Saturday, March 26, 2011

After The Fall

Nicole Gelinas, a senior fellow at the Manhattan Institute and a contributing editor to City Journal, wrote  "After the Fall" in 2009, which Noman proposes to review over the coming weeks.  Though the Obama Administration hustled through financial reform (Dodd-Frank, 2010) while the citizenry was still panicked and pliable--indeed, before the release of its own Financial Crisis Inquiry Commission's findings (January, 2011)--Gelinas's prescriptions for reasonable regulation according to well-tested principles should provide a useful scale with which to measure Congress's actions.

Gelinas prefaces her book with a 1993 quote from Wendy Gramm, former Commodity Futures Trading Commission (CFTC) chairwoman: "The only reasons...why firms might underinvest to control risk are due to failures in government: Firms may believe that government will not let them fail under a Too Big to Fail Policy...or that the bankruptcy code may not impose sufficient penalties for failing."  Gelinas believes that government worked to create the financial crisis of '08 and the resulting recession by granting "freedom from the fear of failure" to financial firms over a 25-year period, beginning with President Ronald Reagan.  Because government adopted the view that some financial firms were "too big to fail," lenders to those firms no longer feared losing their investment.  Consequently, their actions--i.e., the amounts they were willing to lend, and at what rate--ceased to transmit "vital signals about the prospects for success or failure."

Firms and bankers enjoying implicit government subsidization became reckless in their measurement of risk-taking, and in the creation of novel instruments that circumvented regulatory limits on borrowing and exposure, and sidestepped disclosure requirements.  It was one thing to let finance evolve while saying that markets could regulate themselves better than government could.  It was another to allow that same evolution to occur while short circuiting the ability of markets to perform their regulative function.  Washington's too-big-to-fail policy prevented the market from reigning in speculative and evolutionary excesses.  

Financial firms liberated from market discipline lent profligately to consumers, and lavishly rewarded executives and high performers, thereby draining talent from other industries.  By 2007, the market had had enough, and in 2008 Washington was compelled to replace private risk takers in the economy with government capital in order to avert a depression precipitated by the freezing of money and credit markets.

It is the function of the financial system to determine which people and businesses should have access to capital, and on what terms.  When lenders make mistakes by extending credit to failed institutions, they must take their losses.  That is the market discipline that regulates financial activity, and sends clear signals. 

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