Discretionary Failure

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was enacted to prevent another financial crisis, but it misdiagnosed the crisis and enacted the wrong remedies.  People are now waking up to the fact that the bill does not do what its supporters claimed.  The sheer complexity of the 2,319- page Dodd-Frank bill certainly increases risks to the economy, but when we sift through the many sections and subsection, we find much more than complexity to worry about.  Instead of preventing future financial crises, it make them more likely. And in the meantime it impedes economic growth.  Critics on both the left and the right have attacked Dodd-Frank: “The Failure of Financial Reform, Itemized,” from John Talbott of the Huffington Post; “Phony Financial Reform” from Thomas Donlan of Barron’s. Congressman Paul Ryan writingin the Wall Street Journal, argued that the bill created a “permanent Wall Street bailout authority.”  Simon Johnson, former chief economist at the International Monetary Fund, argues that it is an “illusion to think that  this solves the problems posed by the impending collapse of one or more global megabanks,” and that any Treasury Secretary could circumvent the act and simply bail out the creditors of large financial firms as they did in 2008.

While political factors- special-interest lobbying, social-activist pressures, covering up past mistakes- were probably behind much of the bill’s architecture, economic analysis reveals that it also was based on a misdiagnosis of the financial crisis.  As a result, the bill is riddled with deviations from sensible policy.  The biggest factor contributing to the misdiagnosis is the presumption that the government did not have enough power to avoid the crisis.  It most certainly did.  The Federal Reserve had the power to avoid the monetary excesses that accelerated the housing boom and therefor led to defaults, foreclosures and toxic assets.  The New York Fed had the power to stop the questionbable lending and trading decision of Citigroup and others.  With hundreds of regulators on the premisis of such large banks, it also should have had the information to do so.  The SEC could have insisted on reasonable liquidity rules to prevent banks from relying on short-term funds to finance long term investments. And the Treasury, in concert with the Fed, had the power to intervene with troubled financial firms.

In fact, during the crisis, Federal Reserve and Treasury Power became highly discretionary. They chose to bail out some creditors and not others, to take over some businesses and not other, to let some firms go through bankruptcy and not others.  These on-again/ off-again policies directly contributed to the financial panic in the fall of 2008.

Instead of trying to implement existing government regulations more effectively and thereby help prevent future crises, the Dodd-Frank bill vastly increased the power of government in ways that are unrelated to the recent crisis and may even encourage future ones.  The bill creates a new resolution or “orderly liquidation” authority, in which the FDIC can intervene  between any complex financial institution and its creditors in any way it wants to.  Effectively the bill institutionalizes the bailout process by giving the government more discretionary power to intervene.  Because the FDIC does not have the experience taking over such large complex financial institutions, the government in a state of panic  would likely bail them out again.

From First Principles by John Taylor

HKO comments:

Adding complexity and uncertainty to a system that is already too complex almost ensures another failure.  Legislators think incompetence in the private sector can be cured with incompetence in the public sector.  In the private sector mistakes are recognized and eventually corrected. They are less likely to be repeated. In the public sector they are institutionalized.  Political ideologues prefer demons to solutions.

The Dodd-Frank bill extended regulations to areas that had nothing to do with the collapse (debit card fees?) yet totally avoided the both responsible institutions; Fannie Mae and Freddie Mac.

It is perverse that the bill to ”correct” the financial collapse would be named after the two congressmen who were in the most responsible positions when it happened, were the least receptive to the warnings of problems and fraud in Fannie Mae, and did the least to prevent it.

Barney Frank is about 5 minutes in and also appears later about 6 minutes in.