By request: Blogging the meltdown

In the comments to the previous post, Zhubin sarcastically requests an entry on the financial crisis:

I wouldn’t mind a blog post about the current economic meltdown (I can see Lehman Brothers employees shuffling out of their offices from my window!) and … any rationalization you may have for why this proves that government regulation over the financial sector needs to be reduced.

If I better understood the workings of the financial sector there’s a decent chance I’d have spent the past few years earning six figures in New York rather than making coffee and writing articles about raw milk. I’m not going to make a vague case for generalized deregulation, but it is clear that government policies have contributed significantly to the current crisis. Here are a few things to keep in mind.

1. The current crisis is in large part the result of misguided policies from the past. Even many libertarians concede that dealing with the fallout from those mistakes may justify some of the recent bailouts, despite the risk that this creates an expectation of future rescues. Policy changes should focus on avoiding a repeat of these mistakes and getting the Fed and Treasury to make a credible commitment to letting firms fail. In that sense, it’s something of a relief that they turned Lehman away when it came by with cap in hand.

2. Fannie Mae and Freddie Mac are obvious examples of federal policy contributing to the meltdown. Congress created a massive duopoly in the mortgage market in which these two firms were able to crowd out private lenders and make risky loans with the expectation that the government would cover any major defaults. Profits are privatized, losses covered by taxpayers. The current response hasn’t done anything to address this problem. See Arnold Kling for more [pdf].

3. For the rest, I’ll punt to Tyler Cowen:

In short, there was plenty of regulation — yet much of it made the problem worse. These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not. This deficiency — not a conscientious laissez-faire policy — is where the Bush administration went wrong.

It would be unfair, however, to blame the Republicans alone for these regulatory failures. The Democrats have a long history of uncritically favoring expansion of homeownership, which contributed to the excesses at Fannie Mae and Freddie Mac, the humbled mortgage giants…

In other words, financial regulation has produced a lot of laws and a lot of spending but poor priorities and little success in using the most important laws to head off a disaster. The pattern is reminiscent of how legislators often seem more interested in building new highways — which are highly visible projects — than in maintaining old ones.

The biggest financial deregulation in recent times has been an implicit one — namely, that hedge funds and many new exotic financial instruments have grown in importance but have remained largely unregulated. To be sure, these institutions contributed to the severity of the Bear Stearns crisis and to the related global credit crisis. But it’s not obvious that the less regulated financial sector performed any worse than the highly regulated housing and bank mortgage lending sectors, including, of course, the government-sponsored mortgage agencies…

…regulators will never be in a position to accurately evaluate or second-guess many of the most important market transactions. In finance, trillions of dollars change hands, market players are very sophisticated, and much of the activity takes place outside the United States — or easily could.

Under these circumstances, the real issue is setting strong regulatory priorities to prevent outright fraud and to encourage market transparency, given that government scrutiny will never be universal or even close to it. Identifying underregulated sectors in hindsight isn’t a useful guide for what to do the next time.

Both presidential candidates have endorsed regulatory reform, but they have yet to signal that it will become a priority. That isn’t surprising. Fixing these problems may seem a very abstract way of helping the average citizen, and it will certainly require taking on special interests. It’s easier to tell voters that the regulators have taken care of last year’s problem, even if that accomplishes nothing for the future.

In the meantime, if you hear a call for more regulation, without a clear explanation of why regulation failed in the past, beware. The odds are that we’ll get additional regulation but with even less accountability and even less focus on solving our very real economic problems.