Regulatory War of Choice

November 5, 2009

by Chidem Kurdas

“A just war” is how Treasury Secretary Timothy Geithner describes the movement to expand financial regulation.  “It’s a war of necessity, not a war of choice,” he  is reported as saying about  the battle to impose greater government control on the financial sector.

This is the man who presided over the New York Federal Reserve Bank as the Fed assiduously provided the monetary fuel for the over-expansion of credit and the associated property bubble. The eventual implosion  of the twin bubbles caused the financial crisis of 2008.

For sure, markets are prone to ups and downs, because people are prone to behaviors like herding. And yes, bankers drank the spiked punch, as did myriad others from mortgage originators and real estate developers to over-extended households. But the Fed provided the heady stuff, thereby creating a boom-and-bust cycle of extraordinary magnitude.

Now, does Mr. Geithner’s proposed regulations seek to prevent similar nefarious policies in the future by limiting the Fed’s discretionary powers? Of course not. Silly even to ask. His quest is to expand the authority of government agencies, not to regulate them.

The one attempt to get a sense of what the Fed is up to, a bill by Congressman Ron Paul, has been destroyed at a Congressional sub-committee—even though it had 308 co-sponsors.

The fact that it is so hard even to get a very mild measure through Congress is a sign that there are powerful interests against regulating the regulators.  Of course, it is understandable that Mr. Geithner’s former colleagues at the Fed would not want themselves to be audited—nobody likes being examined. It is understandable, too, that he’d side with them. But this is not a matter of blaming people or institutions for past deeds. We’re talking about  loose canon policies that are almost sure to be repeated.

The Fed’s easy money was known as the Greenspan put—an inspired term that, ironically enough, came from Merrill Lynch. A put is a derivative, a contract that protects you against a fall in the price of a security. Wall Street believed that the Fed would open the money spigots whenever markets showed signs of sagging. Wall Street was right.

The Fed fostered asset bubbles. This was not an act of omission – failing to regulate banks – but an act of commission. Bubbles, as long as they’re expanding, make people feel good. Of course sooner or later they collapse, but Fed chiefs can keep things going for a long time.

And after the collapse, one becomes Treasury Secretary and calls for the increase of the bubble blowers’ authority. That is a war of choice, chosen because it is in the interest of the political elite.

18 Responses to “Regulatory War of Choice”

  1. Lee Kelly Says:

    So long as risk is being subsidised, regulation is a unfortunate necessity. What are the chances of deposit insurance being abolished, for example?

    The financial system has huge chimey stacks pumping out noxious risks downwind and smothering the general public. In other words, the government, by subsidising risk, has created an negative externality. Since the policies which create the pollution aren’t going to go away any time soon, what recourse is there but to empower regulators enforce discipline?

    As people disposed to liberty, we are in a terrible bind when contemplating policy. Although deregulation is ideal, while risk is being subsidised it is also foolhardy. Though it pains me to say it, on a pragmatic level surely tighter regulation is necessary to offset the intensifying moral hazard (after accounting for regulator error and capture).

  2. chidemkurdas Says:

    It’s an age-old question, I think maybe Madison asked it–who’s going to oversee the overseers? They’re creating risk. The more power they get, the more risk they’ll create. How is that solving the problem?

  3. The post and comments sum up the situation quite well. I emphasize that no practical regulation could have offset the effects of the Fed’s easy monetary policy. At one point, I feared there would be a move to regulatory over-kill. Now I think nothing serious will be done to restrain banks’ risk taking. The next bubble is already inflating.

  4. chidemkurdas Says:

    Absolutely. A survey of 147 clients by Goldman Sachs found 75% think low rates are triggering excessive rises in asset prices, according to a Bloomberg report today. It is a reasonable bet that despite UK Chancellor of the Exchequer’s call for policies to restrain asset-price bubbles, most central banks will keep rates down and bubbles expanding.

  5. Lee Kelly Says:

    That said, the Fed’s monetary policy was too tight in the immediate aftermath of the housing bust, in my opinion. It is still too tight if you listen to people like Scott Sumner, and he makes a good case!

    Central banks are quite capable of mismanaging the money supply by creating too little as they are by creating too much; though, admittedly, they have a greater propensity to do the latter.

  6. Only a central bank can destroy base money. That having been said, there is an inherent inflationary bias within central banks. Focusing on CPI (or worse, core CPI) let the Fed produce the asset bubble. Only by ignoring the same signs (e.g., property and asset markets, especially in Asia) could one conclude policy is too tight now.

  7. Drewfus Says:

    “…what recourse is there but to empower regulators enforce discipline?”

    Lee Kelly,
    your argument presumes that regulations will have the desired effects. I.e. that regulations will in fact regulate. defines regulate as:

    1. to control or direct by a rule, principle, method, etc.: to regulate household expenses.
    2. to adjust to some standard or requirement, as amount, degree, etc.: to regulate the temperature.
    3. to adjust so as to ensure accuracy of operation: to regulate a watch.
    4. to put in good order: to regulate the digestion.

    Your PoV would seem most in accordance with def 1. My concept of financial regulation would be most similar to def 2. Which makes me wonder – if regulations fail “to adjust to some standard or requirement, as amount, degree, etc”, are they still regulations?

    Those in favor of regulation seem to presume the efficacy of regulation by definition.

  8. Lee Kelly Says:


    I don’t expect regulation to be perfect; there is the knowledge problem, regulatory capture, and plain old human error to reckon with. That said, if regulators merely reduce the propensity for banks to take too much risk, then it might be preferable to allowing subsidised risks without any regulation at all.

  9. chidemkurdas Says:

    Lee, given the practical problem you’re addressing, your argument is logical. But you’ve defined the problem narrowly–why accept the subsidization of risk taking as a given? The subsidies can be dismantled, at least some of them, if slowly over time to allow markets to adjust. Of course, politically that may not be possible. And even discontinued policies will be assumed to be re-instituted in another crisis. But then the discussion should be focused on the public choice issues.

  10. Lee Kelly Says:


    I don’t know how to dismantle the subsidisation of risk-taking. Sure, I could say “abolish subsidy x” or “eliminate policy y,” but that isn’t a practical solution. Given prevailing political institutions, I perceive no way of moving from the current policy regime to one where risk-taking is no longer subsidised.

    I would infinitely prefer that risk-taking not be subsidised, but that’s like saying I want a Ferrari more than a Ford. In a world where I could snap my fingers and it would happen I would have the Ferrari, but in a world full of constraints I’d take the Ford.

  11. Drewfus Says:

    First step would be to make a conceptual distinction between the deposits of account holders and the accounts per se as managed by the financial institution.

    Specifically, what risk needs to be protected (if any)? Is it the depositors accounts with respect to the commercial viability of the financial firm, or is the wealth of the account holders as distinct from their current form?

    Why not let the insolvent financial firms fail and pay out the account holders directly, via an appropriate insurance arrangment?

    Lender of the last resort and bailouts conflate the requirement that unviable firms be allowed to fail with the legitimate desire to avoid bank runs, and loss of depositors wealth. Its essentially a design problem.

  12. chidemkurdas Says:

    That is what happens with commercial banks. The controversial bailouts of investment banks were not concerned with depositors–with the large exception of Citigroup, most investment banks don’t take deposits. In the case of Citi, it would have been possible to protect depositors but let the other businesses go.

    Lee– If you accept the argument that because financial risks have become socialized, greater regulation is needed to control risk taking, you’ll have to accept government takeover of the financial sector. If the Treasury is standing behind bank actions and those actions are subject to oversight,you have a regulatory-financial complex that resembles the military-industrial complex. That may be unavoidable, as you suggest. But accepting it guarantees that it will happen.

  13. I am with Chidem in spirit, but what to do before we get to a free market in financial services? Simple rules for a complex world are the only way to go. Much higher capital ratios and foresaking the Basel rules, which were central planning of risk, would be my one-two punch. The basic problem for any regulatory reform is the near-total industry capture of the regulatory agencies.

  14. chidemkurdas Says:

    Indeed, simple, transparent and broadly applied rules would minimize political favoritism & rent seeking, as Hayek pointed out. These attributes may matter more than the exact content of the regulation.

  15. Lee Kelly Says:


    I don’t like the situation, but I can’t honestly oppose regulation when risk taking is being subsidised. I may oppose particular regulatory institutions, but even a poorly functioning regulator might be better to none at all.

  16. chidemkurdas Says:

    Look, finance and insurance are already heavily regulated industries. (The other most regulated industry is probably pharmaceuticals & health care.) Despite the conventional wisdom that there wasn’t enough regulation in the past decade or so, in fact an immense new layer of regulation was added with Sarbanes-Oxley, which now even the Democrats have recognized as an excessive burden and are modifying. Existing rules & authorities were not used in a way to prevent bubbles and crashes. There is no evidence that adding new rules and authority will change that.

  17. Again, I agree with Chidem. A little known fact is that Sarbanes-Oxley was patterned after an earlier piece of banking legislation. Neither the earlier piece of legislation, nor Sarbox prevented financial institutions from over-valuing assets on their books and over-stating their income. Some sanity is creeping into the debate, as reported on the front page in today’s Washington Times. Left and right have come together to oppose the Administration’s approach to bank regulation. Both sides of the political spectrum want to end too-big-to fail.

  18. Lee Kelly Says:


    I never meant to imply that I like the prevailing regulatory institutions.

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