The Atlantic Home

The most questionable proposals in Financial Regulatory Reform--the 88-page blueprint for regulatory reform issued by the Treasury Department on June 24--concern the protection of investors and consumers from false, misleading, or "unfair" practices by the banking industry (as always, broadly construed to include the "shadow banking" industry, consisting of financial intermediaries that provide services similar to banking) and the credit-rating agencies. I shall discuss three of the proposals: that originators of mortgage-backed securities and other securitized debt be required to retain a minimum 5 percent interest in the securities that they sell; that oversight of credit-rating agencies be increased; and that a new agency be established, the Consumer Financial Protection Agency, to protect consumers from making mistaken or foolish decisions regarding taking on debt, such as credit-card or mortgage debt.

The premise of all three proposals is that the financial and broader economic crisis in which the nation finds itself is due mainly on the one hand to the irrationality and sharp practices of bankers and on the other to the irrationality and gullibility of their customers. The bankers are fools and knaves and consumers are fools. This is, to put it mildly, an oversimplification. There are fraudulent sellers, of financial as of other services, and dumb buyers of those services, as of other services, but I am unpersuaded that the character and intellectual flaws of the participants in the financial markets were major factors in the housing and credit bubbles and the ensuing disaster. The disaster is more plausibly attributed to regulatory errors, as I have explained in my book and my previous blog entries. But since the Report advocates more regulation, it is unsurprising that it should downplay--to the extent virtually of ignoring--the regulatory errors that are the main underlying causes of the disaster.

Especially implausible is the idea that sophisticated investors were gulled. The specific premise of the proposal that the originators of securitized debt be required to retain an interest in the securities when they sell them is that the requirement will make them less likely to sell securities that they know to be worth less than the selling price. Now it is true that the seller of a product usually knows more about its possible flaws than the buyer, that a security that consists of a package of thousands of mortgages is as a practical matter impossible for the buyer to inspect, and that the seller's retaining "skin in the game" is a conventional method of reducing the risk to the buyer that the product may be defective; in effect, the seller is giving the buyer a hostage--the seller's interest will die if the product explodes.

But all this is well known to the banks, pension funds, sovereign wealth funds, and other buyers of interests in mortgage-backed and similar securities. These interests ("tranches," as they are called) are not marketed to or bought by consumers. They are sold to highly sophisticated investors. If those investors want the sellers to retain "skin in the game" as a guarantor of the quality of the product, they can negotiate for such a provision in the contract of sale--as some did. None of them needs the government's protection, as is further shown by the fact banks that originated securitized debt also often bought interests in such debt from other originators, something they would not have done if they were skeptical about the value of such securities, as they would have been if they were deceiving the buyers of the securities that they originated.

I have a similar reaction to proposals to tighten oversight of credit-rating agencies. It is true that these agencies have a conflict of interest in rating corporate debt, because they are paid for their rating services by the issuers of the debt that they rate. It is also true that they have difficulty rating highly complex securities. But these things are well known to sophisticated investors--if not, their ignorance is culpable. No one is required to buy an interest in a mortgage-backed security merely because that interest has been rated triple A by a rating agency. It is reckless to make a large investment on the strength of a credit rating; and if that recklessness was indeed (as I doubt) widespread before the crash, it will not be from now on; the investors will have learned their lesson. (Much of the Report is about closing the barn door after the horses have escaped.)

What might call for reform, though ignored in the Report, is the SEC's certification of the leading credit-rating agencies as "Nationally Recognized Statistical Rating Organizations." (Ten have now been certified, including the two leaders--Moody's and Standard and Poor's.) Such certification allows the issuers of debt rated by an NRSRO to provde prospective investors with a less elaborate offering document. And apparently some customers of American Insurance Group allowed AIG to substitute its triple A rating for collateral to back the credit-default swaps that it issued. In addition, insurance companies, pension funds, and other investment entities that are permitted to invest only in "investment-grade" securities cannot be sued for failing to comply with this restriction if the securities they invest in are rated triple A by a NRSRO. This puts the NRSROs under greater pressure to give the sellers of securities a high rating, and thus weakens market discipline.

There is no good reason for giving a federal stamp of approval to designated credit-rating agencies, and other privileges denied competitors, just as there is no good reason to have the government sponsor mortgage companies (Fannie Mae and Freddie Mac). But the proposition that NRSRO privileging was a major factor in the financial crash is again dubious, for sophisticated investors--and they are the only customers for tranches of securitized debt--are capable of giving proper weight to an NRSRO's rating, as they are to give proper weight to the designation of a private company as a "GSE" (government-sponsored enterprise).

To go beyond stripping the NRSROs of their privileged status, therefore, seems unwarranted by what is known at present about the causes of the crash. In hindsight the credit-rating agencies may have done a poor job in rating securitized debt, though even this is uncertain, because the consensus view was that securitized debt was safe because it diversified the risks created by the underlying assets (such as the mortgages that back mortgage-backed securities). But if the rating agencies did do a poor job, and not just in hindsight, the market will punish them if the government allows it to, and it is in this respect that eliminating NRSRO status would be a step in the right direction, as it would increase competition in the ratings industry. Generally, the market disciplines even firms that labor under a conflict of interest, as of course many do--insurance companies obviously, but also accountants, lawyers, doctors, and automobile body shops. If credit ratings are distrusted, credit-rating agencies will not be able to extract high fees for rating a company's debt.

The case for the government's protecting consumers of financial products as distinct from sophisticated investors is stronger, but the government's efforts should in my view be limited to protecting consumers from fraud. From this perspective the creation of the Consumer Financial Protection Agency would be a step in the wrong direction. There are plenty of remedies against financial fraud, including criminal remedies, and plenty of enforcers, including not only the Justice Department, the Securities Exchange Commission, and the Federal Trade Commission, and their state counterparts. The new agency, as the Report makes clear, would have the more dubious mandate of protecting consumers of financial products from themselves. There is a telling remark in the Report that oversight of financial markets should be based on "actual data about how people make financial decisions." The authors believe that they do not make financial decisions on a rational basis because they cannot understand financial products. So the new agency if it is created will design "plain vanilla" financial products, such as a mortgage, and require that they be offered to prospective borrowers along with the lender's own product. And the agency is to restrict the terms that lenders offer in their own products if the benefits of the restrictions are deemed by the agency to outweigh the costs. Since no responsible cost-benefit analysis will actually be conducted, the agency will have carte blanche to impose its view of optimal mortgage terms on the housing market.

In doing so it may for example decide to forbid ARMs--adjustable-rate mortgages, thought a culprit in the housing bubble. What is true is that an ARM is cheaper than the conventional fixed-rate mortgage because it shifts the risk of interest-rate fluctuations from the lender to the borrower. But that is a tradeoff (lower rate for greater risk) that a perfectly rational and well-informed homebuyer might make, especially since a fixed-rate mortgage with prepayment penalties (which makes refinancing costly), in contrast to an ARM, makes it more difficult for the borrower to benefit from a future decline in mortgage interest rates. The new agency might want to outlaw prepayment penalties as well, though, again, a mortgage that includes such penalties is cheaper than one without, precisely because it denies an opportunity to the borrower; and once again the tradeoff may be preferred by a rational borrower.

Notice the conflict between the mandate of the new agency, which is to protect consumers from foolish credit decisions, and the mandate of the Community Reinvestment Act, to which the Report pledges allegiance, to encourage home financing in "underserved" communities. If mortgage lenders are forbidden to shift risk to the borrowers, as through ARMs and prepayment penalties, they will charge higher interest rates, and impecunious persons will be prevented from owning a home.

Last week I blogged on the Administration's ambitious proposals for altering the regulation of the financial markets, proposals set forth in the 88-page report Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation, which the Treasury Department issued on June 17. (I'll call it the "Report.") The proposals require a fuller analysis, which I shall conduct in four parts published this week. The first--the subject of this blog entry--addresses what seem to me the fundamental weaknesses in the Report: weaknesses in the overall conception rather than the specific proposals. The second entry will take up the proposals concerning the problem of "systemic risk." The third will address the proposals concerning consumer and investor protection, and the last will consider a few alternative proposals.

The Report's fundamental weaknesses are prematurity, overambitiousness, reorganization mania, and FDR envy--and let me start with the last.  It is natural for a new President, taking office in the midst of an economic crisis, to want to emulate the extraordinary accomplishments of Roosevelt's initial months in office. Within what seemed the blink of an eye the banking crisis was resolved, public-works agencies were created and hired millions of unemployed workers, and economic output rose sharply. But that was 76 years ago. The federal government has since grown fat and constipated. The program proposed in the Report could not be implemented in months, in years, perhaps in decades--as would be apparent had the report addressed costs, staffing requirements, and milestones for determining progress toward program goals and attempted an overall assessment of feasibility.

The Report is premature in two respects. The first is that it advocates a specific course of treatment for a disease the cause or causes of which have not been determined. Now it is not always necessary to understand the cause of something you don't like in order to be able to eliminate the effect. If you have typical allergy symptoms you may get complete relief by taking an antihistamine and not think it necessary to find out what you're allergic to. But in the case of the current economic crisis, unless the causes are understood it will be impossible to come up with good solutions. The causes have not been studied systematically, and are not obvious though treated as such in the report. (The Great Depression of the 1930s ended 68 years ago and economists are still debating its causes.) We need some counterpart to the 9/11 Commission's investigation of an earlier unforeseen disaster.

The Report asserts without evidence or references that the near collapse of the banking industry last September was due to a combination of folly--a kind of collective madness--on the part of bankers (in part reflected in their compensation practices), of credit-rating agencies, and of consumers (gulled into taking on debt, particularly mortgage debt, that they could not afford), and to defects in the regulatory structure. This leaves out a lot that other students of the crisis have emphasized. The Report does not mention the errors of monetary policy by the Federal Reserve that pushed interest rates down too far in the early part of this decade. Because houses are bought mainly with debt (for example, an 80 percent mortgage), a reduction in interest rates reduces the cost of owning a house and can and did cause a housing bubble, which when it burst took down, along with the homeowners, the banks and related institutions that had financed the bubble. Mortgage debt is huge--$12 trillion--and the banks (a term I use broadly, to include financial intermediaries besides commercial banks) were therefore deeply invested in the housing industry and incurred substantial losses when housing values fell precipitately.

Alan Greenspan has argued that because the Federal Reserve controls only short-term interest rates, and mortgage interest rates are long term, the pushing down and keeping down of the federal funds rate (the interest rate at which banks borrow from each other overnight in order to meet loan demands) could not have created the bubble. I disagree. Short-term and long-term interest rates are linked in a variety of ways, one of which is that many mortgages in the bubble era were "ARM" (AR = adjustable rate) mortgages. That is, the interest rate was altered from time to time, rather than being fixed, to track changes in prevailing interest rates, and usually the adjustment was based on current short-term rather than long-term interest rates. Another linkage is that banks tend to borrow short and lend long, and the difference between the short-term interest rate they pay and the long-term interest rate they charge generates a spread that includes profit. Competition limits profits and hence tends to push down the interest rates that banks charge when the interest rates they pay, the short-term rates controlled by the Fed, fall. In any event, when finally the Fed raised the federal funds rate, mortgage rates followed and the housing bubble collapsed.

The Report also does not mention the Bush Administration's large annual budget deficits, even though they have made it difficult for the government to dig the economy out of its hole without setting the stage for high inflation, heavy taxes, devaluation of the dollar, or increased dependence on foreign lenders. The Federal Reserve may have to push up interest rates in order to head off these looming consequences, but if it does so this will retard the recovery.

There is no mention in the Report of the deregulation movement in banking, which allowed essentially unregulated nonbank banks (constituting a "shadow" banking system of investment banks, money-market funds, broker-dealers, insurance companies, and hedge funds) to offer banking services, and lightened the regulation of commercial banks so that they could compete with the free-wheeling nonbanks.

There is no mention of lax enforcement of the remaining regulations. Regulatory errors are tepidly acknowledged but ascribed to defects in the regulatory structure--the sort of thing a government reorganization might repair, and of course the Report goes on to propose an ambitious reorganization. One gets the sense that the solution to the problem of financial collapse was chosen first and the problem was then fitted to the solution--first the treatment, then the diagnosis.

The regulators were asleep at the switch. That is the elephant in the room that the Report ignores. When suddenly awakened last September by the financial crash they reacted with spasmodic improvisations that sapped business and public confidence. The Report is scathing about the financial incontinence of bankers and consumers but complacent about regulatory failures, perhaps because authors of the Report were implicated in that failure and (a related point) because the failure was bipartisan; the deregulation of banking began in the Carter Administration. Since many of the Report's authors are economists as well as officials, it is unsurprising that the Report also does not mention the economics profession's complacency and short-sightedness as causal factors in the crisis. And the omission to mention budget deficits as a factor in the crisis may reflect the fact that the Administration's programs will if enacted in the form proposed create huge deficits.

The emphasis the Report places on the folly of private-sector actors--investors, consumers, credit-rating agencies, but above all bankers--ignores the possibility that most of these actors were behaving rationally given the environment of dangerously low interest rates, complacency about asset-price recognition (the bubble that the regulators ignored), and light and lax regulation--an environment created by the government. Again, it is unsurprising, given where the Report is going, that it should depict the problem as having been created by private rather than public folly. Since the solution is to be a series of structural changes in government that will prevent regulators from repeating their mistakes, there is no need to dwell on those mistakes and by doing so shake the readers' confidence in the Report's proposals, which depend on regulators' being competent.

Now when I say that the Report places undue emphasis on the behavior of the market participants as distinct from the regulators, I mean, undue on the basis of what we know, or at least of what I think I know. I may be wrong, but my point is that it is too early to draw firm enough conclusions about the causes of the crisis to base radical policy changes on those conclusions. Remember that economists are still debating the causes of the Great Depression, and of its unusual severity relative to economic downturns before and since. This suggests that no account of the causes of our current depression is likely to be definitive, no matter how long we wait for the account. But the causal account in the Report is notably thin, one-sided, unsubstantiated, and implausible. And yet the validity of its proposals hinges on the accuracy of its causal account.

The Report is premature in a second sense, one illustrated by the proposals (discussed in greater detail in Part III of this series of entries) for limiting the provision of credit to high-risk borrowers. In an economic boom, thrift (restraint in consumption) reduces the amplitude of the business cycle by reducing consumption and increasing savings, which can be reallocated to consumption at the bottom of the cycle. Thus thrift makes the peak of the cycle lower and the trough higher. But in the trough, thrift, by reducing consumption, retards economic recovery. The less that people spend on consumption goods, the less production there is and therefore the higher the unemployment rate, which by reducing incomes further depresses spending, which further depresses production, and so on. To want to tighten credit at the bottom of the cycle is bad timing. And while the Report creates the impression that high-risk borrowers are feckless consumers unable to curb their greed for material goods, many high-risk borrowers are small businesses dependent on credit-card debt to finance their business, and they are struggling.

Furthermore, throwing a raft of proposals at abanking industry struggling to regain its footing is sure to distract the banks' management, not to mention the Administration's economic team. There is a danger, in short, of information overload. And some of the proposals in the Report are contradictory, which reinforces their effect in increasing the uncertainty of the economic environment. For example, the banks are not to make unsafe loans, but the Community Reinvestment Act, which encourages lending to "underserved" individuals and communities, is to be vigorously enforced, even though many of the individuals intended to be protected by the Act are poor credit risks. The banks are to be placed on a razor's edge.

The proposals are presented as if their merit were self-evident. A more thoughtful document would have discussed the objections to each proposal and explained why in the authors' view the objections were not decisive. Consider the proposals for substantial reorganization of the regulatory structure. Government officials and politicians typically respond to a government failure (in this case the failure to prevent the economic crisis that has engulfed us) by proposing a reorganization, because reorganizations are relatively cheap, visible, and easily explained. More precisely, plans for reorganizations are cheap, visible, etc.--and plans are the easy part; it is at the stage of implementation that our government falls down. But even when the plan leads to an actual reorganization, the reorganization usually fails, because of inertia, turf warfare, passive resistance, and lack of follow through, leaving in its wake merely more bureaucracy. One of the Report's proposals is to create a powerful new agency for the protection of consumer borrowers, and this agency, if it is ever actually created, will overlap and scrap with the Securities Exchange Commission and the Federal Trade Commission. Another proposal, to create a National Bank Supervisor, will incite conflict with the Comptroller of the Currency, who regulates national banks. (The Comptroller is to hand over his "prudential responsibilities" to the NBS.) There is also to be a council of regulators (the "Financial Services Oversight Council") layered over the regulatory agencies themselves, and if the council is not merely a committee of kibitzers, it will muddy the regulatory process.

We have seen a similar process at work in the national intelligence field. After the security agencies failed to prevent the 9/11 attacks, the system was reorganized by the creation of the Department of Homeland Security, the Office of the Director of National Intelligence, the National Counterterrorism Center, the National Security Branch (in the FBI), and other entities. The main result, after several years, has been--many competent observers believe--new layers of bureaucracy, turf wars, overstaffing, and confusion, rather than improved performance.

Politics, as an impediment to effective regulation, is not mentioned. The Report worries about actions by private persons that can precipitate an economic crisis, but not about actions (or inaction) by regulators. Its concern with market failures is not matched by a concern with regulatory failure. If brilliant bankers screw up, why not not-so-brilliant regulators? Don't the enormous disparities in income between successful bankers and financial civil servants have implications for the competence of the latter? And isn't there a revolving-door problem?

Congressman Barney Frank made a telling comment in an interview with Charlie Rose last fall. He said that the basic problem in the regulation of banking is that financial regulation lags financial innovation. This problem is compounded by the dependence of regulators on information supplied to them by the regulated firms, which have of course superior knowledge of their own businesses. As soon as the proposals in the Report are implemented (if they ever are), or even before, the banking industry will game them, looking for loopholes and openings for counter strategies, and as a result when the next financial crisis hits it won't look like the current one and the regulators may be unprepared and ineffectual.

If one may judge from the current crisis, which is global, regulatory organization is uncorrelated with failures of financial regulation; for the nations' regulatory structures are diverse, but none is pointed to as a model for the United States. The pathologies of regulation are not rooted in tables of organization or curable by adding new bureaucratic layers. Ignored by the Report are problems of regulatory capture and regulatory culture, though the subject of a large academic literature; the timidity of civil servants and the contamination of public administration by politics and interest groups; the mutual dependence of regulators and regulated, which resembles that of prison guards and prisoners; and the power of the "office consensus" to marginalize independent thinkers for failing to be "team players."

Finally, despite its length, the Report is lacking in detail. There is nothing about the cost of implementing the proposals, the staff required to man the new agencies and shoulder the new regulatory responsibilities that are to be imposed on the existing agencies, the time it will take for implementation, or the methods of determining the capital requirements of the banks and other financial institutions that are believed to create "systemic" risk (a concept I will examine in my next entry in this series). No evaluation of the feasibility of the package of proposals is possible without carefully attention to impediments to implementation.

So there is a sense in which the 88-page Report is at once too short and too long: too long to be a statement of principles that would provide a basis for discussion, too short to enable an assessment of the desirability and feasibility of the specific proposals that the Report makes.

The Administration's proposals for altering the regulation of the financial markets are found in an 88-page report entitled Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation (Treasury Dept., June 17, 2009). This is a well-written report but suffers from two grave weaknesses: prematurity and a failure to address objections.

Now it is true that it is not always necessary to understand a cause in order to be able to eliminate its unwanted effects. If you have typical allergy symptoms, you may get complete relief by taking an antihistamine and not think it necessary to find out what you're allergic to. But generally and in the case of the current economic crisis, if the causes of a problem are not understood it will be impossible to come up with a good solution. The causes of the crisis have not been studied systematically--there is no counterpart to the 9/11 Commission's exhaustive study of the 9/11 terrorist attacks--and they are not obvious though treated as such in the report. The report asserts without evidence or references that the near collapse of the banking industry last September was due to a combination of folly on the part of bankers (in part reflected in their compensation practices), credit-rating agencies, and consumers (gulled into taking on debt, particularly mortgage debt, that they could not afford), and defects in the regulatory structure. There is no mention of errors of monetary policy by the Federal Reserve that pushed interest rates down too far in the early part of this decade. Because houses are bought mainly with debt (for example, an 80 percent mortgage), a reduction in interest rates reduces the cost of owning a house and can and did cause a housing bubble, which when it burst took down along with the homeowners the banks and related institutions that had financed the bubble. The report also fails to mention the deregulation movement in banking, which enabled banks to make much riskier loans than in the old days when regulation discouraged competition in banking. And there is no mention of lax enforcement of existing regulations or the complacency of the economics profession, including its representatives in government, though regulators' failure to spot the evolving crisis is mentioned. There is exaggerated emphasis on mistakes by the banks themselves, and no recognition that a regime of very low interest rates and very light regulation encourages perfectly rational, intelligent bankers to take risks that can, albeit with low probability, precipitate a global financial crisis.

Though the Federal Reserve bears a substantial share of the responsibility for the economic disaster because of its misguided monetary policy, the report proposes to heap heavy new responsibilities on the Fed, and there is no discussion of whether it is capable of shouldering these new responsibilities, given an organizational culture that blinded it to the risks that its monetary policy created. There is no recognition of the risks of competition in so inherently risky a business as banking (that is, lending borrowed capital), and hence the report recommends making banking more competitive by removing remaining restrictions on branch banking, restrictions that limit competition and by doing so may make banking safer.

And because the report attributes the high rate of mortgage and credit card defaults in the current economic situation largely to the ignorance of borrowers and deceit and "unfairness" by lenders, rather than to rational risk taking by borrowers facing very low interest rates and therefore able (in the case of mortgagors) to take advantage of a possibly once-in-a-lifetime opportunity to own their own home, the report proposes the establishment of a new agency with sweeping powers to prevent consumers from taking out risky loans. Sophisticated investors, including large banks, pension funds, and sovereign wealth funds, are assumed to have been fooled by credit ratings issued by credit-rating agencies, even though such investors are well aware of the conflicts of interest that characterize such agencies (they are paid by the firms whose debt they rate) and the difficulty the agencies have in rating highly complex securities, such as securities (in effect bonds) backed by hundreds or thousands of home mortgages.

The report suggests that originators of mortgage-backed and other securitized debt be required to retain an interest in the security when they sell it, so that they will be penalized if the security turns out to be a dog. The premise is that this debt was sold to suckers. But in fact it was sold to sophisticated investors. They knew a disastrous, nationwide fall in housing prices would make the mortgages packaged in these securities worth much less, but they thought, as did most of the financial and regulatory community, that the risk of such a disaster was remote. But risks that seem remote even to informed observers do sometimes materialize. Only in hindisght are they seen as inevitable and the failure to have predicted them is attributed to stupidity, greed, and recklessness.

The report is premature in a second sense, one also illustrated by the proposals for limiting the provision of credit allowed to high-risk borrowers. In an economic boom, thrift is a way of reducing the amplitude of the business cycle by reducing consumption and increasing savings, savings that can be reallocated to consumption at the bottom of the cycle. But when we're at the bottom, thrift, by reducing consumption, makes it more difficult for the economy to recover, because the less people spend on consumption goods, the less production there is and therefore the higher the unemployment rate, which by reducing incomes further depresses spending, creating a vicious cycle. To tighten credit at the bottom of the cycle is thus bad timing. Furthermore, throwing a raft of proposals at the banking industry while the industry is struggling to regain its footing is sure to distract the banks' management, not to mention the Administration's economic team. There is a danger, in short, of information overload. And, what will further befuddle the industry, some of the proposals are contradictory: for example, the banks are not to make unsafe loans, but the Community Reinvestment Act, which encourages lending to "underserved" individuals and communities, is to be vigorously enforced, even though many of the individuals intended to be protected by the Act and therefore supposed to be favored by lenders are poor credit risks.

The proposals are presented as if their merit were self-evident, and required no argument. A more thoughtful document would have discussed the objections to each proposal and explained why in the authors' view the objections were not decisive. The proposals include substantial reorganization of the extensive financial regulatory structure. Government officials and politicians all too often respond to a government failure (in this case the failure to prevent the economic crisis that has engulfed us) by proposing a reorganization of the relevant parts of government, because reorganizations are relatively cheap, visible, and easily explained. They usually fail, because of inertia, turf warfare, passive resistance, and lack of follow through, leaving in their wake merely more bureaucracy.

One of the proposals in the report is to create a powerful new agency (the Consumer Financial Protection Agency) for the protection of consumer borrowers from deceptive and "unfair" tactics by sellers of financial products, such as mortgages and credit cards, and this agency, if it is ever actually created, will overlap and therefore probably scrap with the Securities Exchange Commission and the Federal Trade Commission. Another proposal, to create a National Bank Supervisor, will incite conflict with the Comptroller of the Currency, who regulates national banks. (The Comptroller is to give up his "prudential responsibilities" to the NBS.) There is also to be a council of regulators (the Financial Services Oversight Council) layered over the regulatory agencies themselves, and if the council is not merely a committee of kibitzers, it will merely complicate the regulatory process.

The report doubts the competence of bankers, consumers, and other private persons involved in lending and borrowing, but uncritical concerning the capacities of government. Mistakes of regulators are noted, but are assumed to be easily eliminable. Politics, as an impediment to effective regulation, is not mentioned.

The proposals if adopted would impose onerous restrictions on financial firms deemed so large, or so strategically placed in relation to other financial firms, that they are judged to impose "systemic" risk--that is, the risk that if they fail they may bring down the rest of the global financial system with them, which is what the bankruptcy of Lehman Brothers last September almost did, not because of Lehman's size but because of its central position in several important financial markets, such as commercial paper and letters of credit. But the restrictions proposed to be imposed on such firms (including telling them how to pay their traders and loan officers) may induce some of them to limit their size, or their role in particular markets, in order to fall beneath the level that triggers the restrictions. Yet, oddly, if this happened, systemic risk might not be reduced. For such risk is a property of the financial system, rather than of individual firms. That is, systemic risk is correlated risk. If the entire banking industry were heavily invested in home mortgages, and a housing bubble caused a drastic fall in the value of those mortgages, it wouldn't matter if the banking industry consisted of 10,000 banks of equally small size. The whole industry would be brought down.

If there are substantial economies of scale in banking, so that big banks are more efficient than little ones, the onerous restrictions that the report contemplates will not cause the big banks to reduce their size in order to avoid the restrictions. But it is not clear that there are such economies, and, if not, enactment of the restrictions might induce a substantial restructuring of the industry that would reduce the size of banks without reducing the likelihood of another financial crisis.

One has a sense that the authors of the report, having persuaded themselves that bankers and consumers are on the whole rather dumb, decided that government officials (such as the authors of the report) can manage lending and borrowing better than the actual lenders and borrowers can. I was particularly struck by the proposal that the new Consumer Financial Protection Agency will design "plain vanilla" financial products (such as a mortgage), require that they be offered to borrowers, and restrict the terms that the lenders offer in the financial products that they have designed, if the benefits of the restrictions outweigh the costs, as determined by the agency.

Despite its length, the report is lacking in detail. There is nothing about the cost of the proposals, the staff required, the timetable for implementation, or the methods for determining the capital requirements of the banks and other financial institutions thought to create "systemic" risk. The delegation of powers to the Federal Reserve is breathtaking, as it can swoop down on pretty much any large financial institution, including insurance companies and hedge funds, and classify it as a "tier 1 Financial Holding Company" subject to comprehensive limitations on its business. The Fed's prized independence may be compromised by its exercise of broad discretion to impose tight restrictions on the business of firms that are not commercial banks.

There is no discussion of whether tight restrictions on American banks will shift business to foreign banks that do not labor under such restrictions. A host of obvious questions are left unanswered: for example, how it is possible to prevent a global financial crisis such as erupted last September by requiring big banks to buy "tail insurance"--that is, insurance against very unlikely catastrophic events. Insurance is meant to deal with independent risks, not correlated risks: no insurer other than the federal government is big enough to ensure the nation's entire financial system against a risk common to all the parts of the system.

Despite its length and official imprimatur (and, in fairness, it reflects a good deal of work and thought), the report is best regarded as a discussion paper rather than as a basis for action. 

Conservative economists believe that the most serious problems facing the economy are budget deficits, the threat of a future inflation, and the government's aggressive economic interventions in the economy, which include the stimulus package, the health care plan, and the takeover of General Motors. Liberal economists believe that the most serious problems facing the economy are that the depression may deepen and that the recovery from it, when it comes, will be shallow and protracted. Some of them believe that there is still a threat, indeed an actuality, of deflation; with the consumer price index flat for the past year, anyone who borrowed money last year when interest rates included an inflation component will find himself repaying the loan this year with dollars that are worth more than he expected.

The strong positive correlation between economic diagnosis and ideological presupposition tells you something about economics, more precisely about the economics of the business cycle. If this branch of economics were scientific, the conclusions of economists would be "observer independent" rather than inflected with each individual economist's political outlook. It is when science and other methods of exact reasoning (such as logic and mathematics) give out that a person's political preconceptions influence his views.

Macroeconomists look at the same evidence, the same phenomena, and see different things. Conservatives see a self-regulating economy, which achieves and maintains equilibrium (or an approximation to it) with minimal government regulation. Liberals see an unstable economy that requires, at times, including the present time, aggressive government action to keep the economy from running off the rails.

Conservatives typically believe in "Say's Law"--that supply creates its own demand. There can never be oversupply, because whatever is produced can be sold at some price; if the demand for some product falls, its price will fall until all of it is sold. Say's Law implicitly describes a barter economy, in which the role of money is incidental. Someone produces one good, and someone else another, and the terms on which the goods are exchanged reflect demand and supply. Ordinarily perhaps one widget is valued at two gidgets, but if demand for widgets falls perhaps the widget producer will have to accept one gidget in exchange for a widget. The "good" may of course be labor, but as long as prices are flexible, there will be no unemployment, just as there will be no excess supply. Of course at some point the price of labor may fall so low that many workers may prefer not to work. But they are not unemployed; they just are substituting one job, paid for in leisure, for another, paid for in other goods.

Keynes, the great denouncer of Say's Law, argued that money shouldn't be regarded as a veil between goods that merely facilitates barter. For when A sells B a good, A may decide not to buy any good or service with the money he receives in the sale, but instead to hold the money in some form. And if enough people do this, there may (depending on the form in which the money is held) be excess supply, contrary to Say's Law,. Producers may not be able to cut prices far enough to restore equilibrium. Instead, as prices fall, consumers and businesses may hoard cash all the more, because as prices continue to fall the purchasing power of cash will rise. With demand below the quantity of goods and services that full employment of the society's labor and other productive resources could supply, the government must have to step in and supply the missing demand, for example through a massive public works program employing workers for whom private producers have no jobs. But to a believer in Say's Law, the only effect of governmental demand is to augment private demand, so that total demand exceeds supply and therefore generates inflation.

There is much more to be said about the rival positions, but my simplified version will give the reader an adequate sense of the basic dispute. Although my own view, which is also that of a majority of economists at the present time, leans toward the second, the Keynesian, position, even if it could be proved correct (or more correct) than Say's Law it would not resolve the debate with which I opened. Keynesians acknowledge that there can be excessive government intervention in the economy, that enormous deficits can give rise to inflation, and that inflation can impose substantial social costs. And some conservative economists will concede, however grudgingly, that a stimulus program (Keynesian deficit spending, as on public works) may be a proper supplement to less intervenionist measures for arresting an economic downturn. Conservatives have generally supported the Federal Reserve's efforts to simulate lending by reducing interest rates and the efforts by the Fed and the Treasury Department to recapitalize banks, because bank lending is essential to production and consumption. But as I keep saying, you can lead a bank to money but you can't make it lend, and the experience since last fall has been that banks, nervous about lending into a depression and facing a reduced demand for loans, are not lending enough to stimulate economic recovrery, but instead are hoarding most of the cash that the government's monetary and bailout policies have given them.

The problem is that the degree of agreement that I have indicated on broad principles does not generate an answer to the question what the government should be doing now. If, as some economists, business forecasters, and government officials believe, the economic downturn has reached or is about to reach bottom and we will soon be on the path to a rapid recovery, there is an argument for shifting focus from stimulation of the economy, whether through deficit spending or the purchase of debt by the Federal Reserve to keep interest rates low, to deficit reduction. If, as others believe, the economy may continue declining for a significant amount of time and, more likely, will whenever the bottom is finally reached stay there, or near there, for a long time, then the danger of inflation is remote and more stimulus is indicated. It is not possible to choose between these beliefs, other than on the basis of temperament (optimism versus pessimism) and politics (belief in weak government versus strong government)--and temperament may be influenced by politics: the liberal may be pessimistic about the economic downturn because he wants the fragility of the economy and the salvationist role of government to be demonstrated, and the conservative may be optimistic about the downturn because he is embarrassed that the economy should fall so far that government has to step in and replace private with public demand for goods and services.

The U.S. economy is so complex, and the susceptibility of an economy to adverse feedback loops is so great, that it just isn't possible to determine objectively where exactly we are today in the business cycle and how long (whether given current policies, or different policies) it will take to get back on the economy's normal growth path. As long as unemployment continues rising, even if at a declining rate, there is a danger of negative feedback: the unemployed suffer a loss in income, and workers who are still employed become more anxious about retaining their jobs the higher the unemployment rate (really, the underemployment rate, which increasingly includes workers on short hours), and so both groups spend less and this leads to reduced sales and therefore reduced employment. As long as housing prices continue falling, people's wealth (heavily invested in housing) falls, and with it their desire to spend rather than save. The personal savings rate is way up, and we not know yet how much of those savings will be put to work as productive investment capital rather than hoarded. At the same time, inventories have declined, and at some point production will have to increase in order to satisfy demand even at its current low level--and that level may rise as consumer durables wear out and need to be replaced, or as reviving consumer confidence induced increased personal consumption expenditures.

When it is not possible to decide between two courses of action--in the present instance, between stepping on the economic brakes and stepping on the economic accelerator--on the basis of which is more likely to yield the greater benefits, it may still be possible to make a rational choice by considering the consequences of error. If mistakenly stepping on the brakes would produce worse consequences than mistakenly stepping on the accelerator, we should step on the accelerator. But that can't be determined. If we step on the brakes, this could precipitate a severe recession, as happened in 1936 when the government, fearing inflation, raised taxes and interest rates and reduced the federal budget deficit, But if we step on the accelerator, the resulting increase in the budget deficit might set the stage for an eventual inflation that could, like the inflation of the 1970s, precipitate a severe recession when, the inflation threatening to get out of hand, the Federal Reserve pushed up interest rates steeply.

There is, however, a third way, and that is to take measures to reduce the deficit without exacerbating the economic downturn. The concern with inflation and related methods, harmful to economic activity, of dealing with a swelling national debt, such as heavy taxation, increased dependence on foreign lenders, and devaluation of the dollar is directed at future government revenues and expenditures more than present ones. Tabling programs, such as health care reform, that do not contribute to recovery from the depression would reduce concern for future inflation, and by doing so reduce interest rates, which would in turn speed recovery.