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Allan Meltzer Cautions against over-regulation

Regulatory Overkill
March 27, 2008; Page A14, Wall Street Journal

The claim that deregulation went too far is coming from many sides. We need more regulation, the argument goes, and even a single regulator to bring stability. Former SEC chairman, Arthur Levitt, Jr., made some of that case on this page. House Financial Services Chairman Barney Frank has prepared legislation, and others are rushing forward with their own plans.

Their diagnosis is wrong. Mistaken regulation contributed greatly to the current problems in financial markets. Take the 1970s Basel agreement between developed country governments, which followed bank failures in Germany and the U.S. The idea was to have equivalent risk standards in all the principal lending countries. The agreement required banks to increase their capital if they increased mortgage loans and other risky assets.

The banks responded, however, by developing instruments that avoided higher reserves by moving risky loans off their balance sheets. Risk moved to all corners of the global marketplace. We find out who holds the risky assets when they announce they are about to fail.

The response to the Basel regulation is not unique. The first principle of regulation is: Lawyers and politicians write rules; and markets develop ways to circumvent these rules without violating them.

The financial markets offer many examples. In the 1970s, Federal Reserve Regulation Q restricted the interest rate that banks and thrifts could pay depositors. In response, the market developed money market funds that circumvented the regulation. In the late 1980s, the government set up the Resolution Trust Corporation to buy the mortgages held by failed thrifts. The result: Most of the thrift industry was eliminated and the taxpayers ended up taking a loss of about $150 billion in the early '90s.

The perennial argument of regulators is: "If only I had more power. . ." Not so. Regulators did not see the chicanery at Enron. Nor did they prevent the dot-com bubble or the Latin American debt problems in the 1980s. A main reason is "capture" -- when the interests of the regulated dominate the interests of the public.

Capture is not the only reason regulation often fails. Regulators and most politicians are good at developing rules and restrictions, but poor at thinking about the incentives that the market will face. If the incentives are strong, the market circumvents the regulation. The Basel regulation encouraged a system that is far less transparent than the system it replaced.

Anyone can see where increased regulation leads. The Bush administration abandoned its commitment to rein in the government sponsored enterprises. Instead it increased lending by Fannie and Freddie. This moves risky loans from the financial market to the taxpayers. The Federal Reserve agreed to take $30 billion of risky assets. If defaults occur, the Fed will reduce its annual transfer to the Treasury.

Mr. Frank and Senate Banking Committee Chairman Christopher Dodd are planning more schemes to move the risk to the taxpayers from those who made bad decisions, such as buying mortgages that are now in default. As a result, ordinary citizens will ask themselves: Why should I pay my mortgage if my neighbors can get theirs reduced? These proposals have stark long-term consequences. The financial system cannot survive if the bankers make the profits and the taxpayers take the losses.

The government has a responsibility to prevent systemic crises and financial collapse. Long ago that job was given to the Federal Reserve. It serves as lender of last resort to the market. Today, the Fed should not rescue individual firms, but it must keep the payments system from failing. To carry out that responsibility, the Fed has auctioned reserves and exchanged marketable Treasury bills for illiquid mortgages, and it has succeeded so far. Now, it must stop responding to calls for lower interest rates.

If the government underwrites all the risks, call it socialism. If it underwrites only the failures, call it foolishness.

Mr. Meltzer is a professor of political economy at Carnegie Mellon University, a visiting scholar at the American Enterprise Institute, and the author of "A History of the Federal Reserve" (University of Chicago Press).

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