Reason Foundation - Experts > Anthony Randazzo

Treating Wall Street Like the Mafia

anthony.randazzo@reason.org (Anthony Randazzo) — Fri, 20 Nov 2009 13:53:00 EST

Perhaps Senate Banking Committee Chairman Chris Dodd (D-Conn.) thinks of himself as a modern day John Sherman. In 1890, Ohio Sen. Sherman set out on a mission to establish “just competition” laws and level the economic playing field. His quest culminated in the dismantling of monopolies—such as American Tobacco and Standard Oil—and the passage of new laws prohibiting malicious competitive practices. In a similar way, Dodd now seeks the power to tear apart any company he considers a risk to the national economy. But unlike Sherman, Dodd isn’t out to create the best possible conditions for competition to thrive. He’s out for blood.

Dodd’s plan for overhauling Wall Street regulations, released last week, includes a proposed new organization: the Agency for Financial Stability (AFS). This new regulator would be tasked with identifying and addressing “systemic risks posed by large, complex companies as well as products and activities that can spread risk across firms.” This represents one piece of the most extensive proposal to reform financial services regulation—topping even the ridiculousness of the Obama plan and Barney Frank plan. Which is saying a lot.

The financial crisis has made off with nearly $30 trillion in global wealth. Dodd believes Wall Street banks and other financial institutions are the chief culprits in this dubious economic caper. And to exact revenge, he will push for some of the toughest, most expansive regulatory powers to date.

To do this, Dodd plans to go Elliot Ness on Wall Street, using economists and accountants as if they were FBI agents. Only instead of targeting Al Capone and Big Angelo Lonardo, these number-crunchers would be given nearly limitless power to hunt down systemic risks inside America’s financial institutions.

Here’s one of the biggest problems with this (and with the Obama and Frank plans, too): the government offers only a dangerously vague definition of what constitutes a financial institution. So not only would Goldman Sachs and JP Morgan Chase qualify, but firms like Wal-Mart, Ford, and Texas Instruments—not exactly the companies you think of when discussing Wall Street regulation—might be subject to higher compliance standards as well. It all depends on the subjective whims of the Agency for Financial Stability.

As outlined in the Dodd plan, AFS would be an independent agency, one whose chairman was appointed by the president and confirmed by the Senate. It would also have a 9-member board comprised of federal financial regulators and an independent expert.

The structure is similar to President Obama’s proposed Financial Services Oversight Council. Both of these proposed overseers would monitor the market for systemic risks, and would possess the authority to collect information from financial institutions as needed. The major difference is that where the Obama council would only have the power to designate firms as “Tier 1” companies, a category that would require stricter regulation, Dodd’s agency would actually have the power to break-up those companies considered too big to fail.

In other words, an Agency for Financial Stability would enjoy unprecedented power over the private sector. Presently, if the government wants to take a large firm apart, it must first take its case to court, proving that the company is either a monopoly or that it is maliciously attacking its competitors.

Yet not only would Dodd’s AFS write rules for capital requirements, leverage limiting, and risk management compliance, it would also have the authority to treat Wells Fargo or UBS like the Bonanno crime family.

Which means that the risk of undue political influence is palpable. Let say’s enough people come to believe that Goldman Sachs is secretly controlling the Treasury Department, as Rolling Stone’s Matt Taibbi so viciously claimed. All those people need to do is pressure the government into taking the company apart on the grounds that it’s size has become too critical to the economic health of the nation. There are certainly enough anti-Goldman Sachs staffers on Capitol Hill to make that happen. And it doesn’t take a follower of Ayn Rand to imagine a scenario where flimsy justifications like “to expand competition” and “create a fair playing field” start rolling off the tongues of aggressive AFS agents.

Nor is the Agency for Financial Stability the only part of the Dodd plan worth worrying about. His regulatory overhaul proposal also includes a Consumer Financial Protection Agency, similar to the one currently being considered in the House. Even more aggressive than Rep. Frank’s version, this consumer agency would also ultimately protect the market to death.

The Wall Street Journal pointed out last week that the Dodd overhaul plan would open up anyone who associates with someone accused of fraud to civil suits, even if prosecutors have no proof or are just on a fishing expedition. The Dodd proposal also repeats the errors of the Obama plan on issues like derivative reform, hedge funds, and executive compensation.

There are a few good ideas in the proposal. Consolidating federal banking rules into a single regulator could do a lot to simplify and refocus banking rules. Though that reform shouldn’t be kept separate from consumer protection concerns, and it would be inappropriate for the regulator to force the various charters under its supervision into one-size-fits-all regulations.

The Dodd plan also requires large firms to provide “funeral plans” outlining how they could be quickly and effectively shutdown in the case of an emergency. In theory, this is just a part of responsible risk management. But the Dodd plan treads into dangerous waters by giving AFS the authority to approve or reject such plans.

In the end, the Dodd plan is on the highest order of hubris. Politicians in Washington honestly believe they can fix the economy and prevent future calamity. Sure, they weren’t quite right when they “fixed” the system after Enron, or when they “reformed” the rules under Clinton, or when they “fixed” everything after the Savings and Loan Crisis. But this time will be different! At least Elliot Ness knew enough to change tactics after several initial failures to capture Al Capone.

The current financial crisis was largely brought about by well-intentioned regulations that just got it wrong. We thought that 8 percent was enough capital for banks to hold onto in case they ran into trouble. We thought that subprime mortgage-backed securities were decreasing risk. We were wrong on both counts. We can’t anticipate every risk. Under the Dodd plan—like the Obama and Frank plans before it— we’ll be proven wrong once again.

Anthony Randazzo is a policy analyst for Reason Foundation. This column first appeared at Reason.com.

Three Guiding Principles for Reforming Wall Street

anthony.randazzo@reason.org (Anthony Randazzo) — Mon, 12 Oct 2009 06:00:00 EDT

In the wake of the massive bank bailouts, nearly everyone is calling for some kind of financial regulatory system overhaul. The Obama administration has outlined what it would like to see and Congress is currently holding hearings on how to best reform the regulatory structure. But the lobbying began long ago.

Big banks are squaring off against smaller banks in the debate over consolidating national banking regulatory powers. All banks are lining up against financial institutions like hedge funds on the regulation of products like derivatives. Even the regulating agencies are competing against each other in hopes of garnering more power.

Unfortunately, if Congress makes choices on political criteria alone, reforms are likely to damage the country’s economic recovery.

Instead, there are three guiding principles that lawmakers should bear in mind when writing new regulations for Wall Street.

Principle #1: Facilitate competition; don’t stifle innovation

The foremost goal of financial services regulation is to establish a framework for competition by providing a common set of standards—the rules of the game—that offer accountability and enforce the law. Those standards need to promote market discipline, provide incentives for good banking practices, prevent information asymmetry where a few people have significantly better information than the average investor, and discourage harmful business practices. The rules must not impede the wealth creation process or give certain firms special advantages.

“We don't want to stifle innovation. But I'm convinced that by setting out clear rules of the road and ensuring transparency and fair dealing, we will actually promote a more vibrant market,” President Obama said when he released his plan to overhaul rules for Wall Street.

The current reforms in Congress aim to avoid future problems by limiting the risk that financial institutions can take when investing. But if facilitating competition is the principle, why not limit new rules and increase the consequences for failure?

Financial institutions should be allowed to limit or expand their own risk, knowing that reformed bankruptcy rules allow for the government to rapidly take them over and break them up if they become insolvent.

This would result in firms competing over safety and soundness, leading to the healthy vibrant marketplace the president wants.

Principle #2: Build resilience into risk management

There is a tension between regulations that anticipate risks and regulations that establish resilience during economic downturns. Anticipation seeks to preserve stability by planning for and avoiding foreseeable risks. Resilience takes a flexible approach to risk management, accommodating variability, preparing to take acceptable losses in a downturn while making modest gains in strong economies. The best regulations, like the recently updated mark-to-market accounting rules, contain a healthy mix of both approaches.

Regulators themselves are fallible, with plenty of knowledge about the past, but no crystal ball for the future. It is impossible to know every risk and predict every danger. There is value in designing regulations that accept the reality of some financial risks. There will be economic downturns. Some companies will go out of business. And some investors will lose money. You can’t regulate away those realities. Simple, common-sense regulations can provide basic protections and then the market will absorb blows as they come.

Principle #3: Beware of creating perverse incentives

Regulations always have the potential to create perverse incentives that distort decision-making and restrict wealth creation. Bailouts have sent the signal that the bigger a financial institution becomes, taking on increased risk, the less likely it is to fail.

In July, bankruptcy-bound small business lender CIT Group was refused a bailout. Some experts said it was because the company didn’t take on enough risk or grow quite large enough to get a bailout. Even though CIT was ultimately rescued by the market, it wasn’t considered “too big to fail” by the government.

When CEOs see Citigroup or AIG bailed out, but CIT left to the market, the signal is clear: make sure you are too big to fail.

The biggest mistake in President Obama’s proposed Wall Street regulation overhaul makes is that it formalizes “too big to fail.” Yes, it requires more oversight and regulation, but it actually encourages firms like CIT to unnecessarily take bigger risks so they are eligible for bailouts.

Wall Street reforms should make the consequences of failure uncomfortable. If failure means going out of business, Congress won’t need to set executive pay restrictions and micro-manage capital requirements. Companies will be forced to be more prudent if they are told that there will be no more bailouts and “too big to fail” is a thing of the past.

Getting regulation right is hard work,. Even with their good intentions, regulators too often skew market activity and create perverse incentives for investment. Although many financial sector regulations are out of date and problematic, the restructuring process could cause even more damage if it is not done properly.

Anthony Randazzo is a policy analyst at Reason Foundation.

President Obama's Plan to Help Consumers Will Hurt Them

anthony.randazzo@reason.org (Anthony Randazzo) — Fri, 09 Oct 2009 15:00:00 EDT

Reason.com

When I first learned to drive as a teenager, my mother let me take the wheel on trips to the local grocery store. She was there in the passenger seat, arms flailing every time a squirrel or a piece of sagebrush came across the road, her left forearm pressing my chest back against the seat. It was instinct. She wanted to brace me for the impact of a crash. The only problem was that I needed both arms free to keep the van from crashing in the first place. While I appreciated my mother's concern, I hated the thought that she might protect me to death.

Which is the same attitude every American should have when it comes to the new consumer financial protection laws President Barack Obama and Rep. Barney Frank (D-Mass.) want to impose on businesses.

Today, President Obama gave a White House speech reiterating his support for the creation of a Consumer Financial Protection Agency (CFPA). Obama first proposed the idea in June as a part of his grand plan to overhaul Wall Street regulations. But it has come under considerable attack recently for fear it would smother businesses and end up hurting consumers.

If created, the CFPA would be tasked with ensuring that consumers who use financial products like bank accounts, mortgages, and credit cards are protected from the evil corporations that are out to get their money. In a sense, it is a noble idea, stemming from the mind of a noble woman, Congressional Oversight Panel Chair Elizabeth Warren. But it's going to protect us to death.

In its current form, the CFPA will pile on burdensome new rules, restrict innovation, hurt small businesses, increase the cost of doing business, spawn a massive bureaucracy, and create severe conflicts between state and federal law. Frank's proposed version would even allow the new agency to write and enforce laws beyond the scope of existing legislative authority. There are good ways of reforming consumer protection. The Consumer Financial Protection Agency is not one of them.

Currently, consumers are protected by a layering of federal agencies, depending on the type of financial institution and its corresponding regulator. Much of the consumer protection at banks lies in the Federal Reserve, but the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, along with other agencies in the alphabet soup of regulators, have mandates to watch out for consumers as well. By and large, this protection is supposed to prevent abuse, stop "predatory lending," ensure that banks give out the appropriate information, and stop companies from tricking consumers into buying something they don't want. In theory, that is all good stuff.

The free market needs a regulatory structure, there need to be rules to guide conduct, fraud and theft must be prevented. There's nothing inherently wrong with the government protecting consumers from actual destructive behavior. The problem is that the CFPA would try to protect consumers from themselves, at the expense of business.

Congress has already given in to this paternalistic urge by passing the credit card act in May 2009. That law tried to keep banks from charging high interest rates and fees, but instead has only served to restrict available credit, especially for low-income borrowers. The CFPA is looking to expand that disastrous initiative.

Congress approaches the issue as one of "systemic risk." From the point of view of the Democrats in the House Financial Services Committee (FSC)—the legislative body creating the CFPA—consumers need a single, all-knowing agency to protect them, one that has the power to scan the whole market and assess the dangers of different products. The Democrats argue that had a CFPA been in place, the dangers of subprime mortgages would have been spotted and regulators could have stopped the mortgages' hazardous growth.

In a way, it's a logical argument—but it only works if government agencies could be all-knowing.

The problem is that many people did see the danger in subprime mortgages, particularly their fragmentation into mortgage-backed securities, but it wasn't possible to know everything we know now in the heat of the moment back then. (Which is a reason no one acted.) Regulators are fallible, and there's nothing prudent about trusting a single, bureaucratic agency with managing the safety of the whole market.

Nevertheless, some positive strides have been made recently. Under pressure from the U.S. Chamber of Commerce (USCC)—vehemently opposed to the idea of a CFPA—and Blue Dog Democrats, House FSC Chairman Frank has backed down from some of the more extreme aspects of the original Obama/Warren design.

The Obama/Warren plan would have required financial institutions to offer certain products, including "plain vanilla" versions of checking accounts, mortgages, or IRAs. The Obama/Warren CFPA would also have received the power to create simplified products and force firms to sell those in addition to—or in place of—their own financial products. Those deadly provisions are now out.

The original plan also called for forcing all financial institutions to make their products easier to understand. This is a component of the credit card bill, which limits fine print to allow consumers to understand their purchases in four minutes or less. While Frank is still pushing for increased disclosure, he has taken out the vague and dangerous "Reasonableness" clause, which left it up to the CFPA to determine what was the "reasonable way" to understand a given financial product.

Frank also issued a memo listing the types of institutions that won't be subjected to CFPA regulation, including lawyers, auto dealers, telecom companies, 401(K) providers, and real estate brokers. However, the financial products these companies offer will be subjected to regulatory oversight by the CFPA, a rather significant sleight of hand.

Despite the capitulations, the CFPA will still wind up damaging companies and ultimately hurting consumers. What looks like movement in the right direction is largely a smoke screen to disguise the fact that a Frank designed CFPA will still have power to force the standardization of some products.

Furthermore, Frank has yet to deal with other significant concerns about what the new agency will do to businesses and the market.

In a report released on September 23, the U.S. Chamber of Commerce (USCC) revealed that the CFPA would cause significant harm to small businesses by imposing high fixed costs for complying with the new regulatory burden. These compliance costs are more easily handled by large firms, which have sophisticated legal staff to work through the piles of regulation.

Michael E. Fryzel, former chairman of the National Credit Union Administration said, "The proposed legislation could cause financial institutions to incur additional costs, including those for fees, staff training, and policy development. The higher operating expenses associated with compliance could have a negative impact on the availability of credit." Given that 70 percent of the USCC's 3 million-plus members are small businesses with less than 10 employees, it is easy to understand how overly burdensome new consumer protection rules could cripple growth and lead to many closures.

The USCC also argues that the CFPA would likely reduce small business access to credit, limit start-ups, damage employment opportunities, and favor large financial firms with "one-size-fits all" rules. As Federal Reserve Chairman Ben Bernanke has warned:

There are many issues to consider, including that overly restrictive or burdensome regulations can lead to increases in product pricing or product withdrawals that would overly constrain credit, or in extreme cases, severely impact the availability of responsible credit for consumers.

In addition to limiting credit and expansion opportunities for small businesses, the CFPA would create brain-knotting problems for large firms. Frank's CFPA, like the Obama/Warren version, would require banks to follow both national and state rules for consumer protection. The Wall Street Journal noted that "each state could impose different rules for pricing, product features, repayment schedules, bank capital requirements, consumer disclosure, regulatory reporting requirements, and so on. If each state can set its own rules, expect endless legal confusion over which law prevails when a bank in one state serves a customer in another."

Consider this complication: If Maryland declares a financial product unsafe, could it still be advertised on television in the northern Virginia and Washington D.C. markets where the signal stretches into Maryland? Would someone living in Virginia and working in D.C. not be allowed to use an IRA or 401(k) plan deemed too dangerous by one of those jurisdictions? Without clearly defined federal preemption, large financial institutions could suddenly find themselves subjected to oversight from the attorneys general in every state they do business, a radical shift from the current paradigm.

Unfortunately, the problems with the CFPA go even deeper than that. Consolidating all federal consumer financial protection regulation would divorce "safety and soundness" regulatory oversight from consumer oversight of financial institutions. There is an important complementary relationship between the two that the CFPA would rip apart. As John Bowman, acting director of the Office of Thrift Supervision (a division of the Tim Geithner-run Treasury Department), has said:

Dividing the regulation of safety and soundness and consumer protection would undermine the safety and soundness of the banking system and weaken a regulator's ability to formulate a complete assessment of a financial institution's risk profile.

Fed Chairman Bernanke, recently reappointed by President Obama to another term, has also pointed out this flaw in the CFPA's design:

In the Reserve Banks, the consumer compliance examiners, while specially trained, often share senior management with the prudential examiners. So, at that level, it would not necessarily be a clean transfer. Additionally, the Reserve Bank examiners draw on expertise and knowledge from other areas of the organizations. Those knowledge centers would not be part of the transfer to a new agency... We believe that prudential supervision and consumer compliance are complementary and should not be separated."

This was a proven bad practice at Fannie Mae and Freddie Mac. James Lockhart, the former head of the Federal Housing Finance Agency, has testified that a separation of consumer protection from financial safety and soundness regulation at those government-sponsored enterprises was a definite cause of their downfall.

Smarter, more effective regulation is the answer to fixing consumer financial protection problems. Consumers don't need new layers of regulation leading to more confusion, uncertainty, and lost value. Instead, regulators should focus on vigorous, effective enforcement of current laws against predatory practices and abuse. There is also room for making sure the existing web of agencies covers all regulatory gaps.

As the Consumer Financial Protection Agency stands now, it is President Obama, Elizabeth Warren, and Barney Frank collectively slamming an arm across the collective chest of the nation's businesses and consumers. We're trying to drive an economy here! We don't need to be protected to death.

Anthony Randazzo is a policy analyst at Reason Foundation.

Too Big to Fail Becoming Official Policy

anthony.randazzo@reason.org (Anthony Randazzo) — Wed, 30 Sep 2009 11:30:00 EDT

President Obama recently outlined his plan to fix the regulation of Wall Street and said it was time to “put an end to the idea that some firms are too big to fail.”

Amen.

But the president doesn’t need a new law or a new oversight committee, like the one he proposes, to end the concept of too big to fail. He could, and should, simply make a speech declaring that from this day forward, any company, no matter how big or small, will be allowed to fail. If Bank of America or AIG or Chrysler goes bankrupt, so be it. Obama should unequivocally proclaim, “There will be no more bailouts. Period.”

If given, that speech would surely be the most popular thing Obama’s done since becoming president. Arianna Huffington and other liberals angry that 'crony' capitalists are getting corporate welfare would love it. Glenn Beck, Michelle Malkin, and fiscal conservatives who truly opposed President Bush’s $700 billion Troubled Asset Relief Program bailout would love it. Libertarians and independents would be ecstatic to see the end of a system that protects—and even rewards—businesses that make bad decisions.

Unfortunately, while Obama hints at ending “too big to fail” policies, his financial reforms actually continue to encourage the reckless financial behavior that helped get us into this mess.

The president is worried about system risk. If AIG or Citigroup fails, the whole financial system could be dragged down with them. As economist and historian Niall Ferguson points out, “By the end of 2007, 15 institutions with combined shareholder equity of $857 billion had total assets of $13.6 trillion and off-balance-sheet commitments of $5.8 trillion—a total leverage ratio of 23 to 1.”

But these massive banks don’t worry about being overleveraged because they know the government won’t let them fail. They can take all the risks they want because taxpayer money will be there to bail them out if their gambles don’t succeed. Rather than end this practice, the president’s proposal would label big firms as “Tier 1 Financial Holding Companies" that are subject to tougher rules, a new oversight committee and a bankruptcy insurance fund. The result of Obama's plan is actually a formalized too big to fail structure that encourages financial institutions to take on even more risk knowing they have taxpayer protection.

Actually ending the policy of too big to fail would force financial institutions to self-correct their balance sheets or see a mass exodus of shareholders. Congress wouldn’t have to pass new Wall Street regulations or mandate new leverage ratios for banks because the clear message to investors would be simple: their money isn’t safe if it is sitting in overleveraged banks and companies.

There are also growing concerns that the nation’s biggest banks are just getting bigger, and thus are even less likely to be allowed to fail in the future. CBS News reports that four institutions—JP Morgan Chase, Bank of America, Citigroup and Wells Fargo—now issue one out of every two mortgages and about two out of every three credit cards in the United States.

There’s nothing particularly worrying about those numbers—if you are willing to let those four companies go out of business. But, if taxpayers, via future bailouts, will be on the hook for half of the mortgages or two-thirds or the credit card debt in this country, we are in very bad shape.

President Obama is often at his best talking about personal responsibility. “It was a collective failure of responsibility in Washington, on Wall Street, and across America that led to the near-collapse of our financial system one year ago,” Obama said in his Wall Street speech. “So restoring a willingness to take responsibility—even when it's hard to do—is at the heart of what we must do.”

Responsibility, not expanded regulation, is exactly what is needed. If banks make risky loans to people who can’t pay them back—it is their responsibility. If financial firms get overleveraged and go out of business - it is their responsibility. If a carmaker makes decades of poor decisions and goes under—it is their responsibility.

There might be prudential changes necessary to the regulatory structure. But eliminating too big to fail bailouts from the government’s vocabulary entirely would be the best thing President Obama could do for Wall Street and Main Street.

Anthony Randazzo is a policy analyst at Reason Foundation and author of the new study Fixing the Regulation of Wall Street.

Rebuilding Wall Street

anthony.randazzo@reason.org (Anthony Randazzo) — Tue, 15 Sep 2009 12:00:00 EDT

The role of regulation in the creation and evolution of the financial crisis has been one of the hottest debate topics in the midst of this recession. Undoubtedly, regulators played a part in creating the mess, though how and to what degree remains undecided. One thing that everyone agrees on is the need for change in the current financial sector regulatory structure. What isn’t agreed upon is whether change should take the form of new regulations or the repeal of old, problematic rules. And the change camps disagree on what kind of laws should be added, or which ones should be repealed.

As a part of a broader effort to enhance America’s financial stability, President Obama and his economic team have proposed a series of changes that would dramatically overhaul financial services regulation. In a speech at Federal Hall in New York on September 14, the president explained his philosophy for regulation:

“I believe that the role of the government is not to disparage wealth, but to expand its reach; not to stifle markets, but to provide the ground rules and level playing field that helps to make those markets more vibrant—and that will allow us to better tap the creative and innovative potential of our people. For we know that it is the dynamism of our people that has been the source of America's progress and prosperity.”

This foundation is exactly what should be driving Wall Street regulation reform. The president continued on in his speech to criticize the doctrine of “too big to fail” that led to the massive bailouts of financial firms, and he pledged that taxpayers would never again have to shoulder the failures of risky Wall Street firms.

However, getting regulation right is hard work. And unfortunately, the president’s plan does not succeed in meeting his own standards. The White House proposal depends too heavily on anticipating every future risk to the financial sector. The Administration is overly confident in the power of regulators to collect and analyze information from financial institutions. It simply is impossible for the government, or any private firm, to have complete knowledge of the currents of the financial markets.

The president’s plan also inadvertently codifies bailouts as standard practice, instead of getting rid of too big to fail. The institutionalization of bailouts would put significant amounts of taxpayer money unnecessarily at risk and inappropriately influence the risk assessment process at financial institutions. Furthermore, the president’s plan winds up tightly restricting means of financial innovation, stifling markets instead of encouraging entrepreneurial activity.

Regulations should avoid, as much as possible, limiting the wealth creation process. The best regulation comes through a gradual improvement process over years of experience, focusing on facilitating competition and keeping financial institutions accountable for their own risk. This is the fastest way to recovery, with a fully functioning, vibrant financial market that is driving growth in every sector of the American economy.

Ultimately, when designing new regulations and guidelines for the financial services sector, lawmakers want to make sure they do not create conditions for the next crisis. Although many financial sector regulations are out of date and problematic, the restructuring process could cause even more damage if it is not done properly. This means using restraint, not overreacting, and considering the vast potential unintended consequences of any action.

Here are some suggestions for Congress to consider in designing a regulatory process that disentangles the government from the financial sector and adds to a framework for competition:

Resilience Focus: Focus on aspects of regulation that make the financial sector more resilient during the next economic downturn, like incentivizing firms to bear the responsibility for their own risks, instead of depending on anticipation of every foreseeable problem. Financial institutions should be competing to be the safest and soundest firm in the market, not building up portfolios of risk to be Tier 1 bailout eligible.

Systemic Risk: Design a Financial Services Oversight Council as an informal committee that watches for systemic risk, but works with regulation agencies and makes policy suggestions behind closed doors to avoid affecting market activity.

Bank Supervision: Consolidate the overlapping banking regulations into a national bank supervising agency to simplify the rules, but don’t separate it from consumer protection, a complementary power of oversight. Also, ensure the National Bank Supervisor does not try to force one-size-fits-all regulations on the various types of federal charters within its oversight.

Consumer Protection: Instead of a Consumer Financial Protection Agency, bolster the current consumer protection laws and recognize that people will make financial mistakes even when contracts are clear. Protection reform can come through empowering the current regulators to resolve disputes more easily and collect restitution when necessary. We don’t need an agency with independent power to restrict products it deems harmful; instead, let consumers make choices for themselves. Consumer protection should also be coupled with banking oversight.

Bankruptcy vs. Resolution: Use bankruptcy laws, well developed over the past several decades, to wind down insolvent financial institutions instead of an unfunded resolution authority. If necessary, Treasury could be granted authority to step into non-banks and force them into “chapter 14” bankruptcy if their insolvency was imminent, similar to authority over banking institutions.

Hedge Funds: Only require the largest, highly leveraged hedge funds to register with the SEC, and hedge fund operations that are subsidiaries of financial conglomerates.

Derivatives: Ensure that an open derivative exchange does not reduce the potential for customized, unique financial products to be developed.

Securities Economic Interest: Recognize that even requiring originators to have skin in the game by making them keep some financial interest in securities will not eliminate the potential for failure.

Capital Requirements: Don’t depend on capital requirements or reserve ratios to guide financial institution risk assessment, but rather make sure those firms understand the painful consequences of failure, and be prepared to let them fail.

Mutual Funds: Let money market mutual funds establish their own, internal rules for avoiding bank runs and let those policies be a competitive advantage; some firms will have higher capital reserves, with a lower yield, but be safer in an economic storm, while others will be higher risk money market mutual funds.

Credit Rating Agencies: Don’t allow for the continued existence of a rating cartel. Eliminate all references to rating agencies from U.S. law and ensure expanded competition over the provision of rating services.

Government-Sponsored Enterprises: Quickly work to privatize the GSEs and end government policies encouraging homeownership growth as they have historically interfered with proper growth in the housing market. The ideal plan would wind down the GSEs by the time the stimulus and bailout programs are ended over the next 18 months.

Historical Perspective: Understand that deregulation did not cause the financial crisis, and don’t pile on new rules just for the sake of increasing quantity. The mere creation of new agencies does not reveal future economic conditions any more clearly.

This is an partial adaptation of the new policy study Rebuilding Wall Street: A Review of the White House Proposal for Reforming Financial Services Regulation. A downloadable version of this is located here, and the full policy study here.

Fixing the Regulation of Wall Street

anthony.randazzo@reason.org (Anthony Randazzo) — Mon, 14 Sep 2009 00:00:00 EDT

Today, President Obama urged "common sense" banking regulations and outlined his ideas to overhaul regulation of the financial sector. In response to the costly bailouts and bank failures, Congress is expected to create a new set of financial regulations later this year. This study examines the Obama administration’s proposals to reform Wall Street and offers recommendations to ensure that taxpayers are no longer forced to bail out banks and companies deemed "too big to fail."

The Future of Too Big to Fail and Bailouts

anthony.randazzo@reason.org (Anthony Randazzo) — Mon, 17 Aug 2009 00:00:00 EDT

The role regulation played in the creation and evolution of the recession and financial crisis is a very hot topic. Undoubtedly, regulators helped create the mess, though how and to what degree remains undecided. But everyone agrees that some changes need to be made to the financial sector’s regulatory structure.

President Barack Obama unveiled his proposal to fix Wall Street regulation on June 17, 2009. If enacted, the plan—written with the help of Federal Reserve Chairman Ben Bernanke and Treasury Secretary Tim Geithner—would be the biggest expansion of federal regulation of the financial sector since the Great Depression. The proposal dramatically increases the authority and scope of the Federal Reserve, while also creating a system that codifies the concept of “too big to fail.” That part of the plan would ensure plenty of future bailouts. Still, President Obama’s plan does go a long way toward consolidating complicated layers of oversight in the banking and insurance industries.

Congressional Republicans offered a counter plan on July 23, 2009. Their alternate proposal includes several similar provisions, including establishing a board to oversee systemic risk, reducing Federal Reserve independence, and consolidating banking regulation. The GOP’s plan overreaches in bank regulation reform, takes a weak position against government-sponsored entities, ignores federal insurance reform completely, and unfortunately expands the role of the Securities and Exchange Commission (SEC). However, the Republicans focused chiefly on ending the policy of “too big to fail” and, despite supporting bailouts under President George W. Bush, are now opposed to future bailouts.

Unfortunately, neither plan is perfect. We know Congress is going to pass a bill overhauling financial services regulation. Given that some reform is going to happen, and is probably necessary, there are aspects of each plan that can be mixed and matched to prevent the government from expanding its reach into every corner of the financial market and instead simplify regulations to ensure taxpayer money does not wind up supporting failing financial institutions in the future. To that end, we have provided a condensed comparison of the two plans, what they propose, and what should be done.

The Future of the Financial System, Part II

anthony.randazzo@reason.org (Anthony Randazzo) — Thu, 16 Jul 2009 00:00:00 EDT

In Part I of this interview we talked about causes of the financial crisis, monetary policy, risk management on Wall Street, the value of the FDIC, consumer confidence, and the importance of a strong dollar. Part II continues here.

Randazzo: Shifting gears a little bit, how do you think the end of the Bush tax cuts will affect Wall Street or businesses around America?

Olson: Yeah, why is it that tax reduction bills are always called Job Creation Acts, or Economic Stimulus Acts? But if you increase marginal tax rates, it’s never called the Job Destruction Act of 2009? Raising the capital gains rate is going to be bearish for stocks. This isn’t rocket science! It’s bearish for equities, thereby encouraging more leverage in the economy, and raising marginal income tax rates increases the incentive for people to invest in facilities that employ labor in other places, like Brazil, Russia, India, and China.

Randazzo: Do you have a sense for how much of economic recovery depends on the recovery of the housing market?

Olson: You spoke about confidence a minute ago. What the housing market needs most is for people to have confidence in the pricing. There is a natural course of adjustment that goes on in the wake of a bubble. People realize that the asset prices are too high and there’s a price discovery process where people are trying to find the right price for these assets. Once people restore confidence in the prices of houses and office buildings and shopping centers and so on, then that’s a key step along the road to recovery. The government, when they talk about recovery in the real estate market, they always mean keeping prices higher than they should be.

Randazzo: You’re talking about the government tendency to push more people into home ownership than we can sustain? The rate of home ownership growing from 62 percent to 70 percent of Americans during the course of the bubble?

Olson: Well, people buying homes when they should be renting apartments. The government push is an example of the fatal conceit. Folks in Washington think they know what the optimal percentage of home ownership is in the economy at any given time. I don’t know for any individual whether he should buy or rent. I, myself, am on both sides of that fence. Sometimes I buy, sometimes I rent. How do I know what the whole economy should do?

Randazzo: What kind of problems, moral hazard or otherwise, does the quasi-nationalization of General Motors create?

Olson: There’s a bunch of problems with it. Moral hazard is just one of them. The assets that are owned by General Motors, if the natural course of events had gone forward in accordance with the way the law used to be, would have gone into reorganization under Chapter 11 in the federal courts without government money or interference. And these assets would have been sold and redeployed, put in the hands of somebody that could have used them more productively. A bunch of the folks that are on the payroll at GM would have been taken off the payroll at General Motors and redeployed to more productive use. There would be a labor pool available for other employers at reduced labor costs. We’re obviously not trying to let prices find their proper level, we’re trying to continue to inflate the price of labor and the price of physical assets. You’ve got to find the right use for that labor and the right use for those capital goods. The bailout of General Motors is doing exactly the opposite.

Randazzo: What about problems with the way the Obama administration restructured ownership with the unions and creditors?

Olson: I spoke about confidence in the rule of law. There’s no law more important to creditors than bankruptcy. To the extent that you impair the operation of bankruptcy law, you introduce massive uncertainty. I used to structure bonds, and there are lots of assurances given by borrowers to lenders in bonds. Now what assurances do I put in my next bond issue that’s going to make it attractive for people to buy?

Randazzo: Because people just aren’t going to trust that the government’s going to honor them?

Olson: Well, it used to mean something when you created secured notes. It meant something to be a secured creditor. It still means something, but it’s a lot less clear what it means. Your rights might be enforced, and they might not.

Randazzo: You’re the chairman of FEE and are focused on economic education. If we had better education for how economies functioned, would that have mitigated some of the problems we’ve seen with the government’s response to the crisis? Would this have prevented some of the disrespect for rule of law?

Olson: I do think that economic education would improve matters, but I don’t think that it’s necessary to win over the vast majority of people. There is such a thing as an intellectual elite, people who are involved in the knowledge professions, and it is of particular importance that people who manage words and ideas for a living should be well educated on such questions as, where do jobs come from? There are people in the knowledge professions who pretend to have a well-informed opinion about managing the economy and creating jobs who have no idea where jobs come from, and that makes just as much sense as managing the population without knowing where babies come from. Yes, I think people should know where babies come from, and I think people should know where jobs come from.

Randazzo: Do you think that FEE, along with think tanks and education groups similar to your own, has failed in the past few decades in bringing economic education to America?

Olson: The intellectual environment in which we find ourselves is a lot better than it was when FEE was founded in 1946. In 1946, there was a sense that we were this tiny band, like monks on the west coast of Ireland preserving Christianity in the Dark Ages. We were writing our manuscripts, keeping the sacred texts in print and talking about ourselves as the remnant. Now you have free market think tanks in just about every state in the union. The State Policy Network didn’t exist twenty years ago. Now it does, its members are very active, they’re everywhere, and they do great stuff. To talk about a failure is really overstating the case. The fact that we haven’t changed the world doesn’t mean that we haven’t created a much better environment for the respectability of free market principles.

Randazzo: So with all the turmoil in the economy, but couched in a perspective that we are better off than sixty years ago, are you optimistic or pessimistic about the future of America and the future of the American economy?

Olson: I’m bearish on the relatively near term. I don’t know if I’m bearish on equities, but I do believe that there will be inflation commensurate with the seventies. Stagflation had the unemployment rate and inflation rate approaching double digits for a number of years. Bond yields went crazy. People made more money in commodities and real estate than they did in productive assets. Equities sort of drifted most years. They didn’t really keep up with inflation, but to the extent that equities are based in hard assets, the inflation we will have soon can inflate the price of equities to some extent as well. In terms of productivity of the economy and value of the dollar and leadership of the world and that sort of thing, I don’t think the prospect for the next few years is very good.

Randazzo: What about the long term?

Olson: If you think back to the seventies, we had Nixon, who ended the gold standard. We had Ford, from whom we got “Whip Inflation Now” buttons, you know, we would all “whip inflation” by wearing WIN buttons. We had Jimmy Carter in his cardigan sweaters who was the audacity of hope type, the inspirational sort that Obama is. I was in business school at the time, and I thought there was no hope. It wasn’t just that the government was evil and overreaching, but it was incredibly stupid, and Washington was taking over everything. All of a sudden you got Reagan. Where did that come from? You had Maggie Thatcher. Where did that come from? And now, you know what gives me hope? We’ve got Angela Merkel and Nicolas Sarkozy giving lectures to America on fiscal responsibility and monetary discipline. That gives me hope. There’s such a thing as competition in the world. If I may use the metaphor of a parasite, I recently had the job of cutting back a bunch of wisteria from overrunning the trees in my garden, and I observed that there’s a limit to how much wisteria can take over a garden, because sooner or later it kills the host. Competition ensures that there’s a limit to the extent of which government can impose its will on the economy, because capital just goes someplace else, and freedom arises someplace else.

Randazzo: Well, thank you very much for this conversation. I have found it educational and interesting. I believe our readers will as well.

The Future of the Financial System

anthony.randazzo@reason.org (Anthony Randazzo) — Tue, 14 Jul 2009 00:00:00 EDT

In June, I sat down with Wayne Olson, chairman of the board of Foundation for Economic Education (FEE), one of the oldest free-market organizations in the United States to talk about the future of the financial system. Mr. Olson spent most of his career as a banker focused on fixed-income products with the international financial services institution Credit Suisse. Drawing from his extensive experience, we discussed the financial crisis, Wall Street’s culture of risk taking, financial services regulation, the housing market, and inflation concerns.

Anthony Randazzo, Reason Foundation: Thank you for taking the time to speak to me today, Mr. Olson. With my first question, I’d like to get perspective on where you’re coming from. Our leaders’ decisions are profoundly influenced by their perspective of what caused the housing bubble and who is responsible for the financial crisis. What is the framework that you use to approach events in our tumultuous economy?

Wayne Olson: The folks in Washington have defined the causes of the crisis to exclude themselves. But they are the prime motivators for what happened and what’s going on. In terms of framework, I’ve never seen a plainer example of the textbook Austrian business cycle theory than what we’ve just gone through. Monetary excess causes distortion in investment decisions, and it causes over-investment in long-lived capital goods, as well as excessive consumption because of artificially low interest rates and high liquidity. As a result, the asset prices become grossly inflated and unsustainable.

Randazzo: Do you have a sense of what would have happened if the Federal Reserve had tightened the money supply in 2004 or 2005? Do you consider the arguments that tightening monetary policy would have had some negative impacts in the American economy plausible?

Olson: You mean defending the dollar would be a bad thing?

Randazzo: So you don’t think that that tighter monetary policy would have had a long-term negative impact on the country? What about trade?

Olson: Well, yes, on the margin, a valuable dollar makes it more difficult to export and any tightening after a period of ease is likely to produce a downturn, but probably nothing so severe as what we ended up with anyway. There are costs and benefits to everything, and a stable currency is generally a good thing. That is the upside of more prudent monetary policy. The downside of easy money is what we face now with the credit markets, the economy and the dollar all being more vulnerable than they should have been.

Randazzo: In A Failure of Capitalism, Richard Posner writes that traders and investors on Wall Street acted rationally with high leverage, given the implicit government guarantees on risk. Would you agree?

Olson: You know, there’s this thing called agency theory. Problems will always arise in any business organization when the people who run it are different from the people who own it. It’s no different in a large financial institution from anyplace else. Over the past twenty years or so, there’s been massive consolidation in the financial services industry, for a lot of good reasons. Optimal scale became much greater. A bunch of partnerships went public, and the classic example of a place where you have agency inefficiencies is a publicly traded corporation. So it is not news that the employees will tend to run an organization for their benefit, and not necessarily for the benefit of shareholders.

Randazzo: So, would it be helpful to design regulations that incentivize partnerships?

Olson: If you create a regulation that requires a particular form of business organization, you address one problem and you create a myriad of others. The problem with using incentives to encourage partnerships is that you’re implicitly assuming that you know what the optimal capital structure is of that industry. And if you create an implicit government guarantee, you’re going to create increased risk-taking behavior.

Randazzo: Given your time on Wall Street, do you feel that there’s a culture of excessive risk taking on Wall Street that regulation can’t fix, or is there a way to align investor interests with systemic risk concerns?

Olson: Well, when you talk about behaving responsibly, you have to understand the consequences of responsible and prudent behavior. The responsibility of a market maker is to be correctly positioned for the market as he finds it. In 2006, the prices of credit were razor thin, very low rates for borrowers, high prices for investors. If you took a contrarian view of subprime mortgage-backed securities and said, “these prices for risky assets are too high to be sustainable, I’m not going to buy any more of these subprime loans and distribute them to my customers,” then you’d be shutting down an operation that was generating several hundred million dollars a year in revenue. Making this courageous decision would mean firing fifty or a hundred people. Other firms would hire all your people and laugh at you because they’re making all this money while you watch. It takes a significant amount of courage in your convictions to take that view against what the current market is telling you.

Randazzo: So the nature of Wall Street’s drive for gain drove many people to invest in unwise ways?

Olson: To be fooled by distorted market signals, yes, but I will add that regulatory policies have significantly exacerbated that agency problem and the willingness of institutions to take on risk. When you create this concept that certain things are too big to fail, you increase the optionality of working at a place like that, meaning that upside potential exceeds downside risk.

Randazzo: Do you think it is fair to say that regulators can’t keep up with financial product innovation?

Olson: Senator Chuck Schumer from New York once said that if somebody had been properly positioned as a regulator of Bear Stearns, then they would have had all the facts, and they would have been able to see ahead of time, to say ‘look, you’re taking too much risk here, you’ve got to scale back’, and would’ve had the authority to make that happen. But let’s look at the implications that are involved there.

There’s too much information! This is the classic fallacy of central control. The fact of the matter is that the people at Bear Stearns had all of the information, and they couldn’t figure it out, right? It’s a hellish task to absorb it all and figure out all that information and you’re never sure you’ve got it right. So in Senator Schumer’s scenario you’ve got an omniscient person that’s smarter, with a greater ability to absorb information and analyze it than the folks at Bear Stearns. And you have a wise person, a person of discernment, who would’ve known that the risk was too high. But the guys who do that for the regulatory agencies are no different from the guys working in the credit department at Bear Stearns. The guys who work at the FDIC are the same guys. They went to Wharton, they studied finance, they built models, they worked in banks, they are the same guys. How are these people going to be omniscient? They’re going to absorb the information and analyze it better and make wiser decisions? Because they’re motivated to carry out the public trust? That wouldn’t make them any smarter, and besides, they’re motivated to keep their careers going.

Randazzo: Would the creation of an FDIC insurance and receivership authority for non-bank financial institutions exacerbate a too interconnected to fail system, or is it an appropriate part of regulatory structure?

Olson: The first part of that question is whether it is appropriate to put some kind of government insurance on the obligations of non-banks. And I think it’s a dumb idea. It creates all the distorted incentives that the FDIC’s guarantee on deposits creates. In terms of receivership, my view of the FDIC is actually very positive. I’ve dealt with them in a number of situations when I did work with resolution agencies in the government. Ours is a profit and loss system, and loss is supposed to imply failure. The government, in creating the rule of law, creates ways that we deal with failed institutions, and in my view, the FDIC in general is a very efficient and effective tool for dealing with failed banks. However, non-bank financial institutions are already covered by federal bankruptcy law, which is also pretty good and does a better job of balancing the rights of multiple classes of creditors. Chapter 11 is a very well developed and smart thing that should have been allowed to operate in the case of the auto companies and AIG. The problem is, it’s not being permitted to operate, because certain people’s interests are being protected. The problem is that the government in Washington doesn’t observe the rule of law.

Randazzo: The Obama administration’s regulatory proposal suggests that it is important to fix the financial services sector’s regulation quickly so that the American people will have confidence in the financial structure. Do you believe that consumer confidence is an important aspect of recovery?

Olson: There are several elements of confidence. The most important element of confidence in recovery is the confidence of entrepreneurs and providers of capital. Confidence can’t be manufactured. The confidence born of rational, prudent decision-making is the kind of confidence we need. The notion that reshuffling the regulatory framework is going to restore confidence in the financial services sector and is going to make me buy stock in Citigroup is ludicrous. The regulatory framework around financial institutions has grown up over almost one hundred years. There were a lot of smart people that put in years and years of thought and analysis into a certain design. The notion that re-jiggering the thing in the space of three months is going to restore confidence is insane. What it will do, what the behavior of these regulators has done, is impair confidence in the rule of law. And how about confidence in the dollar? That would be a good thing. I don’t hear anybody talking about that.

Randazzo: Let’s talk about that, confidence in the dollar. There is a lot of debate within the Federal Reserve about how to handle inflation concerns. What do you think the Fed’s best reaction is in this case?

Olson: There’s not a whole lot the Fed can credibly do or say, because I don’t see how the deficit is going to get funded other than by monetizing it. They’re saying the right things now about not monetizing the deficit. Yet, the quantity of new debt that needs to be issued by the treasury to finance its operations over the next few years is astronomical. And who’s going to buy all of these treasury bonds? To the extent that foreign nations don’t, the bonds are going to absorb more of the savings in the United States, and interest rates will naturally rise, because corporations will have to compete with the government for credit. Or the Fed’s going to step in and monetize the deficit, and you’re going to have a massive increase in money supply.

Click here for Part II of the interview with Wayne Olson, where we discuss taxes, the housing market, moral hazard, the importance of contracts, economic education, and what the prospects are for recovery.

Unemployment Statistics are Signaling Economic Recovery

anthony.randazzo@reason.org (Anthony Randazzo) — Thu, 09 Jul 2009 17:00:00 EDT

Believe it or not, the fact that the country’s unemployment rate hit 9.5 percent in June might be a sign that economic recovery is on the way. This is surely hard to see for the millions of Americans looking for work. But despite claims that the economy is in worse shape than expected, a look at labor statistics shows there are several indicators that the recession may be ending.

It is certainly true that political promises of stimulating the economy and creating or saving millions of jobs haven’t been kept. Flames of discontent with the slow-moving stimulus have provoked a range of responses. Vice President Joe Biden has asked the nation to be patient and wait for the stimulus to work. The New York Times economist Paul Krugman is demanding a second stimulus. But all of these solutions are predicated on the belief that the economy is continuing to slide into dismal decay.

There is no doubt that the nation is still reeling from the shocks of the deepest recession since the Great Depression. Since the recession began in December 2007, 7.2 million jobs have been lost. And trillions in spending hasn’t done much to help thus far. A majority of the so-called stimulus spending has just been used to fill holes in state budgets and postpone the day when state legislatures have to make meaningful cuts to their bloated spending. It hasn’t put people to work.

The lack of transparency makes it hard to nail down exactly how much stimulus money has been spent so far. The Wall Street Journal suggests that about $78 billion of the $787 billion package is out the door. The privately tabulated Recovery.org estimates that $65.22 billion has been distributed to projects in all 50 states. The government website established to answer this very question only reports $56.3 billion paid out.

No matter what the actual number is, it is generally agreed the spending has been slow. This has been blamed for the sharp rise in overall unemployment since the Recovery Act passed. In February 2009, 12.5 million people were without jobs, with an overall 8.1 percent unemployment rate. Despite the promise that 3.5 million jobs would be created or saved in the course of two years, the increase to 9.5 percent unemployment has left an additional 2.2 million Americans jobless.

If the measure of success for the stimulus is jobs—as all the Obama administration’s rhetoric would lead you to believe—then the 14.7 million people without jobs in June would mark it as a failure thus far. Hence the calls by Krugman and others for a second stimulus package.

Japan faced this same choice in the 1990s when faced with its Lost Decade recession. When the first 10.7 trillion yen stimulus package didn’t save the economy in 1992, they tried two more stimulus packages in 1993 that together spent 19.2 trillion yen. Over the course of the Lost Decade, the Japanese government would try seven different stimulus packages, all failing to turn the economy around and instead doubling unemployment.

The reality is that the U.S. doesn’t need a second stimulus package. While Vice President Biden is right that people should be patient, he is wrong to assert that the economy is in terrible shape. The economy doesn’t need assistance from the government because it has started towards recovery on its own.

In a speech at the Commonwealth Club of California on June 30, Federal Reserve Bank of San Francisco President Janet Yellen announced that she expects the recession to end later in 2009. “Financial markets are in much better shape today than we ever would have dreamed six months ago,” she said “Investors have gone from disregarding risk, to being paralyzed by it, to once again being willing to take on a reasonable bit. The stock market has rallied and investor appetite for corporate bonds and other assets has rebounded, restoring access to capital for healthy companies.”

A few days later, Christopher Rupkey, chief financial economist for Bank of Tokyo-Mitsubishi UFJ, wrote that the suggestion that economy will soon rebound strongly is “maybe not as far-fetched as you think.” He pointed out that consumers and businesses have postponed purchases for six months, and that this savings is likely to have a very positive impact on the economy in the second half of 2009.

There are other positive signs in the economy that give this optimism credibility. While unemployment did increase to 9.5 percent in June, it was a markedly slowed rate of increase from the previous months, growing just a tenth of a point after increases of .4 to .6 percent in 10 of the past 12 months. The Dow Jones Industrial Average and S&P 500 Index have surged 23 percent and 26 percent respectively from their lows in March. And although it topped off in June, consumer confidence has been on the rise for the entire year.

A more significant indicator that the recession is ending can be found by locating the peak of weekly claims for unemployment benefits. Historically, the overall rate of unemployment is not a guaranteed indicator for when a recession is ending or progressing. The dot-com bubble recession ended in November 2001, even though the overall unemployment rate continued rising into 2003. However, the weekly average of individuals filing as unemployed began to dip in October 2001, before the recession ended.

Northwestern University Economics Professor Robert J. Gordon, a member of the National Bureau of Economic Research—the group that determines when a recession begins and ends—found that as far back at the 1960s, the four-week average of new applications for unemployment benefits reached its highest point about a month before the recession technically ended. If the same holds true for the current economy, then recovery may well have started months ago. According to the Bureau of Labor Statistics, the weekly total of new applications for unemployment benefits has been declining steadily since the end of March.

While 647,000 jobs were lost in March, only 467,000 were lost in June. The overall unemployment rate rising to 9.5 percent in June is due to an increase in the number of long-term unemployed workers. The average number of weeks a worker will be unemployed has risen from 20 to 25 during 2009. And while the total number of weeks a worker is unemployed has increased, the total number of claims is decreasing (see chart below). This shows that the workforce is stabilizing, and that the recession is bottoming out. Employers are beginning to maintain a steady number of workers, which sends signals to the market that we are moving towards recovery.

Source: Bureau of Labor Statistics

The reason for the economic recovery is clearly not the slow-moving stimulus, but probably is a combination of low interest rates expanding the money supply, bank bailouts increasing lending liquidity, and time. Still, it won’t be clear for months whether recovery has technically begun. The National Bureau of Economic Research didn’t officially determine the start of this recession until December 2008, a full year after its actual beginning. Given the depth of this recession, the recovery process is also likely to take some time.

But there are definitely positive signs that the economy is headed towards, or is already in a recovery. The government should sit back and let it recover. The last thing the market needs is another stimulus bill that increases financial concerns about the massive national debt and deficit and feeds pork to special interest groups. The best thing the federal government can do is keep the national wallet closed and allow the recovery process to progress.

Anthony Randazzo is a policy analyst at Reason Foundation. He recently authored the Taxpayer's Guide to the Stimulus and a policy brief on Japan's "Lost Decade."

Taxpayer's Guide to the Stimulus: Financial Crisis Spending Chart

anthony.randazzo@reason.org (Anthony Randazzo) — Sat, 27 Jun 2009 00:00:00 EDT

Back to Taxpayer's Guide > EBS Spending Definitions

>> Financial Crisis Spending, Commitments, and Loans

In February 2008, Congress and the Bush administration passed a stimulus and tax rebate bill to fight the developing recession. Since then, the federal government has put American taxpayers on the hook for nearly $12.9 trillion in spending, loans, and insurance for deposits and investments.

Here is the money spent on specifically fighting the recession:

(In Billions)	Spending by Agency
$168	Economic Stimulus Act of 2008	Treasury
$200	Term Securities Lending Facility (TSLF)	Fed
$30	Bear Stearns	Fed
$11	IndyMac Bank	FDIC
$25	Housing and Economic Recovery Act of 2008	Treasury
$300	American Housing Rescue and Foreclosure Prevention Act	Treasury
$200	Fannie Mae and Freddie Mac Bailout I	Treasury
$150	American Insurance Group	Fed
$427	to improve global liquidity conditions	Fed
$152	Asset-Backed Commercial Paper	Fed
$9	Morgan Stanley	Fed
$700	Troubled Asset Relief Program (TARP)	Treasury
$900	Term Auction Facility Lending (TAF)	Fed
$540	Money Market Investor Funding Facility (MMIFF)	Fed
$1,700	Commercial Paper Funding Facility (CPFF)	Fed
$2,000	Temporary Liquidity Guarantee Program (TLGP)	FDIC
$9	Unemployment Compensation Extension Act of 2008	Treasury
$220	Citigroup Bank	Fed
$71	Citigroup Bank	Treasury
$10	Citigroup Bank	FDIC
$1,450	Mortgage-Backed Securities Purchase Program	Fed
$900	Term Asset-Backed Loan Facility program (TALF)	Fed
$4	Worker, Retiree, and Employer Recovery Act of 2008	Treasury
$87	Bank of America	Fed
$28	Bank of America	Treasury
$3	Bank of America	FDIC
$81	NCUA Capital Stabilization Program	FDIC
$787	American Recovery and Reinvestment Act	Treasury
$200	Fannie Mae and Freddie Mac Bailout II	Treasury
$25	Making Home Affordable Program	FDIC
$300	to purchase “longer term” Treasury securities	Fed
$450	Public-Private Partnership	Fed
$450	Public-Private Partnership	FDIC
$300	to improve global liquidity conditions	Fed

Total: $12,886,700,000,000

(In Billions)	Spending by Type
$168	Economic Stimulus Act of 2008	Tax credits
$200	Term Securities Lending Facility (TSLF)	Loans
$30	Bear Stearns	Loans
$11	IndyMac Bank	Guarantees
$25	Housing and Economic Recovery Act of 2008	Spending
$300	American Housing Rescue and Foreclosure Prevention Act	Guarantees
$200	Fannie Mae and Freddie Mac Bailout I	Spending
$113	American Insurance Group (debt and equity purchases)	Spending
$38	American Insurance Group (loan)	Loans
$427	to improve global liquidity conditions	Loans
$152	Asset-Backed Commercial Paper	Loans
$9	Morgan Stanley	Guarantees
$500	Troubled Asset Relief Program (TARP)	Loans
$200	Troubled Asset Relief Program (TARP)	Guarantees
$900	Term Auction Facility Lending (TAF)	Loans
$540	Money Market Investor Funding Facility (MMIFF)	Guarantees
$1,700	Commercial Paper Funding Facility (CPFF)	Spending
$2,000	Temporary Liquidity Guarantee Program (TLGP)	Guarantees
$9	Unemployment Compensation Extension Act of 2008	Spending
$301	Citigroup Bank	Guarantees
$1,450	Mortgage-Backed Securities Purchase Program	Spending
$900	Term Asset-Backed Loan Facility program (TALF)	Guarantees
$4	Worker, Retiree, and Employer Recovery Act of 2008	Spending
$118	Bank of America	Guarantees
$80	NCUA Capital Stabilization Program	Guarantees
$1	NCUA Capital Stabilization Program	Spending
$486	American Recovery and Reinvestment Act	Spending
$301	American Recovery and Reinvestment Act	Tax credits
$200	Fannie Mae and Freddie Mac Bailout II	Spending
$25	Making Home Affordable Program	Spending
$300	to purchase “longer term” Treasury securities	Spending
$900	Public-Private Investment Program	Loans
$300	to improve global liquidity conditions	Loans

Total: $12,886,700,000,000

* Note that in some of these expenditures, the taxpayer money going out is a loan that is projected to be repaid with interest. However, taxpayers are on the hook for this money regardless of whether or not the firms are actually able to pay it back.

** This page has intentionally left out spending directly related to the federal budget and focuses on the extraordinary activities by Treasury, Congress, FDIC and Federal Reserve.

(Updated: July 1, 2009 -- We will update this chart each month)

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Taxpayer's Guide to the Stimulus: Financial Crisis Spending

anthony.randazzo@reason.org (Anthony Randazzo) — Sat, 27 Jun 2009 00:00:00 EDT

Back to Taxpayer's Guide > EBS Spending Chart

>> Financial Crisis Spending, Commitments, and Loans

Here is the money spent on specifically fighting the recession:

$168 billion for Economic Stimulus Act of 2008 – Feb 13, 2008

In February 2008, Congress passed the first stimulus package as part of the effort to fight the recession. Of the $168 billion, $106 billion went to individual tax rebates and there were $51 billion in business tax cuts.

$200 billion for Term Securities Lending Facility (TSLF) – Mar 11, 2008

The TSLF is used by the Federal Reserve (Fed) to offer overnight loans to primary dealers, banks who can trade directly with the Fed, based on a competitive single-price auction. In March 2008, the program was expanded to offer $200 billion worth of 28-day loans to increase liquidity in the financial markets.

$29.5 billion bailout for Bear Stearns debt – Mar 14, 2008

The Federal Reserve gave a $29.5 billion loan to J.P. Morgan to encourage its purchase of Bear Stearns, and aid the process of liquidating Bear Stearns’ assets.

$10.7 billion for IndyMac Bank – July 11, 2008

The Federal Deposit Insurance Corporation (FDIC) seized IndyMac Federal Bank in July of 2008 after IndyMac’s collapse, which is one of the largest bank failures in U.S. history. OneWest Bank, based in Pasadena, California, purchased its assets for $13.9 billion in January 2009, leaving the FDIC (taxpayers) with a $10.7 billion loss.

$24.9 billion for Housing and Economic Recovery Act of 2008 – July 26, 2008

Congress gave grants for the redevelopment of abandoned and foreclosed homes in high-foreclosure neighborhoods, and a $7,500 tax credit for some first time homebuyers. The bill gave temporary authority to the Secretary of the Treasury to purchase any obligations and other securities in any amounts issued by Government Sponsored Enterprises (GSE) like Fannie Mae and Freddie Mac.

$300 billion for American Housing Rescue and Foreclosure Prevention Act – July 30, 2008

Congress gave the Federal Housing Administration power to insure up to $300 billion in new 30-year fixed-rate mortgages for homeowners that were facing foreclosure on their current loans.

$200 billion for Fannie Mae and Freddie Mac Bailout I – Sept 7, 2008

The Treasury Department, in joint power with the Federal Housing Finance Agency, took over Fannie Mae and Freddie Mac and committed $200 billion for buying stock in the two firms, thus recapitalizing them, and providing funds to pay down debt, and cover their toxic legacy assets and loans.

$150.3 billion for American Insurance Group – Sept 16, 2008

The Federal Reserve gave an initial $85 billion to AIG in exchange for a 79.9 percent equity stake in the company. The price was later reduced to $60 billion but the Treasury Department remains in control of the insurance company. In October they supplemented this with a $37.8 billion loan. In November the Fed purchased $22.5 billion of AIG’s mortgage-backed securities and $30 billion of AIG’s collateralized debt obligations. The bank has separately received $70 billion from TARP as loans in exchange for equity stakes, $40 billion from the Bush administration and $30 billion in March 2009 from the Obama administration.

$427 billion to improve global liquidity conditions – Sept 18, 2008

In a coordinated effort with major international central banks in Europe, Asia, and North America, the Fed expanded its currency swap arrangements in order to improve liquidity conditions in global financial markets. Swap lines are currency exchanges where central banks loan local currency to each other for a specific period of time. This program sent U.S. dollars to foreign banks for them to lend.

$152.1 billion for Asset-Backed Commercial Paper – Sept 19, 2008

This ABCP program specifically is designed to finance the purchase of commercial paper from money market mutual funds to increase liquidity in the market. The program will run until October 30, 2009.

$9 billion to insure Morgan Stanley debt – Sept 29, 2008

In September 2008, Japan’s Mitsubishi UFJ Financial Group bought 21 percent of Morgan Stanley for $9 billion. The Federal Reserve agreed to put taxpayers on the hook for the full $9 billion by insuring the investment.

$700 billion for Troubled Asset Relief Program (TARP) – Oct 3, 2008

The Emergency Economic Stabilization Act, which created TARP, has been used to recapitalize banks by buying equity and assets ($383 billion), to provide loans and capital to General Motors and Chrysler ($25 billion), to partially fund TALF ($100 billion), to fund the Making Home Affordable Program ($50 billion) and Small Business Administration loans ($15 billion), and to establish the Public-Private Investment Program (PPIP) ($100 billion). See note below about the PPIP’s additional costs.

$900 billion for Term Auction Facility Lending (TAF) – Oct 6, 2008

The Federal Reserve auctioned an increased amount of term funds to deposit bearing banks, given proper collateralization, in order to increase immediate liquidity in the market.

$540 billion for Money Market Investor Funding Facility (MMIFF) – Oct 21, 2008

The Federal Reserve guaranteed money market mutual funds, reinvestment funds, portfolios, and similar accounts to increase investor confidence.

$1.7 trillion for Commercial Paper Funding Facility (CPFF) – Oct 27, 2008

The CPFF provides a liquidity backstop to issuers of commercial paper (money-market securities sold by large banks to get money to pay short term debt obligations) and improved liquidity in short-term funding markets by financing the purchase of unsecured and asset-backed commercial paper. It is intended to enhance investor confidence and increase the availability of credit for businesses and households. This program is different from the ABCP liquidity program in that it allows the Fed to directly purchase commercial paper, not just finance. The max amount CPFF can purchase is equal to the size of the commercial paper market, estimated now to be $1.7 trillion, though as of March 2009, only $246 billion of taxpayer money has been spent.

$2 trillion for Temporary Liquidity Guarantee Program (TLGP) – Nov 21, 2008

This program will insure $1.5 trillion of all new unsecured loans (senior subordinated bank debt) that are issued before October 31, 2009. The limit of debt the FDIC will cover is up to 125 percent of all the unsecured debt that existed as of September 30, 2008, estimated to be $1.5 trillion. TLGP will also insure $500 billion for non-interest-bearing deposit accounts until Dec. 31, 2009.

$9 billion for Unemployment Compensation Extension Act of 2008 – Nov 21, 2008

This act provides additional unemployment compensation through August 27, 2009. It funds seven more weeks of unemployment insurance benefits for those still unemployed, and an additional 13 weeks for those in states with unemployment rates above six percent—such as Michigan and California.

$301 billion for Citigroup Bank – Nov 23, 2008

This money insures against losses on loans and securities backed by toxic assets and mortgages. Citi has received a separate $50 billion from TARP as loans in exchange for equity stakes.

$1.45 trillion for Mortgage-Backed Securities Purchase Program – Nov 25, 2008

This Federal Reserve program purchases the direct obligations and mortgage-backed securities (MBSes) of Fannie Mae, Freddie Mac, and other GSEs. Up to $1.25 trillion of MBSes will be sold to asset managers selected via a competitive process. Up to $200 billion in GSE direct obligations will be bought through the Fed’s primary dealers in a series of competitive auctions. The original funding for this program was $600 billion, but in March 2009 the amount increased more than double.

$900 billion for Term Asset-Backed Loan Facility program (TALF) – Nov 25, 2008

This Federal Reserve program has an additional $100 billion in funding from TARP, bringing the total to $1 trillion. TALF is supposed to help market participants meet the credit needs of households and small businesses by supporting new asset-backed securities that are collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. In March 2009, the TALF program was expanded to include loan support for investors to buy frozen “Legacy Assets” which are older and not as highly rated. This updated TALF program will operate in conjunction with the Treasury’s public-private investment funds.

$4 billion for Worker, Retiree, and Employer Recovery Act of 2008 – Dec 23, 2008

This act waives, for one year, the rules that require seniors to make annual withdrawals from their retirement plans and accounts. It also reduces the funding requirements for tax-qualified, defined-benefit pension plans. The cost is based on Congressional Budget Office estimates of decreased revenues due to this pension relief program.

$118 billion for Bank of America – Jan 16, 2009

This money insures losses on loans and securities backed by toxic assets and mortgages. The bank has received a separate $45 billion from TARP as loans in exchange for equity stakes.

$81 billion for NCUA Capital Stabilization Program – Jan 28, 2009

The National Credit Union Administration (NCUA) committed $80 billion to guarantee all uninsured deposits at credit unions until Dec. 31, 2010. NCUA also injected $1 billion of capital into U.S. Central Federal Credit Union of Lenexa, Kansas.

$787.2 billion for American Recovery and Reinvestment Act – Feb 17, 2009

Known prominently as the “stimulus bill” this act is supposed to preserve and create jobs; invest in technological advances in science and health; to invest in transportation, environmental protection, and infrastructure that will provide long-term economic benefits; and stabilize state and local government budgets.

$200 billion for Fannie Mae and Freddie Mac Bailout II – Feb 18, 2009

The Obama administration increased the Treasury Department commitment to Fannie Mae and Freddie Mac an additional $200 billion to $400 billion total.

$25 billion for Making Home Affordable Program – Mar 4, 2009

This program, funded in part by the FDIC and FHA, will offer financing assistance to up to 9 million homeowners to help them pay their mortgage and avoid bankruptcy. The program includes the Home Affordable Modification Program and has $50 billion of additional funding from TARP.

$300 billion to purchase “longer term” Treasury securities – Mar 18, 2009

To help improve conditions in private credit markets, the Federal Open Market Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

$900 billion for Public-Private Investment Program – Mar 23, 2009

The jointly managed Public-Private Investment Program from the Fed, Treasury, and FDIC will match taxpayer money with privately invested funds to purchase Legacy Assets from bank balance sheets in an auction process. Treasury will provide $100 billion from the original TARP bill to provide partial equity. But the Fed and FDIC will also provide financing with non-appropriated funds. This means there is no price ceiling on the PPIP, and the total could reach up to $1 trillion depending on how much financing is required to buy Legacy Assets.

$300 billion to improve global liquidity conditions – Apr 6, 2009

In a coordinated effort with major international central banks in Europe, Asia, and North America, the Fed created new temporary lines of credit in pounds, euros, yen and francs in order to improve liquidity conditions in global financial markets. These foreign currency liquidity swap lines are loans to foreign banks authorized until October 30, 2009.

Total: $12,886,700,000,000

** This page has intentionally left out spending directly related to the federal budget and focuses on the extraordinary activities by Treasury, Congress, FDIC and Federal Reserve.

(Updated: July 1, 2009 -- We will update this chart each month)

Back to Taxpayer's Guide > EBS Spending Chart

Regulation Proposals Could Lead to JP Morgan Mae and Citi Mac

anthony.randazzo@reason.org (Anthony Randazzo) — Thu, 25 Jun 2009 15:00:00 EDT

If there is anything crystal clear about the evolution of the financial crisis, it’s that Fannie Mae and Freddie Mac were problems. These government sponsored enterprises (GSEs) significantly contributed to the housing bubble by taking excessive subprime risk, knowing they had a taxpayer funded safety net backing their $1 trillion exposure. Exacerbating the excessive risk taking behavior was the Congressional protection Fannie and Freddie enjoyed—particularly from Rep. Barney Frank and Sen. Chris Dodd, who stopped GSE reform in 2003.

Logic would suggest that Washington should avoid creating more Fannies and Freddies. But President Obama’s proposed financial sector regulatory overhaul will ironically wind up turning the largest private financial companies into GSE-like entities, with an institutionalized bailout system.

The central plank of the White House regulatory proposal is a “council” of top regulators tasked with detecting systemic risks and using the power of the Federal Reserve (Fed) to prevent another crash. Such a council, made up of the Fed, SEC, FDIC, and others, would have significant sway on financial markets, even without authority to take any action. If the council announced that there was a particular systemic risk, Wall Street would react swiftly, likely with massive selloffs of a company in the council crosshairs. This kind of soft power would give the council immense behind the scenes influence.

In addition to this council, the proposal suggests categories for firms based on their size and interconnectedness with the rest of the financial sector. Financial institutions deemed too big and interconnected to fail, “Tier 1 firms” as the proposal calls them, would be given the highest capital reserve requirements and be subject to increased oversight. The augmented cash on hand requirements might do some firms good, but the increased reserves will only do so much in the event of another crisis. Several of the bailed out financial institutions wouldn’t have survived even with higher ratios because they simply had too much toxic debt and became insolvent (most notably AIG).

Furthermore, the President’s proposal suggests the development of a special “resolution” authority that would have the power to seize and take apart non-bank financial institutions—including investment banks and insurance groups like AIG—if those firms posed a systemic risk. Working closely with the systemic risk council, this resolution authority would act like the FDIC does for banks. Bankruptcy laws have been well developed over the past several decades, and they play a helpful role in winding down insolvent banks. It would not be inappropriate in theory to establish a legal structure for large, non-bank bankruptcies. But the resolution authority faces the practical problems of how the insurance fund will be financed and what it means in context of the other proposals.

When these three aspects of regulatory overhaul come together—a council, Tier 1 designation, and bankruptcy insurance fund—the result is actually a formalized too big to fail structure that encourages financial institutions to take on more risk knowing they have taxpayer protection.

Tier 1 regulatory status tacitly means a financial institution that is deemed too interconnected with the financial system to fail. By bracketing off a certain segment of the market, regulators can hold bigger institutions to higher standards, but in doing so they create an elite class that will take advantage of its new status. Coupled with a safety net, the Tier 1 investment banks and financial product specialists will know that any major losses would be absorbed by the—likely taxpayer funded—resolution authority. This means the special class of firms could operate with an implicit bailout guarantee.

Some may argue that this is inevitable, that we can’t let interconnected companies fail, and that this is a necessary part of regulation. But the whole notion of special privileges created by regulation strikes at the core of what regulation is supposed to do. The goal of regulation is to provide a framework for fair competition. Firms cannot compete on even ground if the regulatory framework gives some institutions an advantage over others.

The White House proposal singles out a class of the financial sector and provides it with taxpayer sponsorship. With taxes funding at least part, if not all, of the insurance for big financial firms facing a collapse, the government will have leverage to make demands on the Tier 1 firms, much like what happened with Congressional mandates to Fannie and Freddie. Sure, the regulatory plan doesn’t call for the nationalization of these banks, but with this new oversight authority in Washington, political interference in operations on some level is bound to raise its ugly head.

The Treasury’s forced sale of Merrill Lynch to Bank of America is a prime example of how Uncle Sam might ask for a favor or two in exchange for this new government sponsorship. Bank of America wanted to back out of its proposed purchase once the weight of subprime mortgages became more difficult to bear, but former Treasury Secretary Henry Paulson thought it would be bad for the market to have the Merrill sale fall through. Given the vice grip bailouts gave to Paulson, Bank of America had little choice but to go through with the sale when asked to—and to be quiet about the extortion as it happened.

Furthermore, giving the government the power to declare that a firm is a systematic risk opens up a wide door for financial institutions to lobby and trade favors to ensure that their firm will be left alone by the regulators—or in academic terms, regulatory capture.

Similar scenarios are virtually guaranteed with Washington essentially turning the top tier of financial institutions into GSEs. Especially considering that, even after all the problems of Congressional demands on Fannie and Freddie were revealed last September, Rep. Frank has gone back to the GSEs to demand they lower lending standards for condo buyers. While lower standards are political gold and may move more people into housing, they were a central part of the growth of the housing bubble, a prime mover towards issuing more subprime loans. The politics of Washington simply don’t mix with the proper business decisions that need to be made on a day-to-day basis.

As Congress weighs the regulatory proposals from the White House and others, careful attention must be paid to the unintended consequences of otherwise noble ideas. A good first step would be to ensure that any systemic risk oversight authority has no teeth or soft power. A second way to avoid the problem of regulation creating new GSEs all over the financial sector would be to make the resolution authority’s process painful enough, with enough disincentives for company executives that the safety net is avoided at all costs and only exists for the extreme scenario.

The days of gentle Fannie- and Freddie-like bailouts must be over. Ultimately, members of Congress must keep in mind that regulation, first and foremost, is supposed to provide a framework to foster competition. Companies and their operators must not be allowed to take risks with taxpayer money, and there must be some skin in the game for everyone.

The Myth of Financial Deregulation

anthony.randazzo@reason.org (Anthony Randazzo) — Mon, 22 Jun 2009 00:00:00 EDT

Reason.com

For the past nine months, Wall Street critics have painted a damning picture of the housing bubble as the product of deregulation and reduced governmental oversight. To read the Obama administration's new financial sector regulation overhaul proposal, the government didn't have anything to do with the current crisis. According to this view, our economy wouldn't be facing a recession with almost 10 percent unemployment if the government had been more involved with the market. This picture is about as historically accurate as the famous portrait Washington Crossing the Delaware.

On Wednesday, President Obama laid out his vision for changing the way Wall Street does business. From creating a council to oversee systemic risk to expanding the powers of the Federal Reserve to requiring hedge fund and private equity pools to register with the SEC for the first time, the proposal is a massive regulatory expansion.

Along with the president's speech, the White House released an 89-page "white paper" with all the nitty gritty details that make government bureaucracy so much fun. For instance, here's a real sentence from the proposal:

Last year, the IASB and FASB reiterated their objective of achieving broad convergence of IFRS and U.S. GAAP by the end of 2010, which is a necessary precondition under the SEC's proposed roadmap to adopt IFRS.

Government clarity at its finest. (See here for a breakdown and explanation of the whole proposal.)

The core problem of the regulatory proposal is its view of the causes of the crisis. Everything is built on a belief that the market failed and that deregulation created a system of excessive risk and irresponsibility. Ironically, it was government action that created incentives for financial firms to be less risk adverse, not a lack of regulation. As Washington prepares to debate regulatory overhaul this summer, it is more important than ever to wrestle the myth of deregulation to the ground.

Given all the talk of deregulation, you would expect to find dozens of deregulating laws put in place over the past few years. Surprisingly, there have only been three major deregulatory actions in the past 30 years. Ultimately, the data points to bad regulation as complicit in the creation of the financial crisis, not deregulation.

The modern era's first major Wall Street deregulation was the Depository Institutions Deregulation and Monetary Control Act of 1980. This law repealed so-called "Regulation Q ceilings" that limited the amount of interest consumers could earn from savings and checking accounts. The law also expanded the types of financial institutions that could get overnight loans from Fed discount windows.

Since letting banks pay interest to their customers encourages saving, this aspect of deregulation certainly can't be blamed. And though it could be argued that more financial institutions borrowing money partially allowed for the housing bubble, that money was being borrowed from the government—hardly deregulation. And that doesn't even begin to address the fact that there have been multiple recessions and bubbles since this law was passed.

The second major deregulation was the Garn-St. Germain Depository Institutions Act of 1982. This authorized banks to compete with money market mutual funds. (Ironically, this bill was co-sponsored by then-Rep. Charles Schumer, a key lawmaker driving the current regulatory overhaul.) Garn-St. Germain has been linked to today's crisis because it loosened restrictions on issuing mortgages, allowing for the eventual development of subprime loans.

However, it wasn't Garn-St. Germain specifically that created a subprime mortgage riddled bubble—it was the surrounding body of poorly designed, bad regulations that created perverse incentives. Garn-St. Germain should have allowed banks more freedom to compete while also clarifying the role of the FDIC. But it failed, along with other regulations, to outline the role of the government in the case of financial institution failure. As a result, the implicit government guarantee for firms "too big to fail" skewed the risk assessment process that aids market efficiency. The promise of rescue was much more damaging than loosened lending standards.

It is worth noting that the impact of Garn-St. Germain has also been blamed for causing the Savings and Loan Crisis by allowing certain financial institutions, thrifts, to gamble with taxpayer insured investments. But in this case there was an implicit government rescue guarantee for massive failure that encouraged high-risk taking.

The third deregulation blamed for causing the financial crisis is the repeal of the famed Glass-Steagall Act in 1999. This law, passed in 1933, had kept deposit-bearing banks and investment banks from competing for over six decades. After this repeal, banks were able to maximize their resources and many grew large enough to be classified too big to fail. However, they really were too entwined to fail, and the problems came with fringe regulations related to the interconnectedness of financial institutions.

Had mark-to-market regulations been more flexible banks would have had more time to raise capital and sell assets. Had Wall Street firms not seen Washington as a lender of last resort that would bail out investments gone awry, they would have managed their risk better. Had capital reserve ratios been higher banks and investment institutions would have had more liquidity when prices dropped (though some firms, like AIG, simply became insolvent and wouldn't have been saved by higher reserves). Or, if qualified special purpose entities—an off-balance sheet accounting method—had required more transparency, banks would have had to keep more risky mortgages on their books, subject to reserve requirements.

Indeed, even if these three deregulations had no caveats explaining away their supposed link to the current financial crisis, they would still hardly constitute a historical trend. In contrast, historical periods of high regulation have proven decidedly unfavorable. Financial sector regulation during the 1970s was much heavier than today, and that did not prevent stagflation, with unemployment reaching nine percent in May 1975 and inflation nearly topping 14 percent.

Similarly, Europe currently boasts some of the world's tightest financial sector regulations, and its banks have suffered just as much, if not more than American banks in this recession. European banks made the same bad bets, the same poor investments, and the same over-leveraged mistakes—despite more regulation and government oversight.

None of this is to say that there shouldn't be regulatory change. The current regulation framework creates plenty of perverse incentives that stem from outdated rules. There is much to be desired in terms of governmental transparency and clarity.

However, the answer is not increased layers of government oversight. Giving regulators increased oversight of hedge funds, forcing the standardization of derivatives, or creating a systemic risk council will cause more harm than any good. Neither will expanding the Fed's powers ex post facto. Richard Fisher, President of the Federal Reserve Bank of Dallas, told the Wall Street Journal last month that regulators had enough authority to prevent a crisis. They simply failed to do so.

A far more prudential regulatory response is to fix broken rules—like the government has done with mark-to-market—and to have regulating agencies do a better job of oversight for 21st Century financial products. In a world of continually innovative investment strategies, flexible regulation from a loose government hand will prove most beneficial to a sustainable economy. The worst thing Washington could do is buy into the false history of phony deregulation and create more oppressive rules and stifling agencies that extend our economic struggles.

Anthony Randazzo is a policy analyst for Reason Foundation. This column first appeared at Reason.com.

Taxpayer's Guide to the Stimulus

anthony.randazzo@reason.org (Anthony Randazzo) — Wed, 17 Jun 2009 00:00:00 EDT

Reason Foundation’s Taxpayer’s Guide to the Stimulus breaks down each section of the American Recovery and Reinvestment Act to explain just how all that money is being spent, who is spending it, and what the whole stimulus means in layman's terms.

Introduction
How To Read This Guide

Analysis of Stimulus Spending and Major Provisions

Conclusion: Bloating the Bureaucracy and the Growth of Government

Spending Charts and Graphs

Just the Numbers
Spending Graphs
State-by-State

Overall Financial Crisis, Bailouts, and Stimulus Spending

Resources to Explore the Stimulus Bill

Recovery.gov - The government's website to track the stimulus
Recovery.org - Keep track of how the stimulus money is actually being spent
ReadTheStimulus.org - Read any part of the stimulus bill yourself
WSJ Accounting - The Wall Street Journal's assessment of stimulus spending
ProPublica Accounting - ProPublica's assessment of stimulus spending

Taxpayer's Guide to the Stimulus: Conclusion and New Spending

anthony.randazzo@reason.org (Anthony Randazzo) — Wed, 17 Jun 2009 00:00:00 EDT

Previous: 15. General > Taxpayer's Guide

>> Conclusion

The American Recovery and Reinvestment Act largely just provides general funds to government agency budgets, bloating the already large bureaucracy. The stimulus bill does not focus on fiscal responsibility, but rather makes the government even larger, funding many untested programs that could significantly add to government waste. From funding the War on Drugs to Comparative Effectiveness Research, the policy implications of the stimulus spending will leave a permanent stamp on the future of the American economy and society.

To follow the progress of stimulus spending, visit Onvia's Recovery.org "Tracking Recovery" website and check out all of Reason's coverage of stimulus and bailout spending.

>> New Spending

A significant portion of the money in stimulus was directed towards expanding the size of government by over $97 billion. This money creates 30 new programs that dramatically increase the role of government in the lives of individuals and operations of businesses. The new programs are 18 percent of the spending in the stimulus bill. These programs largely focus on increasing government funding of energy related projects and providing social services, with $16.1 billion being given to energy projects.

The unfortunate thing is that the spending won’t be limited to just this money. Those energy projects never existed before and won’t be over within one or two years. In this way the government has committed itself to long-term funding of billions of dollars worth of projects and programs. That’s $16.1 billion that will be needed from the next budget and the budget after that for years to come.

Here is a list of the stimulus bill's newly proposed, or previously unfunded, programs and their costs:

Grants to stabilize state education funds ($40.6 billion)
Grant programs to fund state and local social services ($8 billion)
High-speed intercity-rail ($8 billion)
Energy Innovative Technology Loan Guarantee Program ($6 billion)
Grant program to give bonuses to successful schools ($5 billion)
Smart grid program ($4.5 billion)
Wireless broadband technology program ($4.35 billion)
Grant program for energy efficiency and conservation ($3.2 billion)
Grants for low-income housing tax credit ($2.25 billion)
Sec. 8 Housing energy efficiency homeowners program ($2.25 billion)
Advanced battery manufacturing grants ($2 billion)
Implementing "Health Information Technology" ($2 billion)
Grants for improving the national highway system ($1.5 billion)
Grant for youth summer jobs program ($1.2 billion)
"Comparative Effectiveness Research" ($1.1 billion)
"Preventative Wellness Trust" ($1 billion)
Green job training grants ($750 million)
Subsidies for SBA direct and guaranteed loans ($636 million)
Grants for Amtrak security initiative ($450 million)
Grant for "Advanced Research Project Agency," energy division ($400 million)
Grants for emissions reduction program ($400 million)
Rural broadband technology opportunities program ($350 million)
Federal vehicle fleet replacement ($300 million)
"Clean Cities Program" ($300 million)
FEMA grants for fire departments ($210 million)
NSF grants for research facilities modernization ($200 million)
Impact Aid school construction ($100 million)
Agriculture Department after school feeding program ($100 million)
Upgrade initiative for visa processing facilities ($90 million)
Funding for the Recovery and Accountability Board ($84 million)

Total: $97,320,000,000

Previous: 15. General > Taxpayer's Guide

Written by: Anthony Randazzo. Please email with any comments or corrections.

Is America Following the Policies that Caused Japan's "Lost Decade"?

Wed, 10 Jun 2009 00:00:00 EDT

The scenario was eerily familiar. A long real estate bubble that had expanded extra rapidly for the previous five years suddenly burst, and asset prices came crashing back down to earth. Banks and financial institutions were left holding piles of worthless paper, and the economy soon headed south. The national government responded to the crisis by encouraging more lending and spending previously unfathomable amounts of money on public works projects in an effort to stimulate consumer spending and restart growth.

But that stimulus did not save the Japanese economy in the 1990s; far from it. The ensuing period came to be known as the Lost Decade, characterized by multiple recessions, an annual average growth rate of less than 1 percent, and a two-decade decline in stock prices and corporate profits.

The Japanese government’s easing of credit rates, instead of spurring real demand, created artificial demand. Federal loans and stimulus spending were not economically productive, and they vastly increased the nation’s debt and prolonged the economic malaise. Worse, businesses spent critical time on the sidelines, waiting for government bailouts and other centralized actions, instead of speedily consolidating their losses, clearing their balance sheets of bad investments, and reorganizing.

The United States in 2008–09, unfortunately, has started down the same path. Federal intervention and the expectation of additional government action are removing firms’ incentive to clean up their balance sheets by selling “toxic” assets. Why accept pennies on the dollar if a deep-pocketed new bidder (i.e., the state) looms large on the scene? The Japanese experience shows that when the government is an active participant in the market, many firms would rather accept state support than initiate the inevitable financial reckoning. Such a status quo does not provide a sustainable foundation for the economy. Instead, it restricts economic growth and creates a cycle of stagnation.

How Bubbles Form—and Burst

The Japanese asset bubble grew out of a long postwar economic boom that accelerated in the latter half of the 1980s, spurred in part by the central bank’s loosening of monetary policy. With access to easy credit, businesses sped up the country’s transformation into an economy based on technology, most prominently in the consumer electronics, telecommunications, and finance sectors.

The ensuing demand for new and better technology products, combined with increased living standards, fed an asset investment craze referred to as the Heisei boom, after the emperor who took the Japanese throne in 1989. The value of the yen increased during this time, due primarily to the 1985 Plaza Accord, an agreement reached at an international conference in New York that depreciated the dollar against the yen, and Tokyo became a major financial services center. The Japanese Stock Market grew enormously, with the Nikkei 225 (an index similar to the Dow Jones Industrial Average) more than tripling between 1985 and the end of 1989.

Times looked so good that U.S. bestseller lists were sprinkled with anxious tracts about Japan eclipsing the country that had defeated it militarily less than half a century before. But a more real threat was hiding in plain sight: Japanese asset prices, after rising precipitously, were about to come crashing down to earth.

The late-’80s Japanese bubble and the mid-’00s American bubble had similar causes that are worth pondering:

Overaggressive financial institutions and poor risk management that ignored traditional economic fundamentals. In both Japan and the U.S., excessively optimistic expectations led to bad investment decisions from Wall Street to Main Street and a pervasive culture of denial that there was any bubble at all.

Japanese asset inflation was fueled by a 51 percent average growth rate in housing prices and an 80 percent increase in average commercial property values between 1985 and 1991. This spike created an overconfident climate in which investors failed to adequately prepare for a correction. Since that peak, asset values in Japan have fallen by more than 40 percent as of 2008.

Japan was flush with capital in the 1980s, in part due to an export boom that started the decade before. The country was becoming an increasingly important player in the world financial system, and international investors came looking for a stake. In the preceding years, Japanese individuals and firms had built up a large pool of savings and begun investing those resources in real property. This rapid rate of investment pushed the value of land, buildings, and other capital investments higher, encouraging even more investment, and in turn speculation, based on the belief that values and returns would keep rising.

Riding this asset appreciation, Japanese banks borrowed nearly ¥200 trillion ($3.4 trillion in today’s dollars) from foreign markets. This sum sloshed throughout the Japanese economy. The lending was further fueled by tiny debt-to-equity requirements, a relatively recent development that encouraged financial institutions to heavily leverage their bets. By 1991 Japanese banks held reserves of only ¥3 trillion to cover the ¥450 trillion they had lent. Normally, such a lopsided portfolio would have triggered widespread concern. But the economic climate in Japan back then was often described as “euphoric.” Prudence was not in vogue.

The American housing bubble was bigger, although values have yet to fall as much as those of Japanese real estate. Between 2000 and 2006, average home prices in the U.S. grew by 90 percent, and commercial property values rose at the same rate. Since the peak in July 2006, home prices nationwide have declined more than 30 percent, and certain regions have experienced even sharper drops. Prices were still falling as of press time.

After the twin shocks of the dot-com bubble bursting and the September 11 attacks, the Federal Reserve repeatedly slashed interest rates. And like Japan in the 1980s, the U.S. was seen as an attractive destination for international investment. With more investors using more money to chase high returns, Wall Street began aggressively “securitizing” home mortgages by bundling and reselling bits of loans and doing likewise with the insurance contracts underwriting them. New subprime mortgages became increasingly available to home buyers with spotty credit histories. Because of the risk, subprime loans brought a higher rate of return. But since they were bundled with safer loans, the entire packages received ratings from credit agencies that were higher than warranted.

Investment patterns suggest that most Americans thought rising stock values and AAA ratings on securitized mortgages were safe financial bets. This overconfidence led most major Wall Street firms to decrease their capital ratios, taking on more debt and decreasing the amount of cash on their balance sheets. By 2007 the investment bank Lehman Brothers was leveraged 30 to 1, meaning just a 3.3 percent decline in asset values would wipe out its capital—which is in fact what happened.

Stock market bubbles. In both the U.S. and Japan, the rapid rise in property values fueled gains in the stock markets. The Japanese stock index Nikkei 225 rose from 13,000 in 1986 to an intraday high of 38,975 by the end of 1989. But the implosion of the property market sent the index crashing. It had dropped to 15,025 by July 1992, and it continued a steady decline throughout the Lost Decade. By April 2003, the Nikkei had fallen to 7,603, less than 20 percent of its peak.

Similarly, the Dow Jones Industrial Average went from 7,489 in July 2002 to an intraday high of 14,115 in October 2007. After that high point, the market began a modest decline, reaching 10,850 on September 30, 2008, then plummeting to 7,552 by November 20. The Dow continued to fall over the ensuing months and closed at 6,547 on March 9. (It has since rallied to just over 8,000.) In the U.S. as in Japan, the quick run-up in stock valuations lured people to invest money they did not have. The result was inadequate risk management, over-leveraged investments, and fragile capital reserves. Investors did not adequately plan for any contingency other than continued high growth and largely ignored those who warned that such growth was not sustainable.

Monetary policy errors. Although private financial institutions played a key role in the booms and busts of both Japan and the U.S., monetary policy was a critical root cause. In both cases, the central bank helped set off a boom in asset prices by expanding credit and driving interest rates to artificially low levels. This encouraged individuals and businesses to take on debt they otherwise would not have accepted and make investments they otherwise would not have considered.

When a central bank inflates the money supply and drives interest rates below those that would exist in a free marketplace, it sends a false signal to businesses to borrow and invest more in capital projects and goods than they otherwise might. Similarly, consumers respond to the signal by taking on higher mortgage and/or credit card debt, saving less, and spending more. Credit binges cannot last forever; when interest rates increase again, the bad investments are revealed, and it becomes painfully clear that much of the outstanding credit cannot be paid back.

Between January 1986 and February 1987, the Bank of Japan cut its discount rate—the interest rate charged by the central bank on loans to its member banks—from 5 percent to 2.5 percent, leading to an increase in real estate and stock market prices. Realizing a bubble was forming, the central bank then raised rates five times in 1989 and 1990, to a high of 6 percent. This increase revealed that many investments were built on extensive, unsustainable debt. Stocks began their long and painful slide.

When a recession began to set in after the 1990 stock market crash, Japan responded by reversing its tight money policy, cutting rates to 4.5 percent in 1991, 3.25 percent in 1992, 1.75 percent from 1993 to 1994, 0.5 percent from 1995 to 2000, and as low as 0.1 percent in September 2001.

A similar pattern took place in the United States. From 2000 to 2002, the Federal Reserve slashed the target discount rate from 6 percent to 0.75 percent. Fearing irrational exuberance, to borrow Alan Greenspan’s famous phrase, the Fed then raised the rate as high as 6.25 percent in June 2006. But now that the bubble has burst and the economy contracted, the Fed has cut the discount rate 12 times, lowering it to the current 0.5 percent. Federal Reserve Chairman Ben Bernanke has repeatedly stated that he sees interest rate cuts as a way to “support growth and to provide adequate insurance against downside risks.”

In both the Japanese and the American cases, post-bubble policy makers believed that lowering interest rates would make credit easier to obtain, thus recreating the environment that had spurred economic growth to begin with. But this meant that the supposed cure for a bubble created by easy credit was to extend even more easy credit.

These rate cuts only perpetuated the distortion of economic decisions and prevented savings, investment, and consumption from realigning with true preferences, as opposed to the illusory ones created by easy credit and artificially low interest rates. The lesson is that when monetary policy is used to “smooth” or “tweak” the market, it inevitably causes unintended consequences that in some cases can be very damaging to long-term economic growth.

Regulatory Responsibility

The current American debate often falls into broad-brush discussions about whether the nation had “too much” or “too little” regulation. The real issue is how the existing regulatory order helped spawn the financial crisis. We see it doing so in at least a couple of areas:

Capital reserve requirements. In 1988 the Basel I Accord between the Group of 10—which then included the U.S., Switzerland, Japan, Germany, France, and the U.K., among others—set new capital requirements for banks around the world. But the requirements were focused on loan amounts and did not factor in a debt’s underlying risk. In other words, a loan to a sound borrower required the same percentage of capital to be set aside as an equal amount lent to a high-risk borrower. There was already a developing atmosphere of heavy lending and insensitivity to risk, but the Basel requirements rewarded firms for making loans to shaky borrowers because they could earn higher interest rates that way without having to set aside any more capital than they would for loans to safe borrowers.

The chief problem was not that the requirements were too low. It was that the rules created a false sense of security for investors and lenders. Banks were meeting their legal requirements, although it was never clear what kind of debt they were holding capital to cover. Without a standard or competing standards for transparently measuring the value and risks of portfolios, Basel I proved ineffective at preventing systemic rot.

In the United States, when firms calculated their reserve requirements, they were required until recently to mark many assets “to market,” i.e., value them at the price they could be sold for immediately. When asset values started falling, and categories of assets stopped trading, firms scrambled to find capital to shore up their shoddy-looking reserves. The collapse of the government-created mortgage behemoths Fannie Mae and Freddie Mac suddenly devalued mortgage-backed securities, and that meant banks holding large swaths of these assets had to come up with millions in cash overnight to meet their capital ratios. Many of the worst or most toxic mortgage-backed securities could not be sold immediately because their values were hard to determine. Under “mark to market” accounting rules, they were in effect worth nothing for the time being.

The market needed time to reassess the mortgage market, given the new information it was facing from the Fannie and Freddie debacle. In the meantime, banks watched the numbers on their balance sheets go from millions to zero. Unable to find sufficient capital to meet the requirements demanded by mark-to-market accounting, institutions such as Lehman Brothers, Washington Mutual, and Citigroup fell prey to their debt. Easing the mark-to-market rules at the onset of the crisis, instead of a year later, would have bought firms precious time to recapitalize their balance sheets in a more stable manner. The banks still would have lost money, but they might not have gone bankrupt and caused a negative ripple effect throughout the economy.

Government housing policy. Both Japan and the United States had explicit government policies that encouraged an unhealthy appreciation in land and housing prices. A 2003 report from the Bank of Japan blamed tax and regulatory policies for an unnatural rise in asset values. In America the Federal Housing Administration has for years encouraged the expansion of mortgage lending, including subprime lending, particularly through Fannie Mae and Freddie Mac. This was done to expand homeownership by low-income families. Such policies span administrations of both political parties, from the Community Reinvestment Act passed during the Carter administration in 1977 to George W. Bush’s efforts to create an “ownership society.”

The push to expand homeownership had two big effects. First, it greatly increased the number of buyers, driving up housing prices. Second, it provided mortgages to a large number of people who had a high risk of default.

Recession Responses

By early 1992, realizing that the economy was not going to rebound quickly, the Japanese government hurriedly enacted its first recession-fighting stimulus package. Government spending and loans during the next several years propped up failing Japanese financial firms, but the companies’ lack of vitality and perpetual operating losses earned them the moniker “zombie businesses.”

Given the similar source of the U.S. bubble, American officials should take a careful look at Japan’s ineffectual and massively expensive response to ensure that the United States does not duplicate the following mistakes:

Government lending to poorly managed firms. The Bank of Japan tried to ease economic pain by loaning large amounts to businesses. But the attempts to recapitalize the market ignored underlying management problems in the dying firms. It was a costly mistake. Intense lobbying from special-interest groups representing various sectors of the Japanese economy perpetuated the ill-fated loans and funneled government money to zombie businesses.

The United States has already begun to copy this policy, lending billions of dollars to financial institutions and auto companies and buying up billions more in bank equity in an effort to recapitalize the marketplace. The effect has been to keep poorly managed firms alive with taxpayer money.

Just months after a $25 billion investment in Citigroup, the government had to step in with a second bailout of $20 billion. Despite the infusions, Citigroup is now breaking up its holdings, a process that could have been started months earlier if the authorities had not used tax dollars to feed the zombie firm. Instead of letting the Big Three automakers go bankrupt, the administration has kept them on life support with tens of billions in loans to buy enough time for...likely bankruptcy.

Conflicts of interests. With all those loans, the Japanese government found itself deeply entwined in the market, skewing its policy incentives. Daniel I. Okimoto, former director of the Shorenstein Asia-Pacific Research Center at Stanford University, points out that Japan’s banking industry and economic bureaucracies were too interdependent. Studies from Okimoto’s center and the Bank of Japan concluded that data revealing the scope of the economic malaise were suppressed and that regulations were developed with governmental interests in mind. At the height of financial industry bailouts, there was little transparency or public accountability.

The United States has ventured into the same dangerous waters. In an attempt to recapitalize the banking industry, the Treasury Department forced the major banks to take bailout funds from the Troubled Asset Relief Program, in exchange for which the government took equity stakes. The federal government now owns a majority of the American International Group insurance company, as well as major chunks of General Motors and Chrysler. The dangers of interconnectedness have already become apparent.

With taxpayer money on the line, elected officials feel emboldened to prescribe the marketing, compensation, travel, and other business policies of companies taking government money. Members of Congress and White House staff have criticized specific spending decisions by participating firms. Concern over bonuses to AIG employees led the House to pass an arbitrary tax on a standard business practice that lost public favor. President Obama himself has delved into such business minutiae as whether General Motors should be focusing more on brand consolidation. And a bill now in the Senate would give the Treasury Secretary power to set the salary of all employees, not just executives, at any firm with bailout money burning in its pockets.

Lawmakers’ incentives are to serve their constituencies or their own political careers. This can put them at odds with the businesses they are suddenly attempting to manage. The more the government is involved in directing business activity, the less likely those firms will succeed in maintaining long-term growth, and the more likely they will turn into Japanese-style zombies.

Short-term, static political vision. You can blame the length of Japan’s asset deflation, recession, and liquidity struggles on an unwillingness to choose hard but necessary policies, such as allowing banks to fail and the market to reset itself. Politicians bent on retaining their power and showing the public they were doing something took actions without regard to their long-term effects.

There was little effort to clean up the banking system or get rid of harmful regulations. The government refused to acknowledge the breadth of Japan’s economic troubles, and the Ministry of Finance went so far as to order banks to hide their toxic loans to create the appearance of success. This approach was largely due to fear of the keiretsus, the powerful alliance of Japanese businesses that propped each other up with cross-shareholding and loans. Taking swift action would have upset the traditional way of business and forced the government to admit mistakes.

The principle of creative destruction—the economic mutation that continuously breaks down old forms and creates newer, more productive and efficient ones—was ignored in the hope that legacy corporations could somehow save Japan. From Wall Street to Detroit, under both George W. Bush and Barack Obama, the American government has been equally unwilling to let once-formidable companies fail.

Bad tax policy. In different periods, Japan tried to climb out of its economic mess by both cutting and raising taxes. There were two major tax cuts during the Lost Decade: a ¥5.8 trillion ($69 billion in today’s dollars) income tax cut in 1994 that lasted for one year, and a ¥4 trillion ($46 billion) income tax cut in 1998 spread over two years. The problem was that these tax cuts were not permanent and thus did not increase long-term aggregate consumption.

From 1994 to 1995, the Japanese economy began experiencing modest growth, partially due to the first tax cut. But deflation in 1995 reduced government revenues. In an effort to stem surging national debt, the consumption tax was increased from 3 percent to 5 percent in 1997, which slowed the economy again.

President Obama and Republicans in Congress have proposed various tax cuts and tax credits to stimulate the American economy. The American Recovery and Reinvestment Act (the “stimulus” bill) included the president’s signature “Making Work Pay” $400-per-taxpayer ($800-per-family) tax credit that eliminates all federal income taxes for up to 18 million Americans. The legislation also increased the amount of losses that businesses may write off on their taxes while providing tax credits to new homeowners, students, and efficient energy developers.

Other ideas, such as the GOP push for reductions in capital gains taxes, have been tossed aside.

As welcome as tax cuts are, without a decrease in spending they will require an increase in taxes later to cover the lost revenue and pay off the debt incurred.

Japan found that temporary tax rate cuts combined with increased spending did not spur economic growth. Neither did an attempt to increase government revenues through tax increases. Reducing taxes for businesses—permanently, not until the next shortfall—allows firms to keep more revenue, which in turn lets them reinvest that money to innovate and expand their business, hire new workers, pay out dividends, or just be inspired to continue their hard work. Tax rate cuts for individuals—all individuals, including those with income over the arbitrary $250,000 threshold—give people more control over their income, allowing them to pay down debt, save, invest, or increase consumption. Those tax policies are the quickest way to stem a recession.

Government infrastructure “investment.” In an attempt to encourage growth, the Japanese embarked on a massive, multi-billion-yen infrastructure program. They built roads, bridges, and airports, all with the goal of creating jobs and reviving the economy. This didn’t work either.

During the 1990s, Japan passed 10 fiscal stimulus packages, focused largely on public works, totaling more than ¥120 trillion ($1.4 trillion in today’s dollars). When one construction plan failed to stimulate economic growth, another was tried. Those plans did not succeed in reviving the economy, but they did saddle the nation with a mountain of IOUs that helped postpone recovery for years. Including “off-budget” borrowing, Japan’s debt was estimated to exceed 200 percent of GDP in 2001.

Construction plans often set job growth targets but rarely focused on project prices. From 1992 to 1999, the Japanese government spent more than $500 billion (in today’s dollars) on public works projects. Yet the construction jobs were not long-term and did not lead to sustained economic growth. Public debt sky-rocketed, unemployment actually doubled from 2.3 percent to 5 percent, and the economy remained stagnant. As Gavan McCormack, a historian at Australian National University, noted in his 1996 book The Emptiness of Japanese Affluence, “The construction state is in some respects akin to the military-industrial complex in Cold War America (or the Soviet Union), sucking in the country’s wealth, consuming it inefficiently, growing like a cancer and bequeathing both fiscal crisis and environmental devastation.” The government failed to properly identify which projects should be pursued, ignoring demand signals that the private sector is better at recognizing and responding to.

The United States has started down a similar path. In February, Congress passed nearly $100 billion in transportation and public works spending. Naturally, political interests, not economic viability, are determining how this money is being spent.

An American Lost Decade

The Japanese government’s monetary expansion and poor regulation, coupled with the risky behavior and ineptitude it encouraged in the financial sector, led to distortions in private investment instead of economic recovery. Recessions are the unavoidable costs of unsustainable booms fostered by government policy. While politicians would like to stave off the negative effects they create—business failures, unemployment, falling housing prices—bankruptcies and corrections are necessary steps in realigning consumer preferences and the structure of production.

The U.S. government is repeating many of the same mistakes that created Japan’s Lost Decade, becoming entangled with the business community through bailout equity purchases and trillions of dollars in loans and guarantees to keep failing American firms alive. This policy is making the recession worse, extending it further than it would otherwise last.

Any attempts to artificially spur a credit expansion through either low interest rates or “fiscal stimulus” will only add to the economic distortions and make the market correction longer and more severe. Spending hundreds of billions of dollars on infrastructure, broadband Internet, and the like may provide some short-term benefits for some Americans, but as Japan discovered the hard way, it won’t rescue the economy. The history lessons from Japan are plentiful and clear. If the American government continues its pattern of intervention, the United States may soon be trapped in a zombie business economy and a lost decade of our own, ensuring economic stagnation for a long time to come.

Anthony Randazzo is a policy analyst at the Reason Foundation. Michael Flynn is president of Marengo Strategies. Adam B. Summers is a policy analyst at the Reason Foundation. This column first appeared in Reason magazine.

Put the Patients' Welfare First in Hospital Privatization Dispute

Thu, 14 May 2009 11:39:00 EDT

James Madison Institute

Opponents of privatizing the Northeast Florida State Hospital (NEFSH) in Macclenny killed an important opportunity in the legislature, claiming that privatization would have caused the state to lose jobs and the local economy to suffer. Not only was this fear misguided, but it also ignored an important reality: State psychiatric hospitals exist to provide quality care to individuals suffering from severe mental illness, not to be a government jobs program.

Area legislators and their union allies apparently felt otherwise, deciding that the preservation of government largesse was more important than care for the mentally ill. One government union lobbyist went so far as to call the privatization defeat "a victory for the community." But what about the patients?

The reality is that privatization could have saved the state money while also ensuring higher quality care for patients at NEFSH. Opponents will falsely claim that cost-cutting reduces the quality of care. Yet, for over a decade, Florida has successfully privatized a number of state psychiatric hospitals and correctional mental health services, dramatically improving patient care and outcomes while innovating to drive costs down.

South Florida State Hospital (SFSH)—the first state psychiatric hospital privatized in Florida in the late 1990s offers an excellent example. The aging Pembroke Pines facility had never been accredited in its 50-year history and was facing a major class action lawsuit concerning patient abuse and abysmal conditions when it was privatized. Within 10 months of receiving the contract, the private operator was able to get the existing facility accredited and the lawsuit dismissed, while at the same time financing and building a new, modern facility to replace it. No state capital dollars were involved, and the state will own the new facility when the debt is retired.

The results speak for themselves. Since privatization, the hospital has reached some significant operational milestones, such as dramatically reducing waiting lists for patient admissions, reducing the average patient stay from eight years to less than one year, and nearly eliminating the use of seclusion and restraint to manage patient behavior.

SFSH also recently rolled out the first electronic health records system in a Florida psychiatric hospital—at its own expense. The system increases the accuracy of treatment at the hospital and has created a benchmark for every other hospital in the state to aspire to.

Significantly, the contractor paid to develop this cutting-edge system itself—recognizing the operational improvements it would facilitate—even though such improvements immediately become property of the state.

The Florida Statewide Advocacy Council—a human rights advocacy group that initially opposed the SFSH privatization—noted the turnaround, unanimously passing a resolution in 2003 supporting further privatization of Florida's psychiatric facilities. Policymakers paid attention as well and subsequently privatized several additional forensic psychiatric hospitals, as well as several prison mental health programs.

Cost savings through privatization have also been impressive. The Florida Department of Children and Families told a legislative committee in 2007 that the average cost per bed in privately operated psychiatric facilities was as much as 15 percent lower than at the state-run hospitals.

Missing in opponents' anti-privatization rhetoric is the important fact that the privately-operated hospitals actually receive more monitoring and oversight than those run by the state. After privatization, SFSH and all of Florida's other privately-operated state psychiatric facilities have become accredited by the Joint Commission, a national, nonprofit health care accreditation organization.

By contrast, no state-run facility—including NEFSH—has received this respected seal of approval. Are taxpayers just supposed to take it on faith that the state is providing quality care in-house?

Florida just missed a tremendous opportunity to modernize service delivery at NEFSH by engaging the private sector. Privately-run psychiatric facilities have a proven track record of providing higher quality care in the Sunshine State, no matter the complexity and severity of the patients' illnesses they treat. And they are doing it at a lower cost, innovating through more efficient business practices that offer better care for less money.

While some in Tallahassee clamor to preserve government jobs, it's the individuals in Florida's mental health care facilities who deserved the legislature's full attention. Instead they sacrificed patients' well-being to retain legacy jobs on the state's payroll.

Leonard C. Gilroy, AICP is an adjunct scholar at the Tallahassee-based James Madison Institute and director of government reform at Reason Foundation. Anthony Randazzo is a policy analyst at Reason Foundation. This column was originally published by the Tallahassee-based James Madison Institute.

Meddling Congress Wants to Set Your Pay

anthony.randazzo@reason.org (Anthony Randazzo) — Wed, 29 Apr 2009 09:00:00 EDT

Six months after the Troubled Asset Relief Program was passed to “save” America’s banks, the banks are trying to return the money. Couple that with the Dow’s recent uptick and it might sound like the economy is recovering. Unfortunately, it’s just a sign that sometimes even hundreds of billions of dollars aren’t worth the headache of dealing with the federal government. Banks are trying to get Congress out of their boardrooms.

The House has already passed, and the Senate may consider, a bill that would give Treasury Secretary Tim Geithner the power to set salaries of all employees at any bank that has received bailout cash. And not just the CEO’s salary, any employee: tellers, janitors, everybody.

Over 500 banks have received TARP money and they’d all be subject to intense micromanaging from the feds if the “Pay for Performance Act” becomes law.

At least eight banks have returned the money (or are trying to do so) thus far, including New York’s Signature Bank, which has over 20 branches in the five boroughs and Long Island. Their CEO Joseph DePaolo said Congress setting workers’ pay would “adversely affect” business.

DePaolo’s fears are justified. President Barack Obama fired the head of massive General Motors. Would Obama, or Congress, think twice about firing the CEO of little ol’ Signature Bank?

Sadly the answer is, no. Not even the spirit of the Constitution matters in DC these days. The 90 percent “AIG bonus tax,” showed that. Congress is becoming a runaway train, playing politics with the financial industry.

There is a sliver of hope though. At the G-20 meetings in Europe, Obama responded to a question about executive pay and said, “It doesn't mean that we want the state dictating salaries; we don't.”

Obama says he favors a system where shareholders have a say in what corporate bosses get paid. That’s not a bad idea. Shareholders are owners of a company and they have a vested interest in the success or failure.

The idea that companies should pay employees based on performance is a good one. In fact, it’s proven strategy used by nearly every successful company in every industry. You pay to keep your best workers, and you pay to keep them happy. The government doesn’t need to teach anyone that. Nor does it need to be telling banks what a teller or janitor should make.

Signature’s DePaolo said, “The return of these funds allows us to continue to execute our business model, which includes the successful recruitment and retention of highly talented banking professionals throughout the metropolitan New York area.”

Congress and the Treasury Department don’t have a clue about what individual employees bring to any financial firm so there is no way for them to accurately determine what people should be paid.

Washington’s activity is dictated by politics, not smart business decisions. The American people got angry about the AIG bonuses, so the House passed the AIG punishment tax. The auto bailouts are terribly unpopular with the public, so firing a CEO shows you are shaking things up.

The AIG bonus tax bill didn’t become law because President Obama eventually expressed his disapproval with it. He needs to do the same here. And if “Pay for Performance” is such a great idea, why don’t members of Congress ask taxpayers to vote on their salaries? Then we’ll see how fair it really is.

Anthony Randazzo is a policy analyst at Reason Foundation.

Feds Should Allow the Market to Work Freely

anthony.randazzo@reason.org (Anthony Randazzo) info@reason.org (J. Dustin Pope) — Thu, 16 Apr 2009 12:37:00 EDT

As Congress comes back from recess, the move towards increasing financial regulations will pick back up in earnest. From regulating hedge funds to widening the oversight roles of the Federal Reserve and Securities and Exchange Commission, we’re seeing a Washington power grab like never before. Treasury Secretary Tim Geithner has asked Congress to grant the government more authority, but before they do, lawmakers should take a look at history to see the consequences of past federal financial activism.

Before 1979, the Federal Reserve (Fed) used “interest rate targeting” as monetary policy to stimulate economic growth. But to manipulate interest rates the Fed would expand and contract the money supply in reaction to the market cycle. But because of the lag between this policy’s implementation and when it impacts the economy, the long-term ramifications were nearly impossible to predict. We now know that the unforeseen result of excessive growth in the money supply, combined with oil price shocks and price controls, ultimately resulted in 1970s “stagflation.”

To address this issue, then Fed Chairman Paul Volcker (now chairman of the President’s Economic Recovery Advisory Board), decided in October 1979 to annually increase the money supply at a fixed rate, essentially slowly increasing inflation in a predictable way. By slowly increasing the money supply annually and directly adjusting interest rates, lag effects become more stable. However, this policy of “inflation targeting” can result in wildly fluctuating interest rates—and that can have negative long-term consequences.

Bond prices move inversely to interest rates, and after Volcker’s monetary policy shift towards steady inflation in 1979, bond prices began fluctuate. Traditionally a conservative investment instrument, the destabilization of bond prices increased their potential value. This stability shift contributed to the emergence of junk bonds that, despite their high yield potential, carried a high risk of default and were partially to blame for the Savings and Loan Crisis in the 1980s.

But more important for our story today was the development of mortgage bonds—and ultimately the infamous mortgage-backed security.

Ironically, the whole mortgage-backed investment model almost never got off the ground. Lewis Ranieri, a trader at Salomon Brothers (now a part of Citigroup), is credited with first conceiving the idea in 1978. But Salomon Brothers almost canned Ranieri’s whole department because there didn’t seem to be a profitable future for mortgage trading.

Former Salomon broker Michael Lewis writes in his book Liar’s Poker, “The mortgage department wasn't making money. The other mortgage units on Wall Street—Merrill Lynch, First Boston, Goldman Sachs—were stillborn. They closed almost before they had opened. The prevailing wisdom was that mortgages were not for Wall Street.”

That’s when the government stepped in.

A side effect of the Fed decision to increase the money supply was an uptick in interest rates after 1979. This negatively impacted mortgage lending at Savings and Loan banks (S&Ls). Under “Regulation Q” of the 1933 Glass-Steagall Act, the government, seeking to promote homeownership, exercised its power to place a ceiling on the interest rate S&Ls could charge a borrower for a mortgage. But this limited their ability to compete with alternative, unregulated funds for capital. The unregulated funds (such as money market funds) could offer a better rate of return for investors

The S&Ls had two options: make no further loans until interests rates went down, leaving them with no revenue, or sell off their loans at a loss and hopefully last long enough for rates to decline. As a result, many S&Ls without enough capital to wait for lower interest rates were forced to shut down.

In late 1981, seeing the error of their ways, Congress offered S&Ls a tax break. As a reward for their advocacy of homeownership, the banks could get up to 10 years of taxes per loan back, if they showed a loss on the sale of that loan. Essentially the government gave S&Ls an incentive to take a loss.

Selling off the mortgages was easy. All S&Ls had to do was call an investment bank and take whatever price they could get. Salomon Brothers and others snapped up the mortgages at rock bottom prices. Then investment banks began bundling these cheaply acquired mortgages into different investment vehicles, and sold them to investors looking for a quick dollar. Suddenly, mortgages were more profitable for Ranieri’s department. Mortgage-backed investments were saved, thanks to Uncle Sam.

The rest of the story is already widely known. The lesson has not quite set in though.

While banks share a hefty portion of the blame for our current financial crisis, it wasn’t capitalism that failed. Lew Ranieri wasn’t wrong for trying to develop a new mortgage bond investment vehicle. But when it was first introduced to the market it wasn’t very successful. The demand wasn’t there. Or at least it wasn’t there yet. It took government activity in the financial sector, through S&L rate ceilings and fancy tax incentives, to create a market for the evolution of mortgage-backed securities.

Mortgage bonds might have died at the hands of the free market long ago. But the government, as it does more often than not, felt it could help the free market do better. It was noble for the government to promote the “American Dream” and under Presidents Bill Clinton and George W. Bush, Fannie Mae and Freddie Mac handed out billions in subprime loans that did help many get affordable housing. However, those risky loans haven’t lasted, and the long-term effects have only hurt the economy and American people.

The Obama administration’s push for increased regulatory power appears to be well-intentioned--to prevent another downturn like this. But history has shown time and again that government is unable to predict the negative and long-term consequences of its actions. Allowing the market to work freely is the best way to help people across the economic spectrum live more prosperously.

Anthony Randazzo is a policy analyst at Reason Foundation. J. Dustin Pope is a Business Development Associate with Hynes Associates.

Rolling Out TARP II

anthony.randazzo@reason.org (Anthony Randazzo) — Fri, 27 Mar 2009 10:20:00 EDT

The Treasury Department has created a bit of a conundrum for libertarians when it comes to the newly announced Jekyll and Hyde-like TARP II. On the one hand, the government is finally reaching out to the private sector through this initiative, recognizing the power of markets and price discovery as means to end the economic crisis. But on the other hand, the taxpayers are still taking up to 93 percent of the risk in this new venture. That’s hardly an equitable solution and it could end up costing incalculable billions.

Since the Troubled Asset Relief Program (TARP) bailout was passed last September the money has been used for a host of recovery initiatives. The first half was used largely to recapitalize the banks by buying up equity shares. The second half, TARP II, will be focused on the initial goal of the bailout: to get the deadly mortgage-backed securities and toxic assets off bank balance sheets.

These real estate loans and securities have been rebranded as “Legacy Assets.” They are essentially mortgages, subprime and other, abandoned or in foreclosure, leaving the bank holding the debt in the weak housing market. Because balance sheets are cluttered with unpaid loans, banks have limited the amount of credit they are willing to extend, which is part of the cause of the economic slow down.

TARP II will use $100 billion of the Congressionally approved money to create the Public-Private Investment Program (PPIP) , a plan to unite private capital with taxpayer dollars to buy up to $1 trillion of the Legacy Assets from banks, easing their debt levels, allowing credit to flow more freely.

Treasury Secretary Tim Geithner argues that creating a program like this will leverage the price discovery process of the free market to help find the right price to buy the Legacy Assets from banks, and is better than the government trying to value the toxic debt on their own. On this point, Geithner is absolutely right. On its own, the government would almost certainly overpay for the assets.

Another positive of the plan is that banks, who have been holding out on selling their assets at a loss because bailouts have been keeping them alive, will be forced to either clean their books or stop asking for taxpayer money. However, these positives are countered by the fact that the American taxpayer winds up on the hook for most of the risk in this plan.

Here’s how the public-private TARP II will work. First, banks will determine what Legacy Assets they want to sell and put them up on an auction block. Assets will probably be grouped together and sold in “pools.” Second, the government will decide how much it thinks the assets are worth and announce what percentage of a sale it will cover. Private market actors will then bid for the assets. Bidders could be pension funds, mutual funds, private equity firms, or even individual investors with enough capital. The assets will be sold to the highest bidder.

Finally, the FDIC and Treasury Department will provide financing to the private investor, and together they will assume joint ownership of the assets. Private fund firms will be hired to manage the assets until prices rise to the point that the assets can be sold and both investors and taxpayers get a return on their investment.

At least that is how the program is supposed to work.

The very real possibility exists that Legacy Assets will never regain their value, which means a loss to whoever owns them. This is where the first major flaw in the Public-Private Investment Program becomes apparent: if an asset matures in value then everyone wins big, but if an asset suffers a loss it will be the taxpayer who takes the biggest hit.

When you do the math, after FDIC financing and Treasury funds, private investors may only have to put up 7 percent of the money in buying a pool of assets, leaving the government to take a 93 percent loss if necessary. Such a low private market share defeats the purpose of a public-private partnership in the first place.

A key advantage of public-private partnerships, whether through this investment program or by creating a toll road, is to transfer financial risk from the taxpayers to the private sector. But with financing structure as it is, investors have big upsides with little skin in the game, while the government is likely to take big losses .

And that kind of investment is how we got into this mess in the first place. The government cannot continue to socialize losses.

Of course the problem of troubled Legacy Assets won’t go away over night. Some are arguing that the Private-Public Investment Program is a better option than nationalization or having the government buy up assets on their own. While that may be true, it doesn’t mean PPIP is the best choice.

We have no idea how much PPIP may wind up costing the taxpayer. The FDIC will be guaranteeing loans to purchase assets, but that money won’t come from the $100 billion TARP II money, it just appears out of thin air (the government’s favorite magic trick). Depending on how much financing is needed and what kind of losses Legacy Assets yield long term, this program could cost nearly $1 trillion in taxpayer, inflated currency.

Though the TARP II program creates a market for buying and selling these assets, it’s an unnecessarily subsidized one. These assets can be bought and sold now, in the current market. The catch is that the banks don’t want to because they don’t like the prices they are being offered, and bailouts have allowed them to hang on for a better deal. The best option is simply to let the banks that do not want to sell fail, and then divest the assets after going into bankruptcy.

There are other risks with the plan, including the possibility that banks will bid up their own auctions, but this can be stopped with the right oversight . The gravest concern is that there are high odds that many of the toxic Legacy Assets might never regain value, leaving the taxpayers with a heavy loss that should be felt by the banks.

Anthony Randazzo is a policy analyst at Reason Foundation. This column first appeared at Reason.com.

Government Officials Say Sweeping Financial Overhaul Is Coming

anthony.randazzo@reason.org (Anthony Randazzo) — Mon, 23 Mar 2009 16:52:00 EDT

In the coming weeks the movement to reorganize the U.S. financial industry will begin to pick up steam. Federal Reserve Chairman Ben Bernanke is urging a sweeping overhaul of financial regulation.

Lawmakers are wrestling through legislative options in an effort to remake the regulatory system that is being blamed by many for the current recession. While absolutely true that financial sector regulations are out of date and problematic in many ways, the restructuring process could cause even more damage if it’s not done properly.

Some regulation is not necessarily a bad thing, but getting it right takes a lot of work. Broadly speaking, regulation is intended to provide a common set of standards—rules of the game—for market activity and to prevent information asymmetry where a few people have significantly better information than the average investor. Regulations must govern against harmful business practices, but shouldn’t overburden the wealth creation process.

The free market critique of many regulations is that they usually result in a host of unintended consequences, creating perverse incentives that distort decision-making, and unnecessarily restrict business activity. The mark-to-market regulations that rigidly priced assets below their long-term values during the meltdown last fall are a perfect example of a well-intended but harmful regulation practice.

Mark-to-market laws were intended to prevent fraud by creating a standard accounting method for determining the value of financial assets. However, these regulations forced assets that temporarily lost value in September to be priced below what their long-term worth really was. This in turn destroyed bank balance sheets and was the direct cause of firms such as Lehman Brothers and Washington Mutual failing.

In order to avoid similar unintended consequences, there are three things the White House, Federal Reserve, Congress and others should bear in mind as they lay the groundwork for updating the financial regulatory system.

First, regulators should make sure they are identifying and addressing the root problems. Consider the complaints about short selling. This practice, essentially betting that a company is going to do poorly instead of betting that they will do well, has been cited as a cause for many major stock collapses. The theory is that if several people start betting against a particular stock, this can cause a panic, leading to a massive selloff of that stock. In such a case, the short sellers make money, and the firm loses capital.

The question is, should regulators ban or limit short selling in the regulatory overhaul? The reality is that short selling serves a good purpose. Massive short selling of a stock may accurately signal a problem with the firm. It would be foolish to regulate this knowledge sharing process out of the system.

Some believe that traders who short sell stocks spread false rumors that a firm is doing poorly in order to get people to sell the stock. But when this happens it is an exception, not a systemic problem.

“The ban on short-selling may prolong the crisis in the sense that it will now take the markets longer to adjust to the true values of financial companies,” Adam Reed, a finance professor at the University of North Carolina at Chapel Hill, told The New York Times.

Second, when redesigning regulations to avoid future cascading meltdowns, lawmakers should design laws that require firms to be responsible for their market activity. In simple terms: require companies to have some skin in the game. One problem that developed over the past several years is that companies on Wall Street began to act as if they had some implicit safety net. Capital reserve ratios swung heavily towards debt—banks were leveraged as much as 30 to 1—leaving many scrambling when asset values rapidly dropped.

This might mean revisiting capital reserve requirements, but it absolutely means the government should clarify its position relative to these firms. The Fed, FDIC, Treasury, and rest of the government should explicitly state that they will not be responsible for future failures, and that companies should keep this in mind when making investments.

The costly failures of Fannie Mae and Freddie Mac are examples of what happens when government-sponsored entities, or any large firms, believe they can draw on taxpayer funds as an investment safety net.

If a company does not have the capacity to orderly enter bankruptcy proceedings at any given moment, then they must be depending on something else, like taxpayers, to save them—or they are defrauding their investors.

Third, the government should ensure that its newly adjusted regulatory system does not restrict entrepreneurial activity.

The Group of Thirty, an influential group of financial leaders and academics, released a financial overhaul plan with 18 recommendations in January. Chaired by former Federal Reserve chairman Paul Volker, the plan recommends restricting banks from engaging in investment activity, thereby dividing up deposit bearing institutions and private-equity firms. Such a move would virtually reinstate the Glass-Steagall Act regulations that kept commercial and investment banks separate for nearly 70 years.

The repeal of Glass-Steagall in 1999 created an era of unprecedented growth in the financial sector. It allowed for the emergence of firms like Bank of America and Citigroup. But those banks overleveraged themselves and have now fallen. The problem was not that successful banks were too mixed up with investing; they simply failed to adequately manage their risk. And instead of being punished by the market, they are being bailed out by taxpayers.

Under current law, banks can leverage deposits into investments, providing capital to business ventures. Restricting commercial banks from engaging in this investment activity would dramatically reduce the flow of capital to private equity and limit entrepreneurial activity.

Better regulation would concentrate on setting reserve requirements for big firms so that they are not allowed to become “too big to fail.”

The reality is that economic analysts and financial experts are fallible, whether they work on Capitol Hill or in the Financial District. Imagine if after the Dot-Com bubble burst there had been a national movement to overhaul the financial sector’s regulations. The very same people we now demonize for their actions over the past few years would have been the people we asked to fix everything.

Simply put, lawmakers won’t be perfect in redesigning the regulatory system. While this doesn’t mean we shouldn’t try to fix regulatory problems, it does mean that we should recognize the limits of our ability to solve every problem and not excessively regulate, restrict, and handcuff the market.

Anthony Randazzo is a policy analyst at Reason Foundation.

Fear Is the Economy's Biggest Problem Right Now

anthony.randazzo@reason.org (Anthony Randazzo) — Fri, 06 Mar 2009 00:01:00 EST

The most cancerous aspect of the economic crisis today is not toxic debt, the credit crunch, or even the terribly misguided government bailouts. The most deadly challenge we face right now is fear.

As of this writing, the Dow is below 7,000. There is serious talk of nationalizing the banks. And Warren Buffett is telling the country our economy is in shambles. People understandably get scared facing such dread—but no one should panic.

Panics are never good and rarely warranted. It was the Panic of 1929 that sank the Depression-era banks. It was the post-9/11 panic that another terrorist attack was imminent that allowed the privacy-stripping Patriot Act to breeze through Congress. And it's the apocalyptic language surrounding the current economic crisis that is contributing to our deepening recession.

At this point, the depth of the recession has largely been created by the panic started by former Treasury Secretary Henry Paulson and President George W. Bush. "If money isn't loosened up, this sucker could go down," President Bush said about the economy as he urged for bailouts last September.

Dire warnings of "catastrophe” or "before its too late” without any clear definition of what those concepts really mean are similar to, and no less troubling than, Mafioso scare tactics. It is this fear that has been driving the government to quick, impulsive action that is only worsening the problem.

Clearly fear and panic didn't start the recession. There were system-wide failures due to a toxic combination of excessive growth optimism, a belief the boom would go on forever, a lack of healthy fear of losses, incompetency, and coercive regulations. But as Fidelity Investments executive Edward Johnson said this week, "We can only hope that the government's cure doesn't further sicken the patient.”

Looking back, most legislators regret passing their first cure - the Troubled Asset Relief Program (TARP) bill - as fast as they did. There wasn't a clear and present danger at the time—just Secretary Paulson saying if we didn't give him unlimited powers the sky would fall in and economy would collapse. No one understood what Paulson's forecasts of catastrophe would result in, but they didn't want to find out. Terrified, 'doing nothing' was not presented as an option and $700 billion was approved to buy up toxic debt.

Ironically, after a month of discussion the Treasury decided that buying troubled assets wouldn't work after all and decided to go with capital injections instead. But this all took place many weeks after TARP was passed, and the world hadn't ended. So much for the need for speed that was used to push the bailout through.

The same language has since been used, again and again, to push through the stimulus and other government actions. President Obama, officials and pundits keep saying that if we don't act now it will be too late for America—but it is completely ambiguous as to what that warning means. Do banks that failed to protect their customers and investors go out of business? Do investors who bought houses in California or Las Vegas thinking they could flip the homes for big profits end up taking big losses on the properties? Does unemployment go from today's 10 percent in California to 20 or 30 percent? What exactly happens?

The fear and panic has killed investor and consumer market confidence. And confidence is critical for economic stability. When fear sets in people stop consuming, they stop investing, banks stop lending, capital dries up, and growth subsides. America was already in a recession, yes, but the scare tactics of the Obama and Bush administrations have kept the market destabilized longer than it would have been.

"A failure to act, and act now, will turn crisis into a catastrophe and guarantee a longer recession, a less robust recovery, and a more uncertain future," President Obama warned in February.

Pushing major policies on unfounded claims is not the way to govern, even during this steep economic downturn. Historical data offers us many avenues of action (and non-action) that we can consult to give us a good idea about the likely impacts of most fiscal policies.

The economy would not be in the shape it is now, with a Dow cut in half and banks sitting on their capital, if the recession had been allowed to clear misallocated resources, bad management, and general kinks in the market.

Lehman's bankruptcy has actually created thousands of jobs as its assets are being liquidated in the market process. In contrast, bailed out AIG is just sucking down more tax dollars.

Letting AIG go bust, or letting Citigroup fail, surely would have hurt the market to a degree, but their stocks have plunged anyway. More than likely a few spectacular failures would have forced the banks to make the necessary choices to survive, however uncomfortable, and we would be experiencing some degree of stability today. Instead government's activities have created a moral hazard issue as all firms are focused on positioning themselves according to what Uncle Sam says.

From Wall Street to Main Street, everyone is waiting for the government's next move so it can act accordingly. Private equity is largely being hoarded because the market landscape is cluttered with bureaucrats. Why invest in any industry if the government might undermine you by bailing out a competitor or through nationalization? The fear of that is part of what is keeping credit frozen.

Unfortunately, Washington is not the only party guilty of unwarranted claims of doom. Libertarians and fiscal conservatives have frequently used words like communism and socialism when describing government activity to evoke images of the USSR satellite nations rusting into oblivion by their ultra-planned societies. Clearly the stimulus package will not turn America into East Germany. Nor will the trillions we've spent doom us to the Soviet fate without recourse. Capitalists, conservative pundits, libertarians, and the occasional Blue Dog should avoid the trap of apocalyptic propaganda messaging because it carries the same false, fear-mongering tone as the arguments we so harshly criticize.

That said, the White House and Congress need to change the way they are dealing with the financial crisis. Pushing costly taxpayer-funded bailouts in hopes of gaining a little bit of short-term stability is only propping up the problems. Market stability will not return unless investor and consumer confidence return. And confidence will not return until the fear subsides.

Anthony Randazzo is a policy analyst at Reason Foundation.

Avoiding an American Lost Decade

Fri, 20 Feb 2009 00:00:00 EST

The current economic uncertainty in the United States, and the government’s response to it, is eerily similar to that of Japan’s “Lost Decade” according to a new Reason Foundation report.

The study finds that Japan’s housing prices rose by 51 percent and commercial real estate values rose 80 percent between 1985 and 1991. In the U.S., commercial real estate and housing prices both skyrocketed 90 percent from 2000 to 2006.

The Nikkei, Japan's stock index, fell from 38,975 in 1989 to just 18,934 by the end of 1999. During the continuing economic malaise, it dropped even further to 7,603 in 2003. The Dow Jones Industrial Average hit 14,115 in October 2007. On February 19, 2009, the Dow closed at 7,465, its lowest finish since 2002.

President Barack Obama recently signed a $787 stimulus package that includes over $60 billion for infrastructure and transportation projects. Japan passed 10 stimulus packages in the 1990s that would equal $1.4 trillion in today’s dollars. From 1992 to 1999, Japan spent over $500 billion (in today’s dollars) on public works projects. Despite this infrastructure spending, Japan’s unemployment rate more than doubled and the economy remained stagnant.

The Benefits of Tax Cuts and Alternatives to Stimulus Spending

anthony.randazzo@reason.org (Anthony Randazzo) — Wed, 04 Feb 2009 00:00:00 EST

What if someone told you the key to physical health was gorging on fatty foods and lounging on the couch all day? You'd probably write them off faster than if Bernie Madoff asked for a second chance at investing your money.

Why then should taxpayers accept a gorge and spend-like-crazy plan when it comes to the country's economic health?

The road out of this recession is one that creates sustained economic growth, not short-term spending increases. It's the difference between eating healthy with daily exercise and drinking a Red Bull: one offers a lifetime of benefits, the other causes a burst of energy and then a crash.

A healthy recovery plan consists primarily of tax cuts, with a mix of reduced barriers to investment, appropriate regulation, and the right monetary policy. But just like the value of exercise would be negated by poor eating habits, you can't cut taxes and spend too. Fiscal stimulus might be politically advantageous, but a sweeping array of tax cuts, targeted to reach all sectors of the market, would do far more to restore the economy to long-term health.

The myth that stimulus spending works is based on the theory that increased demand for products, encouraged by government spending, will promote increased production and thus spur economic growth. Yet, stimulus spending misdirects resources, fails to increase aggregate consumption, only creates temporary jobs, and adds to the national debt.

Harvard economics professor Gregory Mankiw, who served as chairman of President George W. Bush's Council of Economic Advisers, offers the following example: if you hire your neighbor for $100 to dig a hole in your backyard, and he hires you to do the same in his yard, then government statisticians will report that the economy has created two jobs and increased GDP by $200. But it is unlikely that, having wasted all that time digging, anyone is really better off.

President Barack Obama's aides have said the new administration is only interested in ideas that can be historically and empirically proven to work. Well, the historical and empirical data proves that the fastest way out of economic downturns is letting individuals and businesses keep more of their money, creating more incentives to produce.

The U.S. economy stagnated during the 1970s but was revived from its intense inflation, unemployment, and recession by the pro-growth policies of the Reagan era, not stimulus spending. Tax cuts and appropriate monetary policy improved the economy after spending increases under former Presidents Ford and Carter had failed.

More recently, when the economy was struggling post-9/11, President George W. Bush proposed rate reductions in capital gains and dividends to encourage business growth. The tax cuts took effect immediately and within a few months the economy began to see recovery. Unemployment declined steadily and the economy grew by an average of 4 percent through 2006. Unfortunately, President Bush also spent more than any previous administration and endorsed coercive housing and regulatory policies that attributed to the housing bubbles creation and collapse, which sent the economy into a tailspin. As beneficial as tax cuts are on the one hand, the government can shoot itself in the foot by trying to dictate economic activity with the other hand.

Compare that to the New Deal response to the Great Depression. Intense government control of prices, massive spending on inconsequential public works projects, and heavy regulation of industry kept the economy pinned down. Unemployment grew year after year, despite the holes that the government had people digging and refilling.

According to a recent University of California, San Diego study, government spending is only likely to increase gross domestic product (GDP) $1.4 dollars for every dollar spent. Conversely, a recent study by Christina Romer, chairwoman of President Obama's Council of Economic Advisors, found that tax cuts are likely to raise GDP by $3 for every dollar spent.

The Senate, now debating how much of the proposed stimulus package should go to spending projects and how much should be tax cuts, should consider several options that would promote a healthy economic lifestyle and not just offer the short-term value of energy drinks:

1. An across the board tax cut on both income and business taxes

The House Republican Study Committee has suggested an alternative to the "Making Work Pay" tax credit: reducing the lowest individual tax rates 5% across the board would create an average savings of $500 for those in the 10% tax bracket and nearly $1200 for those in the 15% tax bracket.

The South Korean government has chosen tax cuts to ignite its economy, cutting virtually all tax rates by 2%. A similar action by the U.S. would help individuals and businesses.

2. Cut FICA payroll taxes

An alternative to a broad income tax cut would be cutting FICA taxes, the bulk of the payroll tax, which would help employees and employers. Reducing FICA taxes from 12.4 percent to 6 percent would reduce both the employee paid tax and the employer match by 3.2 percent, increasing take-home pay and leaving companies more money to create jobs or reinvest in production. Cutting payroll taxes also circumvents government bureaucracy because the IRS doesn't have to process income tax adjustments or issue credit checks.

There are downsides to the FICA cut however. Social Security is already in financial trouble, and cutting its revenue stream would require a complete revamping of the social safety net system (a good, though complicated thing to do).

3. Special tax cuts for small businesses

Since small businesses, defined as those employing fewer than 500 people, employ nearly half of all working Americans, reducing their tax obligations would allow them more money for capital investment and new hires. In 2005, small businesses created 78.9 percent of all new jobs in America. House Republicans have suggested allowing small businesses to take a tax deduction equal to 20 percent of their income.

4. Reducing corporate taxes to be globally competitive

Cutting the top corporate tax rate from 35 percent to 25 percent or lower would put the United States on par with the European Union when it comes to tax levels. Europe has been cutting business and capital gains taxes for years to our comparative disadvantage. Ireland has slashed their corporate taxes in half to 12 percent, Austria is at 20 percent, and England is at 28 percent. Among industrialized nations, only Japan has higher business taxes than the United States. To attract more business capital, the American tax code must be competitive with the rest of the world.

5. A tax holiday on all Wall Street investment returns

The federal government could waive taxes on future earnings from investments in stocks, commodities, etc., if they were made between now and any particular end date. A tax holiday of this kind could be structured in different ways, but the outcome would be restoring some confidence and vigor in investment prospects, thawing more credit and letting the market restore itself. Capital gain taxes could also be temporarily or permanently reduced in tandem with this holiday.

6. Tax cuts on anything related to infrastructure investment

If infrastructure investment is critical for America's future, the government should encourage private investment in roads, bridges and schools. The government could waive or reduce taxes on profits made from private equity that is put into building roads, bridges, broadband access and schools. Companies that are hired to do the infrastructure work could also be allowed to operate like non-profits: for instance letting construction firms buy materials tax-free. There are billions of private equity dollars waiting to invest in infrastructure. The fewer barriers there are to this type of investment the faster capital markets will thaw.

7. Making it easier to access money in retirement accounts

There are currently a lot of fees associated with withdrawing funds from tax-sheltered 401(k)s and other retirement accounts. Allowing people to manage their own finances and have access to all of their money in a recession is critical to building consumer confidence. Letting people withdraw money from retirement accounts - tax and penalty free for a year - would be a good way to boost consumer confidence.

There are other ideas on the table too, such as permanently repealing the alternative minimum tax and encouraging infrastructure investment through the expansion of private activity bonds. Rationalizing financial sector regulations such as mark-to-market capital requirements and exclusivity rights in bankruptcy proceedings would not only increase stability, and thus confidence in the current market, but it would protect against future troubles.

Tax cuts will not bring immediate improvement. However, if appropriately used, they will help the economy much faster than stimulus by paving the way for long-term, sustained growth.