A MSM Ally Against the Demonization of Deregulation?

I was shocked to read this piece by Sebestian Mallanby of the Washington Post. I was shocked because I have generally found nothing upon which I agree with Mallanby on. That said, he agrees with me on two points 1) demonizing deregulation for the mortgage crisis is in correct and 2)it is dangerous. Mallanby sees a slightly different culprit for the problem than I do.

The real roots of the crisis lie in a flawed response to China. Starting in the 1990s, the flood of cheap products from China kept global inflation low, allowing central banks to operate relatively loose monetary policies. But the flip side of China's export surplus was that China had a capital surplus, too. Chinese savings sloshed into asset markets 'round the world, driving up the price of everything from Florida condos to Latin American stocks.

That gave central bankers a choice: Should they carry on targeting regular consumer inflation, which Chinese exports had pushed down, or should they restrain asset inflation, which Chinese savings had pushed upward? Alan Greenspan's Fed chose to stand aside as asset prices rose; it preferred to deal with bubbles after they popped by cutting interest rates rather than by preventing those bubbles from inflating. After the dot-com bubble, this clean-up-later policy worked fine. With the real estate bubble, it has proved disastrous.

So the first cause of the crisis lies with the Fed, not with deregulation. If too much money was lent and borrowed, it was because Chinese savings made capital cheap and the Fed was not aggressive enough in hiking interest rates to counteract that. Moreover, the Fed's track record of cutting interest rates to clear up previous bubbles had created a seductive one-way bet. Financial engineers built huge mountains of debt partly because they expected to profit in good times -- and then be rescued by the Fed when they got into trouble.

He blames the Fed like I do only he blames them for not raising interest rates aggressively enough to counteract all the cheap money that China was dumping into the U.S. markets. Frankly, I remember things much differently. When the Fed dropped the Prime Rate to 3.75% the Federal Funds Rate dropped with it to .75%. That, to me, was what created far too much money in the system, not anything that China did or the Fed's non response to their actions. Still, while the debate over the real roots of this crisis is vital, that is one that I will leave for another day. For now, let's examine why Mallanby believes that deregulation is the wrong scapegoat.

The key financiers in this game were not the mortgage lenders, the ratings agencies or the investment banks that created those now infamous mortgage securities. In different ways, these players were all peddling financial snake oil, but as Columbia University's Charles Calomiris observes, there will always be snake-oil salesmen. Rather, the key financiers were the ones who bought the toxic mortgage products. If they hadn't been willing to buy snake oil, nobody would have been peddling it.

Who were the purchasers? They were by no means unregulated. U.S. investment banks, regulated by the Securities and Exchange Commission, bought piles of toxic waste. U.S. commercial banks, regulated by several agencies, including the Fed, also devoured large quantities. European banks, which faced a different and supposedly more up-to-date supervisory scheme, turn out to have been just as rash. By contrast, lightly regulated hedge funds resisted buying toxic waste for the most part -- though they are now vulnerable to the broader credit crunch because they operate with borrowed money.


If that doesn't convince you that deregulation is the wrong scapegoat, consider this: The appetite for toxic mortgages was fueled by Fannie Mae and Freddie Mac, the super-regulated housing finance companies. Calomiris calculates that Fannie and Freddie bought more than a third of the $3 trillion in junk mortgages created during the bubble and that they did so because heavy government oversight obliged them to push money toward marginal home purchasers. There's a vigorous argument about whether Calomiris's number is too high. But everyone concedes that Fannie and Freddie poured fuel on the fire to the tune of hundreds of billions of dollars.

Mallanby is absolutely correct that the purchasers of these bonds were all themselves hyper regulated. Though, if a regulated industry is buying a product that is totally unregulated there is something to be said for regulating that product. These mortgage bonds were extremely sophisticated and as we learned the players buying them didn't really understand the product themselves. While they may themselves have been regulated that doesn't mean the product they were buying was safe. What's missing from Mallanby's argument is what is missing from all discussions about deregulation and this crisis. That's that most of the mortgages were done fraudulently. If the most basic regulation was not enforced, what in the world is more regulation going to do?

Mallanby ends with a word of warning.

So blaming deregulation for the financial mess is misguided. But it is dangerous, too, because one of the big challenges for the next president will be to defend markets against the inevitable backlash that follows this crisis. Even before finance went haywire, the Doha trade negotiations had collapsed; wage stagnation for middle-class Americans had raised legitimate questions about whom the market system served; and the food-price spike had driven many emerging economies to give up on global agricultural markets as a source of food security. Coming on top of all these challenges, the financial turmoil is bound to intensify skepticism about markets. Framing the mess as the product of deregulation will make the backlash nastier.

The next president will have to make some subtle choices. In certain areas, markets need to be reformed -- by pushing murky "over-the-counter" trades between banks onto transparent exchanges, for example. In other areas, government needs to fix itself -- by not subsidizing reckless mortgage lending. But a president who has a mandate only to reregulate will be a boxer with a missing glove. By going along with the market skepticism of his party, Obama may end up winning an election while compromising his presidency.

He's correct. The markets will be weak enough as it is on their own coming out of this crisis. If a whole host of new regulations follow this crisis, that will be an extra incentive for players to stay away. Hyper regulation is the anti thesis of any economic recovery. Adding a whole host of new rules for the players in charge of bringing our economy out of this rut is counter productive.