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Surprise: Democrats offer more government intervention in place of needed financial reforms

In this morning's Wall Street Journal, John Taylor, an economics professor at Stanford University, writes about the massive 2,319 page financial reform bill which is currently working its way through Congress.  The complexity of the legislation is but one of its many problems.  Taylor writes:

The main problem with the bill is that it is based on a misdiagnosis of the causes of the financial crisis, which is not surprising since the bill was rolled out before the congressionally mandated Financial Crisis Inquiry Commission finished its diagnosis.

Taylor asserts that the biggest mistake that the bill makes is that it presumes that the government did not have enough power to avoid the financial crisis.  Listing several examples, he points out that it actually did possess the tools needed to avoid economic disaster:

  • The Federal Reserve had the power to avoid the monetary excesses that accelerated the housing boom that went bust in 2007.

  • The New York Fed had the power to stop Citigroup's questionable lending and trading decisions and, with hundreds of regulators on the premises of such large banks, should have had the information to do so.

  • The Securities and Exchange Commission (SEC) could have insisted on reasonable liquidity rules to prevent investment banks from relying so much on short-term borrowing through repurchase agreements to fund long-term investments.

  • The Treasury working with the Fed had the power to intervene with troubled financial firms, and in fact used this power in a highly discretionary way to create an on-again off-again bailout policy that spooked the markets and led to the panic in the fall of 2008.

Instead of trying to improve upon existing government regulations, the bill vastly increases the size and scope of the federal government in ways that have no relation to the recent crisis.  Such new regulations, Taylor asserts, may even lead to future crises.

He goes on to list some of the bill's "false remedies":

  • The new resolution, or "orderly liquidation," authority in which the Federal Deposit Insurance Corporation (FDIC) can intervene between any complex financial institution and its creditors in any way it wants to.  This will effectively institutionalizes the harmful bailout process by giving the government more discretionary power to intervene which will continue the problem of "too big to fail."

  • The new Bureau of Consumer Financial Protection housed at, and financed by, the Fed.  This new bureau will write rules for every type of financial service, most of which (such as payday loans) have no conceivable connection with the crisis.

  • The new Office of Financial Research at the Treasury that will look into systemic risk.  This new bureaucracy is tasked with doing the same job that the Fed was tasked with leading up to the crisis.  Taylor calls the hope of it doing a better job "unrealistic." 

  • The new regulation for nonfinancial firms that use financial instruments to reduce risks of interest-rate or exchange-rate volatility.  The bill gives the Commodity Futures Trading Corporation (CFTC) authority to place margin requirements, which call for higher collateral on risk-reducing instruments, on such firms even though they had nothing to do with the crisis.

The worst part of the Frank-Dodd financial reform bill, however, is not what it includes but rather what it lacks.  The legislation fails to reform the government sponsored Fannie Mae and Freddie Mac corporations which encouraged the creation of risky mortgages by purchasing them with the support of many in Congress. 

Taylor writes:

Some excuse this omission by saying that it can be handled later. But the purpose of "comprehensive reform" is to balance competing political interests and reach compromise; that will be much harder to do if the Frank-Dodd bill becomes law.

After reviewing all aspects of the Democrats' financial reform bill, it becomes clear that the legislation fails to address the real issues that led to the financial crisis.  Instead, it adds burdensome regulation upon burdensome regulation.  The Frank-Dodd bill will not prevent future crises from occurring.  It will slow economic growth, hinder the workings of the market and may even lead to future financial disasters.