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Click to read Part 1, Part 2 and Part 3

Until I began to examine the Dodd-Frank financial overhaul bill I had no idea that it would so significantly change the direction of the United States. Its scope is so vast and pervasive that it is difficult to grasp its totality. I wrote this article to try to explain this and why I believe it is so important for us to understand it. Because of its complexity it was not possible to do this briefly, so I wrote this major "white paper" and divided it into four parts to make it easier to digest. This is the final part of this four part series.

Part 4 (Final)

Why Regulators Will Always Fail

Why should new regulations work when the old ones failed?:

"We failed completely to understand the complexity of what the impact of the national decline in housing prices would be in the financial system," said Ms. [Janet] Yellen, currently president of the Federal Reserve Bank of San Francisco [and recently nominated as Vice-Chair of the Fed for financial risk]. "We saw a number of different things, and we failed to connect the dots."

The problem with this kind of regulation is that new laws are always looking backward in an attempt to prevent the last bust from happening.

While the origins and outcomes of boom-bust cycles behave similarly, as Rogoff and Reinhart point out in their research, the asset classes and mechanics of the boom are different. As the Fed pumps money into the economy, money follows different paths and inflates and distorts different asset classes each time. In the boom-bust cycle money flowed into high-tech companies and the stock market. Before that cycle, money flowed into real estate, mainly multi-family housing. The current cycle pushed money into housing, and more importantly, new forms of debt based on housing that hadn't previously existed.

It is obviously more complicated than this, but the point of this paper is that regulators will never keep up with the next asset class boom and bust because they will be looking backwards. Will they know the "next one" when they see it? I doubt it.

What They Forgot

I discussed in the Part 1 of this article that there is almost nothing in the Act that actually prevents the Fed from creating new boom-bust cycles or that inhibits the federal government’s policies favoring, and thus distorting, the housing market. Here are things that they should have tackled but didn’t.

Fannie and Freddie

The Act failed to deal with Fannie and Freddie. Recall my question at the beginning of this article about why lenders would make unsafe loans. There is no question that the primary movers in the housing boom and bust were Fannie Mae and Freddie Mac, government sponsored housing financing entities (GSEs). Fannie guaranteed one-half (53%, or about $5.5 trillion) of the U.S. housing market’s $10.7 trillion of mortgages; about 10% ($500 billion) of those were subprime (“toxic”) mortgages. Countrywide, the largest subprime lender, eventually taken over by BofA, sold 90% of its loans to Fannie, and Countrywide’s loans comprised 25% of Fannie’s purchases.

Fannie and Freddie were nationalized in September, 2008 and the federal government assumed their liabilities without limits. As of Q1 2010, Fannie had lost double its profits made for the previous 35 years. They have already cost taxpayers about $85 billion. Estimates of bailout costs range as high as $1 trillion, assuming home values decline another 20% and foreclosure rates continue to climb.

It is interesting that the Republicans tried to introduce provisions in the Act that would reform Fannie and Freddie. But Barney Frank blocked this reform:

Republicans repeatedly tried to attach amendments that would rework government-run mortgage giants Fannie Mae and Freddie Mac, but Mr. Frank repeatedly disallowed Republicans from offering the amendments. At one point, he slammed his gavel down violently out of frustration.

There is no need for the government to be involved in the housing market. It is purely a political play. As Douglas Holtz-Eakin, former Bush II economic advisor and CBO director, said, “Republicans and Democrats love putting Americans in houses, and there’s no getting around that.”

Even FDIC Chair Sheila Bair, said:

"I think a properly regulated and functioning private securitization market perhaps could provide liquidity sources that we need to fund mortgages."

To be fair to the Administration, they and Mr. Frank have said that Fannie and Freddie need “dramatic reform” but they have no political will to get rid of them or let the market function properly.

Meanwhile, the federal government loan guarantee machinery is still roaring along. The FHA has guaranteed about one-half of all new home loans since 2009. Its minimum down payment requirement is 3.5%. About 24% of loans it guaranteed in 2007 and 2008 are in default. Overall delinquencies are 8.3% of their $865.5 billion of loans, up 35% over June last year.

The government continues unabated to favor and distort the housing market despite their role in causing the financial crisis.

Federal Reserve Boom-Bust Generator

The other question I asked at the beginning of this article is, why all of a sudden did we have a boom? No economist, other than Austrian theory economists, answers this question satisfactorily. Keynesians believe that our excesses are caused by our “animal spirits,” i.e., greed. Monetarists and other neo-Classical economists attribute it to the usual factors of an "excessive" money supply (Milton Friedman believed in a steady state monetary inflation of around 4% per year), greed, and perhaps legislative policies such as those favoring housing.

The Austrians have placed the cause of booms and busts at the proper source, and that is the Federal Reserve, the only authority which has the power to “print” money. Nothing in the Act changes the Federal Reserve’s power over interest rates and money supply. The Fed’s dual mandates are still to maintain steady interest rates and maximize employment.

The Fed’s role in the housing boom-bust is shown as follows. From 2000 to 2004 the Fed Funds rate went from about 6.5% to 1.0% and money supply shot up (click to enlarge images):

M1 vs. Fed Funds rate

And so did the housing market:

Housing Starts

When the Fed floods the economy with new money it doesn’t create wealth; if that were the key then we would all be rich. What it does by artificially reducing interest rates is to distort the entire entrepreneurial process and sends capital to places where it isn’t really needed. In this cycle it went into housing, drove prices up, created an unsupportable debt structure, and, as we are now finding, housing was massively over-produced. The result was the greatest expansion of debt in history. In Austrian economics terms this result is called “malinvestment.”

To the Fed’s consternation, money supply is now declining as the above chart shows. The Fed desperately wants to cause inflation because they believe it will rescue the economy. They believe they can cause inflation by pumping money into the economy and expanding money supply. But they have a problem. As a result of malinvestment and the huge amount of debt built up to support it, money supply is now declining even though interest rates are effectively zero. A declining money supply is deflationary. They will eventually find a way to inflate which will lead to stagflation. (See, "Anti-Deflationists Win The Day At The Fed," and this and this.)

Too Big To Fail and Moral Hazard

The most important lesson of this financial crash is that large financial companies now know that they will be bailed out if the Fed and Congress believe it is necessary to “save the economy.” While the President says we’ll never bail out these companies again, the Act, as noted previously, actually does allow the government to bail out “industries.”

The only reason the language in the Act was inserted to “prevent bailouts" was to attempt to placate the general public who believe that bailouts of TBTF companies was wrong. If the government really wished to prevent bailouts, they would have done so explicitly, but they didn’t. They believe bailouts are absolutely necessary to "save the economy."

The expectation of bailouts is what economists call a “moral hazard.” That is, if you bail companies out it encourages risky behavior because of the knowledge that they will be bailed out. Capitalism, as many have pointed out, is a system of profit and loss. The loss part of that equation is essential to capitalism. Austrian economist Joseph Schumpeter called the failure of firms a process of “creative destruction.” Not only does failure wipe out the mistakes of a failed business, but more importantly it is a necessary signal to entrepreneurs, banks, and venture capitalist to not waste their valuable capital on similar ventures. If you remove the concept of loss from TBTF businesses, the signal are you sending is to encourage risk-taking with the taxpayers’ money.

The system of bailouts isn’t new. The federal government has created an entire structure to prevent or cushion failure in those industries which it favors. Professor Russ Roberts in his paper, “Gambling With Other People’s Money: How Perverted Incentives Created the Financial Crisis,” details this process eloquently and in detail. From the fractional reserve banking system allowing banks to back their loans with only 10% of Tier 1 capital, to deposit insurance (now raised to $250,000), to Basel II capital rules, to CRA rules, to Fannie, Freddie, and the FHA, the entire system is skewed toward cushioning the risk-takers from the consequences of their actions.

This has created a system of “crony capitalism,” a system which favors the government’s friends. I call it the Wall Street-Washington Financial Complex. In an article from the City Journal, Nicole Gelinas points to a book, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, by Simon Johnson, MIT entrepreneurship professor, and James Kwak, a former McKinsey consultant, of which she notes:

What Washington has created, then, is best summed up in Johnson and Kwak’s title. The “13 bankers” are the CEOs of the surviving big banks, whom President Obama summoned to the White House just weeks after his inauguration. Obama had convened the bankers to show the public that he was firmly in command of the institutions that the government had rescued. But what markets perceived was protection. “It was clear that the thirteen bankers needed the government,” Johnson and Kwak write. “But why did the government need the bankers?” In pumping trillions of dollars in cash and guarantees into the financial system without demanding change, Johnson and Kwak say, we risk creating a “uniquely American oligarchy”—one that will harm America’s growth, just as similar oligarchies have harmed other nations’ growth throughout history.

The Stifling Hand of the Financial Risk Czars

In August, 2008 I wrote an article predicting the coming creation of a financial risk czar:

Can you imagine [the] financial risk commission at the birth of Wall Street? They would have argued, correctly, that stocks are too volatile and market booms and busts present too great of a risk for the economy. Only bonds would be suitable to keep the economy stable. They would, of course, ignore the benefits of raising capital for enterprise and the dynamic American economy would have never gotten off of the ground.

The new czars will stifle innovation and economic growth because their mandate is to prevent disruption to the economy, not to promote growth.

Because these crises are never quite the same, they won’t see the next one coming, but they will see a lot that aren’t.

To download a PDF of the entire article, go here.

Disclosure: No positions

Source: The Triumph of Crony Capitalism: Part 4 (Final)