Of Horses, Barns and Carts and Financial Regulations

Now that Congress and the President have signed the abomination known as the financial rescue, bailout or what ever the term du jour is, Congress if finally starting to inquire in to what has actually happened. Now, aside from the oddity of now concentrating on the causes of a problem after the solution has been passed into law, there is a growing belief that deregulation is the cause, or at least a leading cause of the finanical crunch. Sebastian Mallaby has a different take on the root causes of the financial moreass. It is not just the subprime mortgage market collapse, but something entirely different---China.

The real roots of the crisis lie in a flawed response to China. Starting in the 1990s, the flood of cheap products from China kept global inflation low, allowing central banks to operate relatively loose monetary policies. But the flip side of China's export surplus was that China had a capital surplus, too. Chinese savings sloshed into asset markets 'round the world, driving up the price of everything from Florida condos to Latin American stocks.

That gave central bankers a choice: Should they carry on targeting regular consumer inflation, which Chinese exports had pushed down, or should they restrain asset inflation, which Chinese savings had pushed upward? Alan Greenspan's Fed chose to stand aside as asset prices rose; it preferred to deal with bubbles after they popped by cutting interest rates rather than by preventing those bubbles from inflating. After the dot-com bubble, this clean-up-later policy worked fine. With the real estate bubble, it has proved disastrous.

So the first cause of the crisis lies with the Fed, not with deregulation. If too much money was lent and borrowed, it was because Chinese savings made capital cheap and the Fed was not aggressive enough in hiking interest rates to counteract that. Moreover, the Fed's track record of cutting interest rates to clear up previous bubbles had created a seductive one-way bet. Financial engineers built huge mountains of debt partly because they expected to profit in good times -- and then be rescued by the Fed when they got into trouble.

Why would financiers believe they would be bailed out--well in large part because they believed and rightly as it turned out, that these financial institutions were too large and comprised too large a segment of the American economy for the govnernment to simply stand aside as they tanked. So the finance community deserves a lion's share of the blame for the current debacle, but the shambolic nature of the government response to the growing housing bubble and the shaky understructure is now being used by the Obama camp and the Democratic Congress to attack the notion of a Bush-McCain deregulation. Never mind that the morass may have been caused by a Democratic push to expand homeownership and the requirement that mortgage lenders ignore basic credit and lending principals or face stiff penalties.

Of course, the financiers did create those piles of debt, and they certainly deserve some blame for today's crisis. But was the financiers' miscalculation caused by deregulation? Not really.

The key financiers in this game were not the mortgage lenders, the ratings agencies or the investment banks that created those now infamous mortgage securities. In different ways, these players were all peddling financial snake oil, but as Columbia University's Charles Calomiris observes, there will always be snake-oil salesmen. Rather, the key financiers were the ones who bought the toxic mortgage products. If they hadn't been willing to buy snake oil, nobody would have been peddling it.

Who were the purchasers? They were by no means unregulated. U.S. investment banks, regulated by the Securities and Exchange Commission, bought piles of toxic waste. U.S. commercial banks, regulated by several agencies, including the Fed, also devoured large quantities. European banks, which faced a different and supposedly more up-to-date supervisory scheme, turn out to have been just as rash. By contrast, lightly regulated hedge funds resisted buying toxic waste for the most part -- though they are now vulnerable to the broader credit crunch because they operate with borrowed money.

If that doesn't convince you that deregulation is the wrong scapegoat, consider this: The appetite for toxic mortgages was fueled by Fannie Mae and Freddie Mac, the super-regulated housing finance companies. Calomiris calculates that Fannie and Freddie bought more than a third of the $3 trillion in junk mortgages created during the bubble and that they did so because heavy government oversight obliged them to push money toward marginal home purchasers. There's a vigorous argument about whether Calomiris's number is too high. But everyone concedes that Fannie and Freddie poured fuel on the fire to the tune of hundreds of billions of dollars.

Mallaby seems to be making the case, by comparing the lightly regualted hedge funds with the more heavily regulated investment banks and others, that the problem was not a lack of regulation, but a plethora of it. Fannie and Freddie were heavily regulated, with probably dozens of Congressional committees and alledged involved investors providing oversight for their actions. But as long as investors were making money--they didn't care and as long as Fannie and Freddie were pushing loans to less than fully qualified individuals, and funnelling large amounts of campaign contributions to favored members of Congress to sweep the problems under the rug, Congress really didn't step in.

Rather than deregulation being the cause, perhaps it is the presence of so much regulation that gave these investment banks, Freddie and Fannie and other institutions such comfort that they would never be held responsible for their failure to use a little common sense and business judgment. It doesn't take a genius to know that the housing bubble, like all other bubbles, was doomed to burst--it was only a matter of time.

So blaming deregulation for the financial mess is misguided. But it is dangerous, too, because one of the big challenges for the next president will be to defend markets against the inevitable backlash that follows this crisis. Even before finance went haywire, the Doha trade negotiations had collapsed; wage stagnation for middle-class Americans had raised legitimate questions about whom the market system served; and the food-price spike had driven many emerging economies to give up on global agricultural markets as a source of food security. Coming on top of all these challenges, the financial turmoil is bound to intensify skepticism about markets. Framing the mess as the product of deregulation will make the backlash nastier.

The next president will have to make some subtle choices. In certain areas, markets need to be reformed -- by pushing murky "over-the-counter" trades between banks onto transparent exchanges, for example. In other areas, government needs to fix itself -- by not subsidizing reckless mortgage lending. But a president who has a mandate only to reregulate will be a boxer with a missing glove. By going along with the market skepticism of his party, Obama may end up winning an election while compromising his presidency.

If Obama is elected, and with a Democratic Congress (no matter how ineffective they may be) the push for regulation is sure to come. But as Mallaby suggested, government needs to take a good long look in the mirror before embarking upon a new plan for "re-regulating" an already regulated industry.

Yes there are legitimate questions related to how the markets have operated and those should be explored. But it seems rash in the extreme to pass a solution to a problem that few people have really explored in depth, particularly those policy and lawmakers responsible for the already passed solution.