Friday, January 18, 2008

How Much Is Too Much? A Response to Barney Frank

Monday's Financial Times carried a significant and timely column by Congressman Barney Frank (D-People's Republic of Cambridge, Massachusetts). And while the Honorable Mr. Frank probably deserves all the opprobrium he continues to receive for years ago having facilitated his same-sex partner's prostitution business, he is nevertheless a thoughtful and articulate spokesman for the social and economic left.

His article was entitled Why America Needs a Little Less Laissez-Faire. That by itself articulates a thoughtful position. The question is not whether free markets are good but the degree to which they require regulation to achieve better performance at any given moment. Economic debate should be framed on such terms, not with the class-warfare rhetoric in which many in Frank's party indulge.

So a serious article deserves a serious response. And we intend to give such. Here it is, point by point.

Frank writes:

As we prepare for this autumn’s election, the results are in on America’s 30-year experiment with radical economic deregulation. Income inequality has risen to levels not seen since the 1920s . . .


And we respond:

You had our interest from the title up to the word "radical." Few who work in American business would say that the burden of their regulation is less than it has been historically. Few who know the American business environment would say that it is more radically unregulated than other countries. A recent evaluation ranks the United States the fifth most free country economically, behind Hong Kong, Singapore, Ireland and Australia. Those ahead of us are notable for their aggressively rising levels of prosperity. Ireland is the economic story of the last decade.

What's worse, he notes what Democrats are really on about. They're not saying that the poor are getting poorer or more numerous, because they aren't. They're saying that the rich are getting richer much faster than everyone else is getting richer. Somehow, the fact that Bill Gates has hundreds of billions hurts someone like SWNID who lives in the middle of the economic landscape, despite the fact that I enjoy a lifestyle unknown a generation ago. And I should be angry about it.

Frank continues:

. . . and the collapse of the unregulated portion of the mortgage and secondary markets threatens the health of the overall economy.

We respond:

Aha! Here's what's up. Something bad happens economically. People who lost money as a result are portrayed as victims. Government promises to step in to prevent such things happening again. The consequences of the actions that led to the economic losses should be lesson enough for the future, but politicians create laws that outlaw what has just occurred, and which no one who pays attention would do again. Those laws in turn have unanticipated effects that drive down economic growth and do nothing to prevent the next problem brought on by unwise business decisions.

A prior case in point: Enron collapsed, taking shareholders' wealth with it. Accountants were complicit. New laws (Sarbanes-Oxley) were passed to prevent accountants doing what no business that wanted to avoid bankruptcy would ever do if it paid the least attention to Enron. Those laws make it more difficult for financial service companies to do business in the United States. So they move to London and elsewhere.

The current case in point: brokers made bad mortgages to people who shouldn't have borrowed so much money to begin with. They then distributed those loans in derivative instruments that broke them into so many pieces and layers that no one knew what loans they were buying. Then the loans started to go bad, and no one knew whether their derivatives had good or bad loans in them, making all of them impossible to value. So now no one will ever do that again (at least at the derivative level), but Frank thinks that the barn door should be closed now that all the animals are gone.

So Frank will say that more laws will make me better off by taking more money from rich people and preventing bad things from happening to people who make bad decisions. We are being offered to trade away some economic freedom for the promises that rich people will be less-richer than we and that economic losses from bad investments will be regulated away. Hmm.

Frank continues:

These two economic failures will be major issues in the forthcoming presidential election, and, importantly, there is an emerging Democratic consensus standing in sharp contrast to the laisser faire Republican approach.

There are two central elements of this consensus. Democrats believe that government’s role as regulator is essential in maintaining confidence in the integrity and fairness of markets, and we believe that economic growth alone is not enough to reverse unacceptable levels of income inequality. In the wake of the subprime mortgage crisis, credit markets round the world contracted sharply in response to concerns among market participants about the value of exotic and opaque securities being offered in largely unregulated secondary markets. This staggering implosion and its damaging and widespread reverberations make it clear that a mature capitalist economy is as likely to suffer from too little regulation as from too much. . . .

We respond:

So there we have it again: linking income inequality (not inadequate incomes but unequal ones) and the mortgage credit problem.

First, these are completely unrelated.

Second, it is the very presence of regulation which sometimes throws kerosene on the fire of imprudence. An investor thinks, "This might not be a wise investment. But the government surely would have outlawed it if it weren't safe. And if it goes bad, they'll probably bail me out." Similar thoughts course through the brain of the mortgage lendee as well.

Frank continues:

With respect to income inequality, since the end of the last recession – a period of steady economic growth – average earnings for the vast majority of workers have fallen in real terms. During this period, after-tax incomes of the top 1 per cent nearly doubled.

Whether because of globalisation, technology or other factors, it is clear that market forces have produced too much inequality and government has not adequately used its capacity to mitigate the impact of these forces.

We respond:

Since the end of the last recession, two significant socio-economic developments trump any theoretical decline in "real wages" as calculated by some formulae. First, the number of households receiving public assistance has dropped significantly, thanks to welfare-to-work legislation. Meanwhile, the percentage of households in poverty has declined slightly while the percentage of households classed as "upper income" has increased significantly. In other words, the middle class has been squeezed because some in the middle class have been getting rich while few have become poor, fewer than in the past.

Can government "mitigate" the effect of globalization and technology? The truth is that those individuals and communities that determine to adapt to the changing marketplace are the ones that will prosper. Depending on government to soften the blow de-incentivizes the changes needed to adapt. If there is work for the government to do, it is in encouraging people to retrain and relocate for productive work in the changing environment. But we doubt that Rep. Frank intends as much.

Frank continues:

Conservatives have long argued that government efforts to address these issues would damage the economy. They are, of course, the same people who predicted
that there would be an economic disaster after Bill Clinton and the Democratic Congress raised marginal tax rates in 1993, and who opposed other tax increases on upper-income people. Economic growth in the ensuing years was among the strongest in the postwar era. It is now clear that growth in the private sector
is consistent with a far greater variation in many aspects of public policy – including taxation and regulation – than conservatives claim. In fact, appropriate intervention with respect to prudential market regulation is necessary to promote growth, and its absence – as we have learned – can retard it.


We respond:

We first thank Rep. Frank for not saying that Clinton's tax increases caused or helped the prosperity of the 1990s. What he's saying is that they didn't hurt it. That says more about the robustness of the economy in that period than it does the value of tax increases.

But the fact that tax increases by themselves didn't hurt the economy doesn't mean that the economy is ready for a beating with other kinds of regulations, which is Frank's implication at the end of the paragraph. What kind of regulation is necessary at this time, Congressman? What does our economy need government to do? If it's raise taxes, the only thing that you've mentioned specifically, what good will that do for anyone?

We will ignore for now the ad hominem aspect of Frank's rhetoric, since there's so much less of it than is typical of members of his party.*

Frank continues:

As recently as a year ago, one often heard the argument that US financial activity would migrate offshore unless we moved to further deregulate markets. There is little evidence to support this claim. . . .

We respond:

Actually, there's a lot of evidence for this. After Sarbanes-Oxley, London experienced a boom of firms that expanded there and not in NYC. The London Stock Exchange has benefited from New York's problems with its regulatory environment. And that isn't just a theoretical issue: jobs that would have been in the United States went elsewhere, and so did the jobs that depend on those jobs.

Frank continues:

In fact, it is now clear that what has been migrating to the rest of the world are the problems associated with securities based on bad loans – often originated by unregulated institutions in the US. Banks in the UK and Germany were forced to close, either as a result of holding large portfolios of these securities or because they could not roll over debt backed by them. Widespread securitisation, and use of the “originate to distribute” model, has turned out to be far less than the unmitigated boon it had once appeared.

The market did its job with great efficiency in exploiting the benefits of securitisation but government failed to make good on its responsibilities. The failure of regulation to keep pace with innovation left us with no replacement for the discipline provided by the lender-borrower relationship that securitisation dissolves. Increasing and largely unregulated leverage multiplies the corrosive effect of this change.

In response to the current crisis, it appears that the regulatory tide may, at long last, be turning.

We respond:

This is the truest part of the essay. It just doesn't support what Frank says. Yes, the markets didn't function well when the originator of the mortgage had no stake in its value. But that's yesterday's story. Regulations to curb that are unnecessary now, because few will repeat the mistake. Zealous regulations will instead interfere with other, productive forms of investment, to the loss of everyone who would have benefited from a more prosperous economy.

But truly, the tide on regulation is turning. Too few remember the 1970s, with price and wage controls, rampant inflation, stagnation, fuel shortages, and high unemployment. What we enjoy now is not a result of the regulations that led to that mess. Many of us want to go back to that as much as we want to go back to listening to KC and the Sunshine Band.

Moreover, the global credit crunch has to do not just with the mortgage problem in the US but with the global decline in real estate prices, something that has been punishing Japan for several years now. We didn't export this. It happened to everyone.

We've been through a real estate bubble like the dot.com bubble of the 1990s. But as no one believed that "profits don't matter" after that previous bubble, so now no one will believe that the orignator of a mortgage should be without a stake in its value. We didn't need laws to regulate startups then, and we don't need whatever Frank has up his sleeve now.

Frank continues:

In 1994 a Democratic Congress – the last before the Republican takeover marked the arrival of the deregulators – passed the homeowners equity protection act, giving the Federal Reserve the power to regulate all home mortgage loans. The avatar of deregulation, Alan Greenspan, then Fed chairman, flatly refused to use any of that authority.

In contrast, today’s Fed will soon issue rules using that authority. That represents a significant repudiation of the previous view. While the proposals made by the Democratic presidential candidates differ in detail, they are to a substantial extent consistent with the argument I have made here. Their Republican counterparts continue to advocate the hands-off approach pursued by the Bush administration. As a result, we are likely to have a healthy debate about the role of government in supporting a robust capitalist economy in the 21st century. It is important to note that this debate is not about policy details but represents fundamentally different views about the nature of our modern economy.

I believe the American people will decide that we should enact policies that seek to curb growing inequality and provide some check on market excesses.

We respond, finally:

We note in passing that the Fed chairman whom Frank derides as "avatar of deregulation" was enthusiastically reappointed by Bill Clinton, who at least followed a reasonably sound economic policy despite his willingness to exploit class envy

But in the end, we see what's up. Frank hopes to use resentment against the wealthy and economic naivety to convince an electorate tired of Republicans that Democrats can regulate them into economic safety and prosperity. All he can name in the process is more regulation of the mortgage industry, likely keeping more people from building wealth over generations by buying a family home, and more taxes on the rich, which will benefit no one but the government that spends it on who knows what.

If you like the sound of that, vote for Mr. Frank's party in November.

If you think that people need opportunity, not protection, vote for the party that began with a platform of ending slavery and allowing free settlement of the frontier.
__________________
*That was our own ad hominem.

1 comment:

Unknown said...

Great post. Love to have you teach a "Economics and Civics" class at CCU.