Financial Crisis: Part III – A New Regulatory Framework

One thing that is clear, following the debates last night, is that the candidates are a little sketchy on the precise reforms that are necessary to prevent another crisis. In Part II of this series, I cataloged the damages of the past few months, and proceeded to explain that we need to accept the reality that a large bailout, like it or not, is necessary for our country’s renewed financial health. The candidates, fortunately, seem to accept this reality. However, they seem unsure on exactly what we should do in terms of long-term reform. In this post, the third and hopefully final post on what I think needs to be done to resolve the crisis; I provide a set of suggestions on how we can reform our governance of financial markets to prevent a recurrence of the current situation. As I mentioned in the last post, some of my suggestions take a cue from Dean Baker at CEPR, though I do differ from him in a few areas.

Before I move into the diagnosis, however, here is a brief comment on my take on the candidates’ economic philosophies. From what I heard last night, I think that Senator Obama’s general philosophy coincides with my impression of specific measures that need to be taken, while Senator McCain seems to still oppose additional regulation in favor of finding bureaucrats to use as scapegoats for a crisis that they could not fully prevent. As I explained in Part I of this series, the Republican Congress of 1999 removed key regulations and handicapped regulators in dealing with this crisis. Blaming regulators for not having the tools at their disposals is nothing if not counterproductive. We need to fix the problems, not look for yet another person who we can blame.

Building with Bricks, Instead of Straw

So, exactly what should we do to prevent another catastrophe? Here are five potential reforms that could have a great deal of impact in reducing volatility and the bubble-bust cycle.

First, all forms of traded assets need to be traded on public exchanges regulated by either the Securities Exchange Commission (SEC) or the Commodity Futures Trading Commission (CFTC). Believe it or not, not all of the instruments that are traded happen on these exchanges. Debt swaps, which are a major part of this situation (mortgage packages are debt securities, after all), are traded off of the exchanges. This makes it very difficult for regulators to access reliable information on the volume and volatility of trading.

Second, Fannie Mae and Freddie Mac need to be subject to more stringent oversight, and perhaps should remain renationalized. Their job, after all, is to repackage mortgages to maintain market solvency. They are a market facilitator, not a profit-focused institution, and a focus on short-term profits is a good part of what got us into this mess. At minimum, there should be two conditions: (1) Fannie and Freddie should be limited in size (in terms of the percentage of the mortgage market they are backing), and (2) Restrictions placed on the riskiness of mortgages that are backed by the institutions. Limiting their size ensures they don’t become overburdened and carried along with asset waves, and limiting the riskiness of their investments ensures they remain solvent and prevents Wall Street from gambling with taxpayer money.

Third, we should establish a public administrative body to assess the riskiness of investments, much as Moody’s and Standard and Poor do now. One of the chief problems leading up to the crisis was the incestuous and corrupt nature of the rating organizations. In essence, they were “in cahoots” with the investment bankers. This public organization should work in tandem with the Federal Reserve. In fact, one key measure that could be put in place to add some teeth to the body would be to place a risk premium on the interest rates charged by the Fed, if a bank allows its balance sheet to sour. A declining credit rating could also automatically trigger negotiations and intervention by the Fed. This could operate in much the same way as debt covenants between private corporations and banks do today. A side benefit of this system is that it forces banks to lend more conservatively, which could stem the trend of Americans piling up their debt until they can barely make minimum payments. It could help reinvigorate a culture of saving now and spending later, rather than the opposite trend that has appeared in today’s consumer culture. High domestic savings rates are almost universally accepted as signs of a healthy and sustainable economy.

Fourth, we need to find a way to break into what has been dubbed the “Wall Street-Treasury Complex” by Columbia economist Jagdish Bhagwati. Hank Paulson, for example, was CEO of Goldman Sachs from 1999-2006 – presiding over the height of the bubble – before becoming Secretary of the Treasury. Preventing this is even more important with respect to the Federal Reserve. Federal Reserve members should go through a full appointment process, requiring the “advice and consent of the Senate” (see Article II, Section 2, paragraph 2 of the US Constitution), as is the case for most other federal officials (e.g. Supreme Court Justices). This could be a requirement of a full senate vote (the standard procedure). Another approach that might make sense is the approval of both the Senate Banking and House Financial Services committees (current Chairs: Chris Dodd and Barney Frank), since many congressmen may not understand the “ins and outs” of finance. In either case, there needs to be an approval process by which the duly elected representatives of the American people have a voice.

Fifth, we should implement two targeted and small tax policies that can minimize speculation and volatility, while at the same time taxing those responsible for this mess in the first place – making them pay for most of it, and not the average taxpayer. The first tax would be a tax on financial transactions, valued at less than 1%. This tax has negligible impact on those investors who are buying and holding for a longer time period, but has a significant impact on the profit margins of speculative day-traders. One estimate suggests this tax could bring in $100 billion in extra revenue. The second tax is a parallel measure attached to currency trading (another 1% or lower tax), known as a “Tobin tax” for the economist who came up with the idea. It has the same impact, removing the profit incentive on speculative currency trading and forcing people to buy and hold for longer periods. This helps to prevent the flight of portfolio capital and precipitous currency devaluation. The proceeds of this tax could be diverted to the foreign exchange reserves, allowing for the US to manage our currency more effectively and combat Chinese currency undervaluation. This will be particularly useful as our economic clout diminishes relative to rapidly developing economies (e.g. China, India, Brazil, Russia), and the dollar ceases to be the “standard” currency of international trade.

The list I have outlined above is in no way meant to be exhaustive. I do think that the above measures could have a beneficial impact, stabilizing the global economy and focusing our energies on productive economic activities, rather than speculative finance. As usual, I welcome any comments you all may have.