US Congress Fumbles Financial Reform

Why Financial regulation will never happen given the makeup of the US Congress (from Robert Kaiser's comments in the video): "...it was the belief that it ... [regulation]... was the wrong way to go held by people who didn't understand the situation."

Mr. Kaiser does not mention the role of money in politics and Upton Sinclair's comment (here) that "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"


Watch New Book Chronicles Fight Over Financial Reform After Crisis  on PBS. See more from PBS NewsHour.

Financial Crisis, Stimulus and Regulation: Next Time Won't Be Different

In spite of the smack down from Rick Santelli (CNBC's "freaked out white man") Ezra Klein, a financial columnist for the Washington Post, recently wrote an excellent piece (here) on the Late 2000 Financial Crisis (also known as the Subprime Mortgage Crisis). Klein's article argues that there is never the political will to either (1) impose strong enough regulation to prevent financial crises or, (2) once the crisis has started, provide enough stimulus to bring the economy back to full employment.

One particular quote from the article caught my attention:

It is never possible for the political system to do enough to stop them [financial crises] at the outset, as it is never quite clear how bad they are. Even if it were, the system is ill-equipped to take action at that scale [once the crisis has started].

If Klein is accurate, the theories of Keynesian intervention and of central bank control of the economy are fundamentally wrong--something to think deeply about at a possible libertarian moment in US politics.

Prohibition vs. Regulation

I just finished watching the three-part PBS series Prohibition by Ken Burns and Lynn Novick. Prohibition in the United States officially began with the Volstead Act in 1919 and ended with its repeal in 1933 during the Great Depression. The images of the period captured in the PBS documentary were nostalgic, compelling and fresh (many I had never seen before). The video above gives a preview of the series.

The timing of the series, right after the current Great Recession, makes the analogy pretty clearly. One of the interesting points made at the end of Episode 3, made by Daniel Okrent (Last Call: The Rise and Fall of Prohibition), was that under Prohibition it was easier for anyone to get a drink then after Prohibition when drinking was regulated--an interesting history lesson in the importance and benefits of regulation.

Another interesting point made by historian Michael Lerner involved the unintended consequences of heavy-handed legislation. Prohibition was the "grade school, college and graduate school" of organized crime in the US, the effects of which remained long after Prohibition had been repealed.

I also enjoyed to comments of Catherine Gilbert Murdock (Domesticating Drink): "One could argue that it was not simply drink that was domesticated in this decade but men as well" (p. 7).

How Canada Avoided the Financial Bubble

Canada avoided the Financial Crisis of 2007-2010 using simple, no-nonsense financial regulation involving (1) capital requirements (targets for tier-one capital holdings), (2) quality of capital regulations (75% of tier-one capital in common rather than preferred stock) and (3) a leverage ratio of 20 to 1.

Similar lesson about no-nonsense control and regulation of the health care system are also available from Canada: (1) control of physicians salaries, (2) control of capital investment and technology and (3) control of drug prices.

Even though Canada has flirted with Neoliberalism, it seems to have avoided the nonsensical parts.

Airline Re-regulation

The process of airline re-regulation is about to start with DOT's decision to fine airlines that keep passengers waiting in planes for more than three hours before takeoff. Airline deregulation started in 1978 and there are two views about how successful it has been. The first view, advanced by neo-liberal and neo-conservative economists is that airline regulation has had "... overwhelmingly positive results." Any small problems (poor service, bankruptcy, safety violations, monopoly practices, overloaded traffic control systems, NIMBY constraints on more airport construction, lack of profitability, luggage fees, TSA shake-downs, intransigent unions, terrorist attacks, etc.) would be solved by more free market fundamentalism.

The other view is that airline deregulation has been an unmitigated disaster--for all the same reasons. Environmentalist would also add that air travel has a very large carbon footprint (even higher than automobile travel). In fact, airlines will be the first industry (even before coal-burning power utilities) to face cap-and-trade requirements in the European Union.

Which side of the argument you favor depends to some extent on your view of the future. If the future holds unrestrained exponential growth in air travel with continually decreasing prices, your projections about the future are probably based on assumptions about how increasingly free markets generate unlimited economic growth. If the future doesn't look that positive, you probably favor some kind of airline re-regulation. You might also favor a broader perspective that looks at a range of transportation alternatives (you probably recall that the Penn Central railroad failed a few years before airlines were deregulated and marked the end of long-haul private-sector passenger service in the US).

So, how well does the airline free market work and what are the predictions for the future? The figure above (data from the US Bureau of Transportation Statistics) shows a forecast for the airline market with airfare prices on the bottom graph and airline operations on the upper graph. Prior to 2009, there was a huge expansion of airline operations peaking in 2008 with very modest price movements (actually, prices have been highly variable, increasing to 2001, decreasing to 2005, increasing again to 2008 and then collapsing during the subprime mortgage crisis--the time plot is just compressed due to the large forecasted price increase).

The forecast suggests that we haven't seen anything yet: prices are going to skyrocket and operations are going to stagnate. If this happens, travelers are going to divert to automobiles (my wife and I are already doing this for long trips in the US). We would use long-haul passenger train service (as we do in Europe) but that was dismantled in the late 1970's. If only the system had not been dismantled in the brave new world of economic deregulation. Do you think we'll all ever have personal jet packs?

P.S. My forecasting model finds that there is very little interaction between quantities and prices in the airline market. That shouldn't be surprising since operations are flow-constrained. Market fundamentalism won't remove the current network and environmental constraints so the neo-liberal dreams of unconstrained growth in air travel are just dreams.

Sheila Bair, Bear Sterns, Bare Knuckles

The regulators are starting to weigh in (the boxing metaphor) on financial regulation. Sheila Bair, FDIC director, gave an interesting interview tonight on the PBS News Hour. Her comment in response to Paul Solman's question about the Christopher Dodd, D-CN, financial regulation bill: "I believe strongly in checks and balances." Reading between the lines, there are no checks and balances on the Federal Reserve. Checks and balances require multiple regulators with clear missions watching not only the regulated but each other.

But, she didn't explain how to avoid regulator shopping (looking for the regulator who will give you the best deal). This problem exists throughout the Federal government and is not unique to the banks. In bioterrorism, for example, university laboratories would rather be regulated by the CDC than by the Department of Agriculture, the later being perceived as uninformed about and out of touch with university research. Multiple regulators, regulator shopping, captive regulators and poor regulators are just some of the problems surrounding practical regulation. There's the bell for round one.

Fixing the Fed

Christopher Dodd, D-CN and chair of the Senate banking committee, introduced a 1,136 page plan to overhaul regulations for banks and other financial institutions. There are many obviously needed new regulations proposed in the bill (control of derivatives, consumer protections, controlling systemic risk, etc.) but what caught my attention was the provision that takes banking regulation away from the Federal Reserve. This step should be thought about very carefully and I haven't seen any blog traffic but expect to see a lot of discussion soon.

The mission of the Federal Reserve has changed over time (read the history here), but one of the original founding objectives was control of the money supply. The US Treasury controls how much money is printed but the banks control the extension of credit (effectively creating money) and the Federal Reserve controls bank reserves (the source of credit). On the one hand, the Fed needs a very good understanding and control over what banks are doing if it wants to control the money supply. On the other hand, the Fed is just another bank, the central bank. Since it operates independently, it begs the question of "who regulates the regulator"? I guess this is the point of Ron Paul's, R-TX, bill and book ("End the Fed").

We seem to be at an historical conjuncture where the Fed is loosing political support for its mission. It would be useful, before acting, to reflect on the financial history of the late 20th century, re-read Hyman Minsky's "Stabilizing an Unstable Economy" and have a very open public discussion about financial regulation and the role of the Federal Reserve. It would also be useful to think about how fast we want the US economy to grow and how much of the growth should be the result of financial manipulation. Slower growth and less financial manipulation would lead to fewer housing and stock market bubbles and lower CO2 emissions. Unfortunately, politicians are hooked on growth and they will ultimately decide the fate of the Fed.

Black Thursday, Monday and Tuesday

This week marks the 79th anniversary of the Great Depression. On October 24, 1929 "Black Thursday," the stock market bubble burst and a pool of bankers attempted to prop up the market with an investment of money. On October 28, 1929 "Black Monday," the stock market fell 22.6% as did markets around the world. On October 29, 1929 "Black Tuesday," panic set in and a record 16 millions shares were sold. Reviewing the history of the Great Depression in the middle of the Subprime mortgage crisis (Great Depression II) is particularly salient. One of the best reviews is currently running on the PBS American Experience "The Crash of 1929".

The history of the Great Depression touches a number of current policy questions: (1) Did government policy before the crash create the bubble and did government policy after the crash make the Depression worse? (2) Should we bring back the Glass-Steagall Act of 1933 that separated banking and financial organizations and was repealed in 1999? (3) Did the stock market crash cause the Great Depression or were there other forces operating in the US economy and the world system? (4) Is our financial system becoming increasingly unstable with larger boom-and-bust episodes? (5) Did anyone see the Great Depression developing? Did anyone see the Subprime mortgage crisis developing? If they did, how were their forecasts received? (6) Is it even possible to forecast recessions and depressions?