Could Regulation Have Prevented The Housing Bubble?

If the proposed financial regulation existed years ago, would it have been enough to prevent the financial crisis? Yale economist Robert Shiller explains why regulation like the Consumer Financial Protection Agency would not have averted the subprime mortgage bubble but could discourage innovation. Then economist Mark Thoma from Economist's View, provides his rebuttal.

Robert Shiller says that while a Consumer Financial Protection Agency is a good idea, it wouldn't have prevented the housing bubble:

Financial Invention vs. Consumer Protection, by Robert J. Shiller, Commentary, NY Times: James Watt, who invented the first practical steam engine in 1765, worried that high-pressure steam could lead to major explosions. So he avoided high pressure and ended up with an inefficient engine. It wasn’t until 1799 that Richard Trevithick ... created a high-pressure engine that opened a new age of steam-powered factories, railways and ships.

That is how innovation often proceeds — by learning from errors and hazards and gradually conquering problems through devices of increasing complexity...

Our financial system has essentially exploded... We need to invent our way out..., and, eventually, we will. That invention will proceed mostly in the private sector. Yet government must play a role, because civil society demands that people’s lives and welfare be ... protected from overzealous innovators who might disregard public safety and take improper advantage of nascent technology.

The Obama administration has proposed a ... Consumer Financial Protection Agency, which would be charged with safeguarding consumers against things like abusive mortgage, auto loan or credit card contracts. The new agency is to encourage “plain vanilla” products that are simpler and easier to understand. But representatives of the financial services industry have criticized the proposal as a threat to innovation...

If a consumer agency had been set up 20 years ago, would the subprime mortgage crisis have been prevented? We don’t know, but it seems improbable. Such an agency would most likely have slowed some abusive practices... That ... would have reduced the severity of the crisis, and that is no small thing.

On the other hand, unless these regulators were extremely vanilla in approach and just said no to any innovation, or unless they had an unusually deep understanding of speculative bubbles, I think they would have allowed most of those subprime mortgages. And they probably wouldn’t have had the detailed knowledge they would have needed to halt the decline of lending standards on prime mortgages in a timely way. In all likelihood, we would still be in this financial crisis.

In short, the new agency seems a good idea, and, if it is created, it should ... support innovation and ...be staffed by people who know finance..., including some who appreciate that human behavior must be understood and factored into financial design.

But that leaves us with the deeper quandary: Our society needs financial innovation, and still seems vulnerable to ... speculative bubbles that create truly big problems. Even if they can be mitigated, periodic crises may not be preventable, at least not by banning abusive credit cards or even by throwing the bad guys in jail. ...

The effectiveness of our free enterprise system depends on allowing business people to manage the myriad risks — including the risk of asset bubbles — that impinge on their operations in the long term. And this process needs constant change and improvement.

Complexity is not in itself a bad thing. ... A laptop computer is an immensely complex instrument... Yet it can be designed well so that it seems plain vanilla to the ultimate user.

And as for steam engines, the modern turbine high-pressure versions are not plain vanilla in any sense. They are sophisticated triumphs of engineering. They help generate most of our electric power with very few accidents.

I'm not sure his example works. If a modern turbine engine fails, it doesn't threaten the broader economy. If the engines were interconnected, so interconnected that the failure of one could bring them all down (beyond a single set at a given geographical location), then they might threaten the entire economy and be more like financial innovation.

The point is, because the costs of a steam or turbine engine blowing up are mostly localized, we can allow innovation to occur with very little regulation within the private sector without too much concern. Of course, we need to make sure that, say, a steam engine blowing up in a garage doesn't harm the neighbors, or harm any employees who might be there, and we also want to protect the inventors from themselves to some extent, but since the threat from an explosion is localized, we can allow innovation to proceed in the private sector under relatively light regulation without incurring great risks.

Suppose, however, that the turbine engines were interconnected and the failure of a single engine anywhere in the system could bring the whole system down, and not just for a day or two, but for months and months, and that the loss of so much power for so long would wreck the economy. In such a case, how much trust would you be willing to place in an unregulated private sector development of a new engine type for the grid? How much complexity would you be comfortable with? How much testing would you want the engines to undergo before being allowed in use? Would the fact that they have "very few accidents" as Shiller notes be of comfort?

When the dangers are great, we need to be careful. The financial grid is interconnected in just this way, and we need to do all that we can to ensure that new innovations do not become engines of destruction yet again.

This post was republished from Mark Thoma's blog, Economist's View.

Preventing Regulators From Favoring Commercial Interests

Is Obama's proposal for regulation doing enough to prevent regulators from acting in the best interest of financial companies? That is the question that is posed by WSJ columnist Thomas Frank. Economist Mark Thoma responds to Frank's criticism.

Thomas Frank says the administration's regulatory overhaul plan is not putting enough emphasis on the problem of regulatory capture:

Obama and 'Regulatory Capture', by Thomas Frank, Commentary, WSJ: ...We have just come through the most wrenching financial disaster in decades, brought about in no small part by either the absence of federal regulation or the amazing indifference of the regulators.

This is the moment for a ringing reclamation of the regulatory project. President Barack Obama is clearly the sort of man who could do it. But ... a white paper his administration released on the subject last week ... uses bland, impersonal explanations for the current crisis. Regulatory agencies were ill-designed... Their jurisdictions overlapped. They had blind spots. They had been obsolete for years.

All of which is true enough. What the report leaves largely unaddressed, however, is the political problem. ... The people who filled regulatory jobs in the past administration were asleep at the switch because they were supposed to be. ...

The reason for that is simple: There are powerful institutions that don't like being regulated. Regulation sometimes cuts into their profits... So they have used the political process to sabotage, redirect, defund, undo or hijack the regulatory state since the regulatory state was first invented.

The first federal regulatory agency, the Interstate Commerce Commission, was set up to regulate railroad freight rates in the 1880s. Soon thereafter, Richard Olney, a prominent railroad lawyer, came to Washington to serve as Grover Cleveland's attorney general. Olney's former boss asked him if he would help kill off the hated ICC. Olney's reply ... should be regarded as an urtext of the regulatory state:

"The Commission . . . is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of the railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. . . . The part of wisdom is not to destroy the Commission, but to utilize it."

The George W. Bush administration elevated this strategy to a snickering, sarcastic art form. It gave us a Food and Drug Administration that sometimes looked as though it was taking orders from Big Pharma, an Environmental Protection Agency that could never rouse itself from the recliner, an energy policy that might well have been dictated by Enron, and a Consumer Product Safety Commission that moved like a rusty wind-up toy.

And it created a situation where banking regulators posed for pictures with banking lobbyists while putting a chainsaw to a pile of regulations. ...

Misgovernment of this kind is not a partisan phenomenon, of course. Democrats have been guilty of it as well as Republicans. ... Yet today we talk around this problem, with its nose-on-your-face obviousness, as though it didn't exist. It's not until page 29 of the Obama administration's densely worded white paper that you find a reference to "regulatory capture," and then it is buried in a list of items to be considered by a future Treasury working group. ...

[T]he administration must go further. ... After all, the Bush team was only able to install the dreadful regulators it did because the governance of federal agencies was rarely a topic of public debate in those days. Mr. Obama should make it an unavoidable subject, something that future politicians will be required to address. The issue cries out for it. And the nation, for once, is listening.

I see this a little bit different. I think the regulatory capture that helped to open the door for the current crisis had more to do with the adoption and promotion of free market ideology and the culture that ideology brought about within the regulatory bodies than to direct capture by regulated industries.

The financial industry certainly promoted the free market, self-healing, self-regulating approach since it coincided with their interests in shedding regulatory constraints, and they also aided politicians who promoted these ideas. Those politicians, in turn, made appointments to key positions within regulatory agencies that were designed to further this ideology and that, too, contributed to the changing culture within the regulatory bodies.

But the idea that, in almost all cases cases markets will self-correct and self-regulate, and that society is best served with a hands off approach to these markets, did not originate within industry. It came from a dominant strain of economic thought supported by theoretical models and empirical evidence. Without the support of these models, the empirical evidence, and the many economists who carried the message - and most of the profession did - it would have been much more difficult for industry to successfully promote the "deregulation is good for everybody always and everywhere" within the political and regulatory arenas.

I don't want to be mistaken here, I still believe that most markets function well with minimal regulation, and that a hands off approach is generally best. But I hope we have learned that financial markets are not among the markets for which this is true. I also hope that, as a profession, we will be more receptive to the idea that markets can fail, and can do so catastrophically, that we will build models that help us to better understand how to minimize the risk that markets will break down, and more importantly that we will interpret data with this in mind. All of the data in the world is useless if you cannot see, refuse to see, or cannot accept what it is trying to tell you.

This article was reposted from Mark Thoma's blog, Economist's View.