon laws and rights, soon to be secured by a written supreme law embodied in the Constitution.  Any erosion in the force and effect of the Constitution is an erosion of the rule of law and of the freedoms that rely upon law for their defense.

The Progressive Movement that thrived about a century ago, and found a major advocate in the federal government in President Woodrow Wilson, aggressively proposed an alternative to the rule of law.  This program was the Rule of Experts.  Their new view—and it really was a very old view though they dressed it up in modern-sounding rhetoric—was that there are Benign People, Experts, who know the process of modern government better than most people do, to whom we can safely yield governing authorities. 

It sounds akin to the ancient theory of Divine Right of Kings, that the monarchs of the world are chosen by God and endowed with greater wisdom and perspective than the average man and woman.  To their benign expertise and fatherly care was to be entrusted the governance of the rest of us.

The modern Rule of Experts people have much the same view, that these experts were endowed by their universities and other sources of expertise with ability far above that of most, and it would be wise to trust ourselves to their benign care.  Not very democratic, and in fact these Benign Experts make no secret of their impatience with the Congress and other constitutional brakes on arbitrary authority.

As King Mosiah wisely pointed out that men are not always just, it is also appropriate to recognize that putting men in government does not make them any more reliably wise than the rest of us.  The American Founders thought to address this problem by dividing political power among not only three branches in the Federal Government but also by embracing the federal system of dividing government with the States.

The current regulatory structure and program of the United States rest heavily on the idea that Benign Experts should be entrusted with authority for many of the big questions facing Americans and for many of the much smaller questions, too.  That is certainly the structure of the Dodd-Frank Act, to offer one recent, prominent example among many.

Charles Calomiris, of the Columbia University business school, described the theory of the Dodd-Frank Act and related regulations this way:

The implicit theory behind these sorts of initiatives, to the extent that there is a theory, is that the recent crisis happened because regulatory standards were not quite complex enough, because the extensive discretionary authority of bank supervisors was not great enough, and because rules and regulations prohibiting or discouraging specific practices were not sufficiently extensive.

(Charles W. Calomiris, “Meaningful Banking Reform and Why it Is so Unlikely,” VoxEU, January 8, 2013)

This program of federal regulation has been imposed increasingly in contravention of the basic constitutional principle of separation of powers, by merging legislative, executive, and judicial authority in “independent” regulatory agencies.  The unelected federal regulator today decides the details and specifics of binding mandates, identifies violators of those regulations, assesses guilt, and applies penalties.

Taken together our current regulatory system, by merging rather than maintaining the separation of powers of the Constitution, is eroding the rule of law.  It is returning us to the age old practice of rule by men, with all of the potential for abuse of rights and freedoms, abuses that fill up most of the sadder pages of human history.

During the debate over the creation of the new financial consumer Bureau, Senate Banking Committee Chairman Dodd boasted that with this new agency people would no longer have to come to Congress for the enactment of new consumer laws.  The Bureau would take care of all that.

There are serious operational flaws—too often overlooked—in the program of governance by Benign Experts.  First, the regulators are not dispassionate umpires, limited to calling the balls and strikes.  These umpires are also players in the game, the federal agencies each having their own set of particular interests and incentives that they take care of first.

Second, reliance on Benign Experts assumes an unproven, undemonstrated level of knowledge, insight, and forecasting skills.  AEI President Arthur Brooks, in his book, The Battle, provides one of many examples of this flaw:

Federal Reserve economists were still forecasting significant positive growth and moderate unemployment in May and June 2008.  They believed that economic growth in 2009 would be 2.4 percent, and unemployment would be 5.5 percent.  What we experienced instead was negative growth, double-digit unemployment, and the destruction of at least $50 trillion in worldwide wealth.  No one can get the numbers exactly right, to be sure.  But getting them this much wrong certainly lends a whole new meaning to the expression ‘margin of error.’

(Arthur C. Brooks, The Battle, p.46)

It is not that regulators are dumber than the rest of the population, but they are no smarter either.  The regulatory problems are increasingly too great for any designated group of humans to solve. 

Third flaw, mission creep:  power attracts power.  Even if the tasks are too great, require too much knowledge, insight, foresight, and other skills in unachievable degree, the regulators still take them on, especially if the task increases the reach and influence of the agency.  

I offer two examples from an example-rich environment.

Basel III capital rules started from a simple idea, that banks all around the world should be subject to the same capital standards.  Capital (the financial cushion a bank carries against losses) is one of the three key elements of sound banking, the other two being liquidity and earnings.  These international rules did not remain simple.  Developed by an international team of experts from around the world, who labored on them for years, the rules number hundreds of pages, affecting the entire financial structure and business model of a bank, any bank.  Congress was not involved and has no particular role in approving the rules.  When exposed to public review they attracted thousands of comment letters expressing dismay that they are a bad fit for the U.S. economy.  In the end, though, the regulators can go ahead with what they alone think is best.

A second example would be the Federal Reserve.  One hundred years ago this year the Fed was created with a specific, identifiable, and rather narrow purpose, to provide liquidity for the banking system in times of financial stress.  Before long, the Federal Reserve gained control of monetary policy and built up the practice of controlling interest rates.  Later, it was given the task of promoting maximum employment.  Under Dodd-Frank the Federal Reserve’s role in supervising banks and bank holding companies was expanded to supervising any financial business considered to be significant for financial stability.  Each of these powers has drawn the Federal Reserve away from its narrow, objective task, to broad fields of subjective authority. 

Perversely, this expansion of authority into more judgmental areas is eroding the independence of the Federal Reserve, making it yet one more political player in Washington, with responsibilities that far exceed human ability to fulfill, but which reach to every business and every home.  The Fed’s prolonged policy of keeping short-term interest rates at or about zero has penalized all who save and live off of their savings, transferring trillions of dollars from savers to borrowers, the biggest borrower being the Federal Government, a policy decided by a small group of Washington experts.

I offer a partial but simple solution to point us back toward strengthening the rule of law and reducing our exposure to the rule of man and men, however expert they might be.  Return the lawmaking and the policy decisions to the elected representatives.  It is a messy process, but exactly the messy process that the Founders intended to preserve freedom from the encroachment of arbitrary and oppressive government.  The regulators, which are theoretically part of the executive branch, should be left with the duty of implementing the laws and policy decisions that the elected and accountable representatives make. 

If Congress were required to write the rules and mandates and delegate to the executive agencies only the execution, the mandates of government would be circumscribed by the limitations of a legislative body forced to be directly accountable for what it has wrought.  It is easy for legislators to complain about bad regulatory decisions, when all too often these are decisions that Congress never should have delegated to regulators in the first place.

We would still have laws and regulations, but the laws might be more direct and specific, and perhaps fewer and surely smaller.  We would probably not have Dodd-Frank Acts that number thousands of pages read by no congressman or Senator, containing a cacophony of half-baked ideas and multiple solutions to the same problem, all left for the regulators to sort out.  

And legislators might recall this caution, from Thomas Paine:

Laws difficult to be executed cannot be generally good.

(Thomas Paine, The Rights of Man)

Of Business Losses and Government Help

In recent days JPMorgan Chase bank announced that it suffered $2 billion in trading losses, and Washington is all a-twitter.  You would think that a government that runs deficits of one and a half trillion dollars would hardly notice any event of $2 billion, but the chattering classes who think that they should have some role in running everything are all chattering about it and how it clearly demonstrates the need for more regulation, i.e. more need for them to be involved in running private businesses.

Mind you, JPMC’s $2 billion loss is a lot of money to you and me, but this does not particularly affect you and me.  JPMC suffered the loss, and given the size of the bank and its earnings (it usually makes somewhere in excess of $4 billion each quarter) it will little affect its bottom line.  JPMC is not asking anyone else to cover its losses, other than its own shareholders, and they will not feel it much if the bank continues to be as well run as it has been.

Ah, but perhaps you are thinking that JPMC got some of that TARP money so involved in the financial panic.  That is true, JPMC was one of the banks whose arms were twisted hard by Treasury Secretary Paulson to take a forced government investment.  Those TARP investments spooked regular, private sector investors, who immediately ran for the sidelines, and the financial crisis was on, propelled (as most are) by bad government efforts to “fix” things.  JPMC did not want the money or need the money and in a few months paid it all back—with substantial interest—as quickly as Congress and the regulators would allow them to.  It reminds me of the elderly gentlemen who finally yielded to family cajoling to take a ride in a stunt plane.  Afterward he thanked the pilot for the two rides, his first and his last.  TARP was such a bad deal for those who received the investments (except for the couple of financial firms that might really have wanted it), that I do not think that any would want a second ride, perhaps not even again at gunpoint.

The recent loss by JPMC, in any event, was one well covered by the bank’s earnings in other of its many lines of business.  Curiously, I do not hear the chattering classes get exercised when each quarter Fannie Mae or Freddie Mac announces several more billions of dollars of losses, losses that they do ask for the Treasury Department to make whole.  Maybe that is because the regulators already run Fannie and Freddie.  Actually, there was a little bit of noise in the past few days when Fannie Mae announced that it had actually turned a profit for the last quarter, the first time in years.

One thing that disturbs me in all of the Washington humbuzzah over JPMC’s trading loss is the implicit notion that there is something wrong about a business losing money on an investment, something wrong enough to call forth a government role.  It seems to me that losses are just as much a sign of a normal market as gains are, that healthy markets have a good share of both.  Nobody seemed to lose money during the housing bubble, no matter what they did, but that was hardly a sign of a healthy market place.

What markets do when they are allowed to is reward good business decisions and punish bad ones, with gains and losses providing some of the most effective means of helping businessmen and their investors understand truly which is which.  JPMC made some bad business decisions and lost money, and the counterparties to those trades made good ones and earned money.  What role can government play in all of that other than to mess it up?

To get government involved in this process rests upon at least two preposterous notions.  First, it suggests that it is somehow the role of government to make sure that businesses do not lose money, otherwise, why all the fuss?  That, of course, was the Soviet business model that did so much to create modern Russia.  Second, and following on the first mistaken notion, it supposes that government officials will know better how to avoid business losses.  Anyone really believe that?  Share with me your examples, and I will pass them on to the Federal budget planners.

Of the Dodd-Frank Act and Preparing for the Next Crisis

Last year Congress passed and President Obama signed into law the Dodd-Frank Act. As advertised, the Dodd-Frank Act was to restructure the entire financial system of the nation to ensure that we do not have another melt down of the economy, at least not one related to the financial system. With that promise, the Dodd-Frank Act set in motion an extensive program of federal government control of the banking and investment industries. Ever after, financial firms would be more responsible to bureaucracies in Washington than they would be to their own customers, but everything financial would be “safer.”

The Dodd-Frank Act is failing. In fact, judged by the most demanding measures possible, those set out by its framers in the Administration, it is an abject failure. And it is getting worse, not better, and it is making financial things worse, not better. A repeat of the troubles of 2007 through 2009 is becoming more likely rather than more remote.

A few days following enactment of Dodd-Frank, Treasury Secretary Timothy Geithner gave a speech at New York University’s Stern School of business in which he outlined six principles that would guide implementation of the new law. It is altogether fitting and proper that we should judge the success of the implementation by those six principles. Secretary Geithner challenged us to do so. He said, “You should hold us accountable for honoring them.” In a few days it will be ten months since President Obama signed the law in a formal White House ceremony. Let us examine progress of the last ten months by the standard of the six principles.

Principle One: Speed, moving as quickly as possible to bring clarity to the new rules of finance. The Dodd-Frank Act mandated an unprecedented program of new regulations that are so numerous and complex that describing them defies hyperbole. Estimates range between 250 and 500 new regulations to be promulgated. One of Washington’s prestigious financial law firms, Davis-Polk, noted by way of illustration that one of the agencies tasked with writing new regulations, the Commodity Futures Trading Commission (CFTC), normally has at most four regulations that it is working on at a time. At the end of December the CFTC had 31 regulations under work.

But starting regulations is not completing them. The Davis-Polk study noted that the law required 26 regulations to be completed in April 2011, but not a single deadline was met. Some 40 Dodd-Frank regulations are now behind schedule. That is not to criticize the regulators, who are cutting as many corners as possible to meet the deadlines. It illustrates how impossible it is to implement Dodd-Frank as mandated.

Principle Two: Full transparency and disclosure, with the regulatory agencies consulting broadly as they write new rules. Compliance with this principle is even worse than the speed test. In fact, in a vain effort to meet the unrealistic deadlines of the Dodd-Frank Act, regulators are shortening comment periods, consulting with each other as little as possible, and in general trusting to their own hasty judgment far too much. One agency head remarked to a banker group that the agency leadership did not need to have long discussions with the public; they have been thinking about the issues and already know what they want to do.

Principle Three: Avoid layering of new rules on top of old, outdated ones, eliminating rules that do not work, and wherever possible streamlining and simplifying. Barbara Rehm, a financial reporter with the independent trade newspaper American Banker, recently observed, “None of the numerous people interviewed could name a single rule that has been repealed or simplified.”

Principle Four: Avoid risking killing freedom of innovation, striving to achieve a careful balance, safeguarding freedom and competition. Since enactment of the Dodd-Frank Act there has been no innovation in the financial services industry, as businessmen do not know what they will be allowed to do and what will be banned once the Act is implemented. Actually, it is worse. The best minds in financial firms have been focused on how to meet the needs of the regulators rather than on how to meet the needs of their customers, and the only competition is among the regulators over who can be “tougher” on the financial industry.

Principle Five: Make sure that we have a more level playing field, both between banks and non-banks as well as with regard to America’s foreign competitors. In this category the talk and promises are extensive and good. So far there are no results. In fact, foreign regulators are quietly backing away from copying the regulatory excesses of the Dodd-Frank Act, positioning American firms to surrender the global financial leadership that they have built up over the last 100 years.

Principle Six: Actually, Secretary Geithner provided a bonus, squeezing two parts into this last standard. Part One: Have more order and coordination in the regulatory process so that regulatory agencies are working together, not against each other. Coordination among the regulators is haphazard at best, with plenty of agency competition in evidence. The new Orwellian Bureau of Consumer Financial Protection has not even been set up, and the other regulators are already competing with it to show who can be more punitive on financial firms in the name of helping their customers. Even the States are joining in, with various state attorneys general pressuring banks to cough up $20 billion to some kind of fund to be used by officers of the Obama Administration to help the fortunate troubled homeowners of their choice.

Principle Six, Part Two: Conduct a careful assessment of costs and benefits of the burdens involved with the regulations. Cost/benefit analyses have been cursory at best but more often non-existent. The inspector general of the CFTC recently chastised his agency for ignoring meaningful inquiry into the cost of its proposed regulations. Ten Republican legislators, troubled by this neglect, sent a letter to all the financial regulators asking for their cost/benefit analyses. There has been no reply.

Ten months into the implementation process, how must we judge the Dodd-Frank Act? Holding Secretary Geithner and the Obama Administration to their own standards, it is hard to avoid a conclusion of complete failure. This is no surprise to those of us who criticized the whole premise of the Dodd-Frank Act, that the government failures that brought on the financial crisis could be resolved by increasing the role of government. So far government is failing in the regulatory implementation crisis created by the Dodd-Frank Act. Do not look to government to be ready to respond to the next financial crisis when that arrives, especially if the confusion of the Dodd-Frank Act helps to hasten that day.

Of Financial Panic and Lessons Learned

Late last month I met with a group of German businessmen. They were on a visit to improve international understanding through cross-Atlantic dialog. As you can imagine, they were most interested in how the economy was doing. The German economy is off to a quicker recovery than is the U.S. economy, but in all fairness the Germans have not had to overcome as much government help as we have (during and following the financial panic of 2008)—although they are very worried about having to swim while being chained to drowning economies like Greece and perhaps others of the European community.

Among the specific issues that they asked to discuss was the question, “Have we learned lessons from the recent world economic crisis?” As I pondered that question, I came up with a list of eight lessons that we perhaps have learned. There are certainly others you or I might add, but here are the eight lessons learned that I came up with at the time, in no particular order of priority:

1. Economic and financial models are not as good as advertised. Much of the financial regulatory program of recent years was based upon the notion that regulators and the firms that they regulated had come up with powerful models to identify how well financial firms and the economy were doing, models that could be relied upon to control the economy. In fact, confidence in models was so high, that policymakers were starting to rely upon them to help predict the future. It turns out that economic reality is far more complex than any models, regardless of how powerful the computers are that run them. Once again we have seen that no group of policymakers, regardless of how smart they are or how much information they have, can control the economy any more than they can control the weather, and we should not fault them for failing to do so. We can only fault them for trying.

2. Fannie Mae and Freddie Mac are not the best run companies in the world. This lesson seems so painfully obvious that it is hard to believe that there was a time when people held them out as examples for emulation of corporate and financial management. But that was their reputation. We now know that the government privileges that they enjoyed allowed them to become sloppy in many crucial ways, especially in the management of their financial risk.

3. The biggest risk to the financial system is regulatory risk. Nearly every one of the financial firms that were strongly “persuaded” by policymakers to take government TARP money suffered market and reputational damage from those investments far worse than any financial challenges that they had. Nearly all of the largest recipients of TARP money paid it back as fast as the Congress and the regulators would let them, at a very expensive rate of interest. While a few have complained of these and other regulatory costs, more would if they were not afraid of the danger of being sent to the cornfield if they did, so they just say that it is “all very good” as their highest new costs today come from government regulations.

4. Economic reality always catches up with you, eventually. By the laws of economics, housing prices cannot long continue to exceed the rate of economic and population growth, but during the housing bubble the myth was that housing prices do not go down, at least not by much and not for long. The same was said about oil prices, by the way, as they grew even faster than housing prices. All came down, and all who believed and acted as if they would forever go up paid for expensive lessons. The same lesson is true today about government deficit spending. In spite of economic reality, too many policymakers act as if there is no limit to how much debt the government can put into the market. That false notion will crash on the rocks of economic reality, eventually.

5. Accounting rules, especially mark-to-market rules, are highly pro-cyclical. Accounting rule makers are on a multi-year crusade to force all companies to value practically everything by what you can sell it for in the market place right now. That means that in times of exuberant markets everything will look great and better than it really is, transferring market manias onto the financial books of companies. It also means that in times of panic, all things will look worse than they really are, accounting rules making sure that panic prices are written onto companies’ financial books. Mark-to-market financial rules were the amplifiers that helped puff up the housing balloon, just as they helped feed the subsequent financial panic.

6. You can hide risk, mask risk, but you cannot avoid risk. All economic growth comes from someone taking a risk. There is risk in whether a new invention will be well received in the market place, or whether a new store will succeed in its new location, or whether the new employees will do a good job, and on and on. There is a natural human tendency to want to harvest the rewards of investment without being exposed to its risks. So people try to get others to take that risk, or try to pretend it is not there, but the risk will be there, and the less obvious it is the less likely that people will take precautions to manage it. The biggest problem from the housing boom was that people thought that building houses and lending people mortgages to buy them were riskless, when in fact they are loaded with risk. A variety of things masked that risk. When it finally asserted itself, people who thought that they had made no-risk investments panicked. The same is happening today with people who invest in “no-risk” government securities. You might be able for a time to hide the risk; you cannot avoid it.

7. Bad underwriting is bad. When a lender decides to lend money he first evaluates the ability of the borrower to repay the loan. That evaluation is called underwriting, it is the lender making the determination that the loan is a good investment. Lenders and others will make mistakes: borrowers will get into unforeseen troubles, their new invention might not work as well as thought, their business might face a new and better competitor, some tax or new regulation might eat away anticipated profits. The lender expects that some small portion of loans will run into repayment problems, and the lender plans for that by setting aside reserves for loan losses. But when the lender does not pay attention to the risks that he can see, then he engages in bad underwriting, and no amount of reserves can absorb those losses. Would we have had a housing bubble and then a housing crash if so many mortgages were not provided to people who could not afford the houses that they were buying? Not enough lenders looked carefully enough into that question.

8. Financial firms cannot long offer products that policymakers and the public do not understand. Recent legislation and regulations are aimed at curbing some of the most successful financial products and practices, largely because policymakers and the public do not understand them. In times of financial turmoil, policymakers look for something to do, and one of the first things that they try to do is stop what they cannot understand. The public is vulnerable to the rants of people seeking to deflect criticism from their failings to products or practices that the public does not understand. The credit default swaps market was one of the few financial markets that worked extremely well throughout the recent financial turmoil, never freezing up while other markets pretty much stopped. As another example, bank investments in the securities markets—other than loans—were an important source of diversified income for banks, helping keep banks afloat when bank loans were suffering heavily from people and businesses that defaulted. Recent legislation and regulations are placing heavy new burdens on these profitable activities, and in some cases banning them entirely, because policymakers do not understand them. Financial firms have to be more active in explaining everything that they do, or they will continue to find many of their newest and best financial activities curbed in times of regulatory fear.

As I say, you can probably add to this list, as could I. As I ponder now the question that the German businessmen put to me, the actual lessons that we have learned seem to me less important than whether we will remember the lessons.

Of What Government Knows and What It Will Do

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.

Of Liberty and the Caesars

As we near another annual celebration of our Declaration of Independence and the proclamation of American liberty, it is worthwhile reflecting on what that independence and liberty rest. At its core, the American Revolution revolved around the deep desire to preserve something. That something was the rule of law, an elementary principle of government that the founding fathers had found here and nurtured. The rule of law is the fundamental idea that we should be governed by laws and not by men. It is that principle that throughout our history has set America apart from the rest of the world. Embracing the rule of law the founders built our nation upon a written Constitution.

Our founding fathers frequently used the word “liberty” when referring to the rule of law. When they said “liberty” they did not mean wantonness and libertinism, to be abusive without consequence. Our founding fathers meant by “liberty” the freedom that they had found in America to live beyond the wanton grasp of the arbitrary rule of kings, lords, ladies, and even parliaments. Our founding fathers were comfortable with the idea of government only if what the government did—or more precisely, if what the people in government did—was closely and clearly controlled by laws that everyone understood. To them that meant that they had liberty, and they loved it. The Declaration of Independence is a detailed protest by the Congress of the thirteen new States against the arbitrary violations of the rule of law—of American liberty—by the British crown.

Precisely because the American Revolution was an appeal to the rule of law we succeeded in creating a stable government and society where the French Revolution (and many others since)—appealing to the rule of men, albeit a different crowd of men—fell into chaos and anarchy, merely replacing one despotism with another. The French tore down the monarchy in order to replace it with the Reign of Terror. Americans enshrined liberty in a document that still operates today to resist the arbitrary rule of one group of men over the rest. The Constitution protects the rights of each and all—individuals and minorities—through the rule of law.

The rule of law was not a new idea. Rome’s greatness was built upon it. Its weakness and eventual collapse came as the Romans traded the rule of law for the rule of men under the Caesars. Even then, the Roman tradition of the rule of law was so strong that it took nearly 500 years for the progressive rule of men to lead to the sack of Rome and the ushering in of the Dark Ages, an era dominated by the rule of men.

The idea of the rule of law, however, is much older than Rome. It is found at the heart of Christianity, reaching back to the Garden, from which man was expelled by the breaking of law. Man was redeemed from the broken law by Jesus Christ, whose great sacrifice was made to bind up the broken law and create the path for man to live in harmony with divine law. In modern times Jesus Christ explained the eternal purpose of law in these words: “that which is governed by law is also preserved by law and perfected and sanctified by the same.” (Doctrine and Covenants 88:34)

As our eternal freedom is protected by law, so it is with our civil freedom. Law is our shield against the whim of other men. Without the law, our only defense against someone’s whim is the protection provided to us by the whim of someone stronger. That is the essence of feudalism. That is what our founding fathers were so desperate to leave behind in the Old World, whichever “Old World” they left. That same search for liberty under the law inspires many refugees to America today.

That is perhaps why Americans are made nervous by all of the policy “czars” that have been created by the Obama administration. Czars suggest rule by men rather than by law. “Czars,” the Russian variant of the Latin “Caesar,” are justified by the argument that “they can get things done,” but in the doing they rely upon the arbitrary will of single individuals invested with extraordinary power: rule by men (and women).

Congress is on the verge of enacting—unless the Senate votes “No” when it returns to session in mid July—a major restructuring of the American financial system that would replace rule of law with the rule of men. The new structure rests upon enormous power given to new financial czars. There is a new czar for all federally-chartered banks and thrifts, a new financial consumer czar with power to dictate every aspect of any financial product and service that is offered to the public, and a new systemic risk council with authority to reorganize or even break up any company in America if in their opinion its operations are too risky for the financial economy. The authorities that this new legislation would give are broad, the instructions on how to use those authorities vague, and the ability to find appeal from the mandates of the new czars seriously restricted.

Our founding fathers, who escaped from that kind of rule, would have warned us.

Of Financial Reform Promises and Too-Big-to-Fail Firms

One of the many astonishing things about the Obama Administration’s financial regulatory legislation is that it promises so much and delivers so little of what it promises. In fact, in most cases it delivers the opposite of what it promises. Seemingly, the Administration knows what the American people want, so it uses promises of delivering what the people want and what the nation needs in order to enact changes that most Americans will neither want nor like.

As Senators and congressmen prepared to return to their states and districts the Administration published a list of “Top Ten Things You Should Know About Financial Reform.” Presumably this would serve as a guide to politicians giving their Memorial Day stump speeches. I heard one Democrat congressman at the Memorial Day ceremonies in Waterloo, New York. Neither the list nor the legislation found its way into his remarks. Good thing for the congressman, because the legislation as currently written fails on all ten of the “Things” that the Administration paperwork boasts that it delivers.

Let us examine Thing 1:

1) End of Too-Big-To-Fail: If a big financial firm is failing, it will have only one fate: liquidation. There will be no taxpayer funded bailout. Instead, regulators will have the ability to shut down and break apart failing financial firms in a safe, orderly way—without putting the rest of the financial system at risk, and without asking the taxpayers to pay a dime.

Part of that Administration statement is true, but only part of it, and not the most important part. The legislation would provide regulators with the ability to shut down and break apart failing financial firms. Regulators already have that authority today and have been exercising it weekly for the past two years to close down failed banks “without putting the rest of the financial system at risk, and without asking the taxpayers to pay a dime.” Failed non-bank firms have been closed down through bankruptcy proceedings—again, “without putting the rest of the financial system at risk, and without asking the taxpayers to pay a dime.”

The risk to the rest of the financial system and the demand for taxpayer bailouts have all come in the past few years as the federal government has gotten involved to prop up firms that the federal government did not want to fail. Prior to the recent financial crisis, too-big-to-fail was a theory. Treasury Secretary Paulson made it official policy and practice, which policies and practices have been officially approved and adopted by the new Administration.

The new financial regulatory legislation—even while making it easier for financial regulators to break up and unwind failing financial firms—would also give to regulators legal authority to bail them out, prop them up, and have them born again as clean firms, free of the financial encumbrances of all of their sins of the past. In very real and important ways the legislation would take the theory of too-big-to-fail, turned into official practice by the Paulson Treasury Department, and make it the law of the land.

There are several ways that the legislation would provide this service. One important tool is the new explicit ability of the FDIC (which would become the agency for handling not just failing banks but any failing firm that government leaders considered important enough for the FDIC’s care) to treat the investors in a failing firm differently. The FDIC would be explicitly authorized to protect some investors and not protect others, giving special attention to the customers of a firm and those who have lent money to the firm. Shareholders are supposed to be wiped out and the leaders of the firm fired, but the bondholders and counterparties doing business could be protected.

If this sounds familiar, this is exactly how the federal government has been treating housing giants Fannie Mae and Freddie Mac. When the government took them over in late 2008, shareholders were nearly but not entirely wiped out, leaders were let go, but all of the bondholders, counterparties, and investors in debt securities of Fannie and Freddie became 100% protected by the federal government and remain so today. Several other participants in the financial system were “put at risk,” the government’s exercise of discretion to pick winners and losers precipitating the failure of several banks that were holding preferred shares of Fannie and Freddie that the government chose not to protect. The taxpayer has not been protected either, the Treasury deciding last Christmas Eve to allow Fannie and Freddie to receive unlimited federal support, already totaling hundreds of billions of dollars.

Fannie and Freddie are government sponsored enterprises (GSEs). The government subsidy programs for these GSEs would be the new model available for any firm designated as systemically significant by the federal government under this legislation. That is to say, that under this legislation, in place of two GSEs we would have potentially dozens.

There is a price for this attention. Whether a firm wants it or not, under this new legislation, if enacted, any firm could be given the GSE treatment. Once the government considered a firm to be “systemically” important it could be told in as much detail as the government leaders considered necessary exactly how to run its business. No part of the business of the firm would be exempt from the government’s reach. The federal government would become the effective partner of that firm. And as former Congressman Dick Armey once said, when you partner with government, the government is never the junior partner.

Now, ask yourself this real-world question: as senior partner, would the government ever let any of its partner financial firms fail? If, as is the case with Fannie and Freddie, by following government mandates the firm got so deep in the red that action became unavoidable, the federal government would be able to use another powerful tool in the proposed new law: the authority to create a “bridge bank." As the government has been doing with Fannie and Freddie—and as many suspect the government will do to “fix” Fannie and Freddie—government officials could take over the operations of the firm and use this bridge bank authority to protect whichever investors they wished and make others (not leaving out the taxpayer) suffer loss. Through a legal and financial “baptism” administered by the federal high priests of finance all of the sins of the failing firm could be gathered together into one “bad bank” and all of the remaining operations of the firm could emerge as a new firm washed completely clean of bad debts and uncollectible assets. The new firm could then be offered up again—either with the same name or a new one—to investors. Of course, the federal government would likely remain as senior partner, but this would give comfort to investors who, like investors in Fannie and Freddie, were looking for a place to put their money where the government would be expected to protect those investments.

Ending too-big-to-fail? In the Administration proposal too-big-to-fail becomes the law of the land. The Administration’s number one selling point for financial legislation is a very good reason to oppose its bill.

Of Financial Safety and Lost Liberty

Americans are about to lose more of their liberty, in a very big way. Like the oil leaking away from the deep well in the Gulf of Mexico, American financial liberty will be steadily draining off with few ideas on how to stop the leaking once it has begun.

First the housing markets panicked, then the Paulson Treasury panicked, and then the financial markets panicked. Now panic has hit Congress. Ignoring that the housing-financial crisis was set up and fomented by bad government regulatory programs, Congress is on the verge of enacting legislation that will give to government regulators authority to control any financial activity in the United States.

You may think that I am exaggerating a bit here, getting carried away by rhetoric. I wish that I were. Looking at the provisions of the legislation that the Senate is now debating and is scheduled to pass in the near future, I cannot think of a single financial transaction that government agencies would not be able to control. By control, I mean set rules as to how the transaction would be structured, to whom it could be offered, by whom it could be offered, how it could be advertised, how it would be priced, or even whether it could be offered at all.

Let us consider a simple financial service: a home equity line of credit, or HELOC. With a HELOC a customer can borrow money from the bank up to the amount of equity that the customer has in his house. The attractiveness of the HELOC is that you do not have to sell your house in order to use the equity in it to help pay for college, fund needed remodeling, or even start a small business. With the loan backed by the equity in the house, the borrower gets a far lower interest rate than he would without that collateral.

The legislation would create a new, totally independent federal bureau of consumer regulation. This new bureau—headed by a one person consumer czar endowed with power that would make an old Russian despot jealous—could determine, for example, that it would be “unfair” or “abusive” if the amount of money that a customer could borrow under a HELOC were reduced by the bank when the value of the customer’s house declined. I am not making this up. At a recent Federal Reserve meeting self-appointed consumer advocates, who would dominate the new bureau, complained that banks during the housing bust were lowering HELOC amounts for no good reason other than that home prices declined, neglecting that what makes a HELOC affordable is that it is backed by the value of the house. The value of the house goes down, so must the value of the collateral and the loan amount secured by the collateral. The law would not require, however, that the new consumer bureau be guided by common sense.

Other provisions of the proposed law would allow government agencies to break up any company in America, or make it set aside any reserves, or give up any line of business—and allow the agencies to play favorites by acting one way with one company and very differently with another—as long as the agencies claimed that their actions were appropriate to deal with systemic risks. The agencies would be the sole judges of what makes for a systemic risk. Or, to look at the authority another way, the federal financial agencies would be able to define what they consider to be “safe” financial conduct and effectively ban everything else, and steer individuals and businesses into government-identified safe financial activity.

In case the recent financial panics tempt you to think that all of this is a good idea, remember that we have tried this all before, and very recently. The example—housing—is staring us in the face. Maybe policymakers in Washington are too close to it all to notice.

In the housing fiasco, the government determined that mortgages were very safe (as demonstrated by Federal Housing Administration programs that allow homeowners to have a negative equity position on day one of their new government-guaranteed mortgages), that investing in mortgages was safe (hence the creation of government-sponsored Fannie Mae and Freddie Mac, to encourage investment in mortgage securities), that packaging mortgage securities was safe (as demonstrated by AAA ratings for packages of securities, awarded by credit rating agencies that were franchised by the Securities and Exchange Commission), and that housing assets on bank balance sheets were safe and worthy of incentives by regulatory standards that allowed banks to hold relatively little capital for their mortgage loans.

So, given how well the government identified safe financial activity in the housing markets we can expect the government officials to be equally mistaken in identifying other forms of safe financial activity. Even as I write this, government officials are working on new plans to establish rules to require banks to stock up on various types of government debt. These rules are based upon the near-sighted assumption that government debt is safe—ignoring the rising flood of Greek government debt, held back only temporarily by sandbags filled with fiat money from other European governments.

On the wall in my family room I have a framed $500 government bond. Only one coupon from it has been clipped, a semiannual payment for $15 in interest. The next coupon is payable on July 1, 1865, by the government of the Confederate States of America. That coupon and all the rest of the coupons through 1894 remain unredeemed. The proposal by Congress to exchange American financial freedom for the wisdom of government to identify safe financial activity has the crackle of Confederate money.

Of Government Collusion and Market Discipline

There is a lot of noise and confusion about what caused the recent financial panic. The Obama Administration believes that the basic problem is that markets do not work right, people are too dumb to choose for themselves, and that regulatory agencies were not able or were unwilling to keep up with bank shenanigans. Their solution: more of the same, that is, create a variety of new government agencies and bureaus that have the authority to dictate and control any part of or player in the financial system, including control of financial customers large and small (look in the mirror for the definition of financial customer). This neglects the fact that government agencies were the most blameworthy in the recent financial panic. In fact, it is impossible to have a long, sustained economic recession or depression without government policies causing it. (I will save for another day how the policies of the Federal Reserve and the Franklin Roosevelt administration made sure that an economic downturn became a depression lasting for a decade.)

Let me address the first of these points in the Obama administration’s justification for taking over the financial system. First of all let us consider the markets. It is true that the markets did not perform right. That was because government rules, structures, and programs did not allow the markets to perform right. The government guarantees bank deposits, so depositors do not care very much how safe or sound a bank is. Government-sponsored enterprises (GSEs), like Fannie Mae and Freddie Mac, bundle up mortgages into securities that investors assume have little or no risk. The Securities and Exchange Commission (SEC) approves and controls the small number of credit rating agencies, and investors believe that these agencies are right when they give to a particular company or investment their highest credit rating (such as AAA), a rating that is thought to present little or no risk. The SEC has protected these agencies from competition and from market discipline for their errors while providing little in the way of regulatory discipline.

With those and other government protections in place the appearance of risk just about disappeared from the mortgage markets. Different investors have different appetites for risk. It was not the people hungry for high risk returns that fueled the housing bubble. Many of those with the weakest appetite for risk, seeking the safest investments, were drawn to the mortgage markets. In this government-manufactured atmosphere of little or no risk, many mortgage firms, increasingly non-bank mortgage firms, made it more and more possible for people to buy houses that they could not afford. Once the mortgage firm made the mortgage, regardless of the ability of the borrower to repay, the firm sold the mortgage to the GSEs, who sold it on to investors who poured trillions of dollars into what they thought was a safe haven. Then the mortgage firm went on to make more mortgages. Investors were shielded from asking whether the mortgages were any good, that is, whether the person buying the house could actually afford it.

That mispricing of the risk pulled more and more money into mortgages and real estate, driving prices up and up, pulling in more and more investors as the prices rose, until it was impossible to put one more Jack on the house of cards without it tumbling down. People panicked when “safe” investments turned out to be risky. Then the government started panicking, bailing out some firms and not others, changing the rules almost weekly, demanding hundreds of billions of dollars from taxpayers in order to pick financial winners and losers. Investors, not knowing where the government would turn next, panicked some more.

It was government interference in the market that failed, not the markets. Without all of the government camouflage, investors would have insisted on knowing that the mortgage borrowers could afford their houses before funding loans to buy them. Ask yourself this: would we have had the whole housing blow up if people who could not afford to buy houses were not given mortgages? Yet the Obama Administration, even today, is tripping over itself to find new ways to guarantee new mortgages, in many cases especially for people who cannot afford their houses. Where have all the subprime mortgages gone? They have gone to the Federal Housing Administration (FHA), where they have a government guaranty. (Watch what happens to the FHA house of cards in the coming months.) When will they every learn? Oh, when will they ever learn?

Giving more power to the kind of government agencies that helped create these problems hardly seems like the sensible answer. That is what the Obama Administration proposes, though. Instead of controlling the markets with more government interference and masking of risk, more bailouts for firms that should be allowed to fail, more power for some new government bureau to pick winners and losers and to tell people which financial products they can and cannot have, we should be exposing financial players more to market discipline. We should make it harder to hide risk and easier for investors to recognize the risks and allow the markets to charge higher prices for higher risks and lower prices for lower risks.

Market discipline has always been the quickest and surest regulator. It rewards the efficient provider of what the buyers in the market want, and it punishes the incompetent. Very importantly today, the market is stingy about bailouts.

Of Bubbles and Treasury Debt

Over the last decade our economy has been buffeted by what appears to be an accelerating series of economic bubbles. It is more than coincidence that this has occurred while government interference in the economy has increased.

That is not to deny that free markets are fully capable of producing economic bubbles, as market participants miscalculate investment risks and rewards and copy-cat each other as they do so. These market participants, however, if left to their own devices will also pay the price for their mistakes. Knowledge that they are at risk acts as a moderator and corrector, limiting the degree of risk investors are willing to take in the first place (and the willingness of lenders to provide money to support the bubble), and leaving the way clear for other investors to come in and pick up the debris (at a profit) when the bubble bursts.

When government is involved non-economic factors are inserted into the calculation of risk, and they affect who pays for the risk. With the existence of federally-supported mortgage guaranties, investors paid very little attention to whether mortgage lenders verified the ability of borrowers to make payments. A government guaranty always means that risks will be undervalued and that someone else (usually the taxpayer) gets to pick up the tab for the miscalculation.

It is neither exaggeration nor hyperbole to recognize that for more than a year the government has been handing out guaranties at a rate never before seen in the history of mankind. That is to say, that mountains of financial risk miscalculations have been made and are being made every day, and the unavoidable consequences are accumulating.

Perhaps the most dangerous miscalculations are those involving the debt issued by the U.S. Treasury. Investors are mistakenly acting as if there is no risk in placing their money in Treasury securities. These investors overlook the risk that buying Treasury securities--with an effective interest rate of 4 one-hundredths of one percent (the rate last week for 1-month Treasuries)--puts investors at risk if interest rates rise even a little bit and exposes the investors to even mild inflation.

Inflation is unlikely to remain mild. Along with all those government guaranties there has been a mountainous accumulation of new money provided by the federal government. All that money has to go somewhere. Right now it is awaiting some slight shock to send it avalanching down on the economy. Much of that money is for the moment being hoarded by investors and businesses afraid to spend it or put it to work while economic prospects remain unsettled and policymakers keep confusing the markets with one economic policy, regulation, restriction, or plan after another. No one wants to play the game while the referees are adjusting the rules.

So the government money makers keep pushing more money out to fund investment even while they toy with new disincentives to investment. People park the money instead in bank deposits (which are growing at record levels) and Treasuries (driving Treasury interest rates down to almost nothing).

That will not continue. At some point, the willingness of investors to hold dollars in accounts earning practically nothing will have played out. They will get their fill of Treasury securities. Foreign investors are already there, in recent weeks reducing their holdings of U.S. Treasury debt. Treasury interest rates will have to rise to attract investors, but as Treasury interest rates rise those who invested in Treasuries at very low interest rates will be on the losing side of their investment. They will start unloading their Treasury investments, further driving Treasury prices down and interest rates up, causing even more losses to those who invested in recent months in the Treasury bubble.

The spiral will be hard to stop, particularly as the Administration will be desperately trying to borrow more money, unheard of new amounts of money, to fund their planned multi-trillion dollar deficits. Interest rates will have to go up very high very fast in order to fund that voracious new appetite of the government for debt. The high interest rates will choke off many new sparks of economic recovery, leaving a lot of money around chasing after fewer goods and services for sale.

The Treasury bubble will likely end in a race that we have not seen for more than a quarter century. The race will be on for which will go higher, inflation or interest rates.