Regulation Mysticism: The Obama Show on Wall Street (Act I)

One thing is for certain, the current administration does not fail in providing ample theatrical events. Monday's speech on Wall Street was again a success in providing some of the same "entertainment", along with being complete with errors and fallacious notions regarding the laws of economics that we have come to expect from the Obama administration. Much like the speech last week to Congress on the health care issue, this week we witnessed much theater but little substance.

Three acts of insincerity that stood out specifically, to me, in Obama's speech were the president's constant calls for "common sense regulations", portrayal of free-market advocacy, and his statements on free trade. I will cover regulation here, and will touch on the other two topics in a separate piece.

The pronouncement of regulation and reform seem to be never ending. However, what type of regulation, how past regulation created the current economic mess, and at what cost we are willing to tolerate for new regulations is constantly lacking in clarity. Moreover, financial market regulation in the context provided by the White House is at best a euphemism for government control, and at worst a government-sponsored, non-market path toward special privileges.

My proclivities in the science of economics are aligned with the Austrian School's explanation that the laws of economics are a priori, thus these laws cannot be changed from day to day or year to year - nor from one administration to another.

Government imposed regulations do not change the way in which rational people respond toward economic incentives. Rather, poorly designed government-created incentives lead to new avenues of risk, uncertainty and market distortions. IBD editorials on Tuesday, in an article titled Lessons Unlearned, stated in simple terms how foolishly inaccurate the premise of calls for "reregulation" in the financial markets is at preventing another market meltdown. "Bad government, not Wall Street, caused the crisis - not a popular sentiment, but true nevertheless".

According to Obama's speech, deregulation of the past is specifically what had caused irresponsible behavior and excess. Aside from a congressional act in 1999 that allowed bank holding companies / institutions to provide and own non-banking financial services (a repeal of the Glass-Stegal Act of 1933), the deregulation of the financial markets is largely a myth.

The largest contributing factors of the financial mess beginning in late 2007, starting in the housing sector via risky packaged loan derivatives and Fed's easy money policy from 2003 to 2004, were the new incentives created and championed by our government. Specifically, the congressional calls for "housing for everyone".

A sharp Boom and bust in the housing markets would be expected to affect the financial markets, as falling house prices led to delinquencies and foreclosures. Those effects were amplified by several complicating factors, including the use of subprime mortgages, especially the adjustable-rate variety, which led to excessive risk taking. In the United States such risk taking was encouraged by government programs designed to promote home ownership, a worthwhile goal but overdone in retrospect,
explains John B. Taylor in Getting Off Track.

Enter laws of economics. People respond to incentives, and when government changes or makes new regulations pertaining to our financial sector, such as encouraging housing for everyone via prodding Freddie and Fannie to take on a larger portion (pouring in loads of money for loans) of the secondary mortgage market and the Fed's role in making money extremely cheap, what you end up with are new incentives not a lessening of risky behavior.

Obama's comment about "common sense regulation" implies risky behavior and excess can be regulated out of existence, and this is where he is both misleading and inaccurate.

In order to prevent moral hazard (externalized risk), we must eliminate bailouts, implied government backing and sponsorship, special favors to coveted financial institutions (by the Fed and Treasury), end the notion of "too big to fail", and reinstate the rule of being responsible for your own actions --- upholding laws that respect and protect private property (including the fruits of one's labor). In other words, allow necessary failures, a much necessary part of capitalism as are profits, to take place to ensure optimal allocation of resources and speedier correctional periods.

Regulation should not and does not imply good behavior or efficient markets, just as "ought does not imply can". This is false, and recent history proves it. Therefore, it is a foolish statement to suggest that new regulation will prevent, if not eliminate future economic distress - of any level or scope, even when the proposed new regulations are professed as "common sense".