President Obama's proposed new financial market regulations are a giant step, but
mostly in the wrong direction.
Rather than establish new rules of behavior, they mostly give government regulators
unchecked, arbitrary, discretionary and sweeping powers.
A committee headed by Treasury would have authority to designate certain financial
institutions as posing a potential systemic risk to the economic system. Such firms
would be subject to additional regulation by the Fed to ensure that they don't in
fact endanger the system.
In the first place, determining which of the blizzard of financial institutions pose
a potential systemic risk, under what circumstances, and what steps would eliminate
that risk is an impossible task. No group of regulators - indeed no group of human
beings - has the knowledge, insight and foresight necessary to make such judgments.
And giving the job of regulating systemic risk to the Fed is a serious mistake. The
Fed already has a big job to do, establishing and maintaining a sound currency. And
it is doing a lousy job of it. In fact, excessively lax monetary policy is the
proximate cause of an overleveraged economy.
Establishing and maintaining a sound currency requires a single-mindedness of
purpose that is inconsistent with giving the Fed the responsibility of chasing after
the ghosts of supposed systemic risks.
Obama's proposed reforms also give the federal government perpetual bailout authority.
The Treasury, with the consent of the Fed or other regulators, could simply seize
any financial institution designated as potentially posing a systemic risk.
After seizure, the federal government could abrogate contracts the company has with
customers, lenders and employees. It could sell off assets, take equity and loan
money to the company.
These would all be decisions made by the government. The shareholders of the company
would have nothing to say about it and no standing to protest or effectively
challenge the decision.
This ought to be considered an unconstitutional taking of property without due
process or fair compensation. But put that aside for the moment. Has the experience
with government takeovers and bailouts really been so good as to warrant making them
a permanent feature of the regulatory apparatus?
Rather than increase broad-based, normative regulatory requirements, the Obama
reforms increase the power of the political class to make discretionary and
arbitrary economic decisions.
In addition to maintaining a sound currency, the Fed operates as the lender of last
resort in our financial system. Various steps are taken to protect the Fed from
political influence in exercising its various responsibilities.
Under Obama's reforms, however, Fed lending in exigent circumstances would be
subject to approval by the treasury secretary, who is a political appointee of the
president. In other words, the Fed's function as the lender of last resort would be
subject to a political check.
Let us assume for purposes of discussion that financial markets do need to be
subject to additional regulation and constraint to limit systemic risk. The way to
do that is to establish broad-based normative standards of behavior.
If financial institutions of more than a certain size are too big to fail, then pass
a law that prohibits financial institutions from getting that large.
If a certain level of leverage constitutes a systemic risk, forbid that amount of
There might be some economic inefficiencies in such an approach. But it would
establish rules of behavior that apply equally to all economic actors and are know
There is some of this in Obama's reforms. Mortgage lenders would have to retain some
part of their loan portfolios to create incentives for sounder underwriting
But there's precious little of it. Instead, politicians and regulators are given
sweeping subjective authority, with little in the way of rules or checks on their