Friday, October 08, 2010

Timing the Next Financial Crisis

-- Posted by Neil H. Buchanan (back in Ithaca, NY, for a few days)

My FindLaw column this week is a written version of some of my comments at Monash University's "Globalisation and Business Challenges in the post-Financial Crisis World" conference in Prato, Italy, last week. The title of my talk was: "How Soon Will the Next Crisis Come, and What Are We Doing Now That Will Hasten It?" My comments in Prato, and my FindLaw column, focused on the second question in that title, i.e., explaining how the U.S. policy response to the 2008-present crisis has been woefully inadequate, thus increasing the likelihood of a repeat performance of the recent near-catastrophe.

The argument essentially boils down to three steps:

(1) We have chosen not to engage in any structural reforms, especially on a large scale, such as bringing back the strict divide between commercial and investment banking, or enacting "too big to fail" limits to break up large institutions into somewhat smaller ones.

(2) We have passed a bill (Dodd-Frank) that, to an apparently unprecedented degree, was written without even the most typical structural (or bright-line) rules, leaving the real work to agency regulation-writing procedures. I refer in the column to an example mentioned in a NYT business column by Gretchen Morgenson, who noted that a straightforward 20% per-bank ownership limit on a key (high-profit) clearinghouse had been replaced by language allowing (but not requiring) a regulatory agency to consider imposing some level of ownership limits. My reading of the commentary on Dodd-Frank indicates that this type of punting was the norm in the bill.

(3) Moving the real action in financial regulation out of Congress and into the internal processes of the SEC, the CFTC, the Fed, etc. is a terrible idea. These agencies are necessary, but recent experience (both within the financial regulatory agencies, and in federal agencies more generally) shows that this is a particularly bad time to give the agencies even more discretion. I believe in the importance of federal regulation of modern economic markets; but I do so knowing that the regulators are quite fallible humans. Adding to their burdens -- and their temptations -- is a very bad move, especially when they have a lot of work to do just to clean up their own recent messes.

That is the bad news, and there is no way to dress it up. I strongly suspect that the next crisis will come rather soon, precisely because of our rather unseemly return to business as usual. Timing crises is nearly impossible, of course, but I offered an outer limit in my talk in Prato: 77 years. This is simple (and simple-minded) arithmetic, with an underlying semi-sarcastic but serious point. It was 79 years from the crisis in 1929 until the crisis in 2008, and it has been two years since then. Hence, 77 years. Q.E.D.

More seriously, the reason to use the 1929 crisis as the baseline is that it takes time for memories to fade (aided by the turnover of generations), guaranteeing that even the best responses to a crisis will ultimately be abandoned by future optimists who believe that "it" can never happen again. It does not seem possible that the responses to the current crisis will be anywhere near as effective or durable as the early-1930's responses that served us so well for almost seven decades (before Bill Clinton joined a Republican Congress in repealing key provisions), meaning that 77 years is a wildly optimistic time frame. As I said during the Q&A, 5 years (or even 5 minutes) seems much more likely to me than the latter half of this century.

Is there anything pushing in the other direction? Certainly, Dodd-Frank is better than nothing (or so we hope). The best part of Dodd-Frank is the Consumer Financial Protection Board, Harvard Law Professor Elizabeth Warren's brain-child. Despite attempts by the banks and credit card companies and their allies in Congress to kill the CFPB, or at least to keep Warren away from it (precisely because she will not be co-opted or deterred by the practices to which I referred above), she is apparently going to be the de facto head of the Board, at least for its start-up phase.

Most of this is good news for potential victims of deceptive practices, etc., which is a good thing in and of itself; but it seems to have little to do with preventing the next financial crisis. Still, the recent crisis was at least proximately caused by the bursting of the housing bubble, a bubble which was enabled by financial practices that the CFPB will probably curb or eliminate.

My suspicion, however, is that there is no limit to the types of financial games that can lead to financial crises. If we successfully shut down mortgages and credit cards as the cause of the next crisis, then that will be a real achievement. Even so, the people who are going to be protected by the CFPB's actions will still be among the victims of the next recession/depression, which we are doing far too little to prevent.


Paul Scott said...

Can you clarify your issue with agency discretion? In particular, can you clarify why it is not preferable to have an agency with true subject matter expertise and more limited political considerations (except, obviously, at the very top) setting the appropriate limits and standards rather than congress - a body with essentially 0 subject matter expertise and whose concerns are almost entirely politically motivated (or am I just too cynical?).

Neil H. Buchanan said...

Generally speaking, I too feel great enthusiasm for turning things over to an expert body. However, Congress should at least say something about the essential structure of what they're enacting.

For an example from tax, Congress in 1997 enacted an exclusion for gains from the sale of a home ($250,000 single, $500,000 joint), with a two-year ownership minimum to prevent the exclusion from being used by house-flippers. It then granted an exception from the two-year minimum for "change in employment, health, or extraordinary circumstances," leaving the Treasury to issue Regs. defining what constitutes extraordinary circumstances.

Arguably, Congress could have written: "We believe that there should be an exclusion for gains on the sale of a home for people who are not gaming the system or who are not too rich." A well-run administrative agency could probably have done a better job than Congress of drawing lines, both in terms of amount and in terms of the nature of the exceptions.

The less one trusts the administrative agency, the more one wants Congress to be explicit. Moreover, even if one trusts an administrative agency, one would want Congress to be fairly explicit about what it has in mind. The current home sales rules strike me as a decent example of what Congress should do -- even though they might have done better by putting in an inflation-adjustment clause for the $250,000/$500,000 cutoff.

My basic take on Dodd/Frank is that Congress sent a nearly blank slate to a set of administrative agencies that are going to completely capitulate to their regulatees. That might be pessimistic, but I do believe that Congress at least needs to make the core legislation specific enough that it cannot be outright negated by agency action.

egarber said...

To ask a legal question, is there some point where Congress is too vague for the law and subsequent delegation of power to be considered constitutional?

Suppose Congress passes a law that says, "people should be protected from bad guys" -- and then it goes to an agency to figure out. Is there any precedent that would nullify the law?

Doug said...

The other concern I'd have is that regulatory agencies report to the president - I wouldn't want to see vast swings in the law at the start of every administration.

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