Financial Reform(ation?)

Anyone with a pulse and access to a newspaper over the past year and a half should not be surprised that the political cause du jour is financial market regulation. The housing crisis and unemployment numbers alone have provided more than enough fuel to feed the reform fire. Democrats who hold majorities in both houses and sit behind the Presidential desk have provided the gasoline. However, like so many other reactionary movements in US history, financial reform is looking more a complete reformation of the financial system based on a populist overreaction rather than an attempt to fix the root causes of the crisis. By way of analogy, it is almost as if prettier flowers are being planted in an unmanaged garden without killing the roots of the weeds. The neighbors will certainly be happier to see the more colorful inhabitants of the flower bed, but within a season or so, the dandelions and ragweed will undoubtedly have returned to choke out the usurpers.

Though there were certainly many factors which played into the current economic malaise, most economists and market observers agree that an overhot housing market stimulated by overextension of loans was the main problem. In this light, it might be surprising to hear that there are no provisions regarding mortgage underwriting in the financial reform legislation the Senate is currently working on. This may be a small oversight, and it is something that might be fixed via amendment. However, the lack of legislation addressing the commonly agreed source of the current troubles is conspicuous by its absence, leaving a nagging question begging; are the powers that be more concerned with fixing the financial system or in reshaping a scapegoated banking sector to appeal to a scorned public? It appears more and more that the answer can be found in the latter half of the question.

This is because much of the proposed legislation seems to center on a thinly-veiled return to the Glass-Steagall banking regime. For financial history novices, this would mean splitting up the investment and commercial operations of banks. This idea is not without merit, and it certainly has appeal to those who are upset that a bank should be doing something so louche as make money in a recession (See Sachs, Goldman). Above all, it would go some way toward solving the 'too big to fail' problem that has been introduced to the system. In other words, the government would not have to step in to save a bank in the future whose collapse would otherwise cause a shock to the system. However, the government caused this problem in the first place when it interfered with the system and used certain banks as tools to put its vision into place during the crisis. For example, it worked closely with banks on a number of occasions to buy assets of others, 'gently' pushed others into changing their structures to facilitate liquidity in the system and ultimately played the hero as an anti-Schumpeterian financial system EMT. Though some of these measure were laudable at the time, it appears more and more that they may have been the first move in a wider game of financial reformation chess.

The current posturing is also curious because there are much less intrusive yet equally effective ways to reduce the concerns of regulators. For example , legislators could introduce stronger controls between the two sides of banking houses and eliminate the ability of banks to insure and receive emergency funds in relation to investment banking and trading operations. This would put safeguards on the system while allowing banks to continue taking risks for shareholders, providing liquidity and acting as counterparties in the trading system. However, recent Congressional hearings involving current whipping boy Goldman Sachs both made it clear that those in power have a poor understanding of how these operations work, and underscore the political gamesmanship that is now omnipresent.

Like death and taxes, financial system reform became inevitable somewhere in between the firesale of Bear Stearns and the collapse of Lehman Brothers. However, what is happening in the halls of Congress right now looks very much like a reformation in the most destructive sense of the word aimed at satisfying populist bloodlust rather than a reform solution with a logical link to the problems it is looking to solve. Interestingly, the changes Congress is looking to make have no more relation to the problems they are attempting to solve than housing prices did to their underlying values in 2007. This risks both damaging the system in the short term and leaving it on shaky legs in the long. Unfortunately, it seems that the lessons of history are often lost upon those best placed to learn them.