New Directions in Financial Services Regulation. Edited by Roger B. Porter, Robert R. Glauber, and Thomas J. Healey. The MIT Press 2011, pp. 227, $35.00
What caused the financial crisis of 2008? Three years after the American financial system teetered on the brink of collapse, analysts and pundits have proffered differing theories as to how and why the United States just barely avoided a second Great Depression. Fannie Mae and Freddie Mac, the Federal Reserve, and too-big-to-fail, highly leveraged banks have all been cited as bad actors. Others have pointed to the Community Reinvestment Act and the federal government’s naive, albeit well intentioned, effort to support homeownership for individuals with poor credit histories. One scholar has – quite convincingly – cited the impact that the Recourse Rule, an amendment to Basel II Accords, had on incentivizing banks to load up on mortgage-backed securities.
There is little doubt that the multiple causes of the financial crisis of 2008 will be debated for years to come. In fifty years, there will almost certainly be historians who will present conference papers debating the issues that constitute our contemporary history. That said, sometimes those closest to an historical event can provide extremely useful insights as to what precipitated the occurrence in question. On October 15 and 16, 2009, a group of experts gathered at Harvard University’s Mossovar-Rahmani Center for Business and Government for a conference to debate and to discuss the recent financial crisis. New Directions in Financial Services Regulation, edited by two Harvard faculty members and by a Senior Fellow at the Kennedy School, is the result of that conference. The book is divided into roughly three parts; the origins of the crisis, appropriate regulatory modifications, and implementing a fitting regulatory structure. The collection concludes with the text of a keynote speech delivered by Paul Volcker, the former chairman of the Federal Reserve best known for his unyielding – and successful – effort to curtail inflation during the early years of the Reagan Administration.
Although the work as a whole is highly recommended for those interested in exposure to myriad takes on the financial crisis, three essays stand out as particularly thought provoking. In “Origins and Policy Implications of the Crisis,” John B. Taylor contends that his empirical approach to the financial crisis leads to the implication that “the federal government’s actions and interventions caused, prolonged, and worsened the financial crisis.” Taylor, who is a professor at Stanford and was Under Secretary of the Treasury for International Affairs in the George W. Bush Administration, puts the blame on the government rather than on the markets. He points to the role played by counterparty risk in the summer of 2007, when interest-rate spreads shot up precipitously. One wishes, however, that he had provided slightly more data and analysis explaining why counterparty risk was the culprit in the unusual interest-rate spreads in the money markets.
Taylor’s main argument is that the federal government failed in its response to the crisis. The government, in his view, failed to articulate a “clear and balanced plan.” Furthermore, he states that, “we have convincing evidence that interventionist government policies have done harm. The crisis did not occur because economy theory went wrong; rather, it occurred because policy went wrong, because policy makers stopped paying attention to sound economic principles.” Given his diagnosis of the problem, it is not surprising that his policy prescription would focus “on proposals to stop systemically risky government actions.” Taylor writes positively of new legislation that would ensure that a more accountable and transparent Federal Reserve focused “on the instruments of monetary policy.” At a more general level, he advocates, “government should set clear rules, stop changing them during the game, and enforce them” and correctly posits that, “the rule of law is essential.” Indeed, it can be argued that although government bailouts may have been necessary to prevent a wider economic collapse, they (the auto bailouts, in particular) may have also damaged the rule of law.
In “Underlying Causes of the Financial Crisis of 2008-2009,” Judge Richard A. Posner, of the Seventh Circuit Court of Appeals, argues that “[t]he financial crisis was at root a failure of monetary policy.” He makes the case that low interest rates helped precipitate a housing bubble; however, he specifically does not place the blame on bankers and homebuyers for the banking sector’s collapse. Posner contends that compensation practices, the derivatives market, structured finance, and the GSEs (government-sponsored enterprises) were secondary factors. Significantly, his discussion of how changes in the federal funds rate affect other interest rates merits close attention. What makes Posner’s somewhat lengthy essay stand out is his discussion of the collapse of the commercial paper market. Far too few commentators have devoted adequate attention to this very important component within the broader narrative of the financial crisis; sadly, many would-be experts on the crisis probably have little notion as to what commercial paper actually is. Many readers would disagree with Posner’s bold contention that the government’s failure to save Lehman Brothers was, in his words, “a critical error.” That said, even skeptics of government bailouts would be well advised to read his contribution to New Directions in Financial Services Regulation.
David A. Moss, in “An Ounce of Prevention: Financial Regulation, Moral Hazard, and the End of ‘Too Big to Fail’,” makes the case that deregulation and a crisis of too-big-to-fail institutions are to blame. Moss, a professor at Harvard Business School, cites the moral hazard problem heightened by implicit federal guarantees of systemically important financial institutions. His preferred solution to a clearly articulated problem, however, is not one that all free market advocates would accept as reasonable. While he rightly acknowledges the problem of regulatory capture, Moss nevertheless advocates the creation of a new regulatory agency, a Systemic Risk Review Board. It is not clear, however, why a new agency would succeed where others have clearly failed. Nevertheless, he is correct to note that “implicit guarantees don’t disappear on their own and cannot be ignored or denied into oblivion.” This point is particularly salient, one that policymakers in federal agencies and those on the Hill should take seriously.
In conclusion, Taylor, Posner, and Moss each provide thoughtful, highly readable commentaries on the recent financial crisis, of which yet much remains to be written. Indeed, it is unlikely that there will be a general consensus any time soon as to what caused the meltdown of the financial sector in 2008. This is not necessarily a bad thing. Furthermore, it appears that, as of this writing, the United States is facing a new type of financial crisis. This time the crisis stems from sovereign debt and a huge deficit, rather than from the banking sector, per se. Much will be written on this topic in the years ahead. Those interested in banking crisis of the past few years, however, would benefit from a close read of the essays in New Directions in Financial Services. For individuals unfamiliar with the commercial paper market, Posner’s essay is particularly illuminating.
Jon Lewis (c) 2011
