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Living in the Political Wake of the Bubble

Monday, January 3, 2011

We are repeating history and thus will repeat the mistakes of history; here are four ideas to make sure the future is better than the past.

We are living in the wake of the great 21st-century bubble and its collapse. It is a dominating influence in the financial, economic, and political spheres.

The financial consequences reflect the huge overhang (and hangover) of excess debt. The financial bubble included a vast creation of debt based on asset prices that no longer exist, particularly in the housing market. After the collapse, there was a $7 trillion price correction (or a 30 percent correction), which took U.S. average house prices back to their long-term trend line. If we continue along the trend line, we will reach 2006 peak prices again in 2020.

While the asset prices have adjusted back to their long-term trend line, debt has only partially adjusted. Here is Pollock’s Law of Finance: when debt cannot be paid, it will default. Additionally, the collapse of the housing market has turned the Federal Reserve into the largest savings and loan in the world, owning $1 trillion in mortgages, all funded short. The Fed, as manager of the Banking Club, is also depressing short-term interest rates so banks can gradually work their way through their loan losses.

The bust slowed economic activity overall, of course. It has now resulted in a bimodal credit market: bond markets are booming, but the banking system is clogged, reflecting procyclical banking and regulatory behavior.

On the whole, the real role of the committee may end up being just for show, to prove that the government is Doing Something, without doing much.

The political aftermath of the bubble is a wholly predictable repeat of history. Following a crisis, there is always a political phase. The political phase involves first finding a way to assign blame and opprobrium, and then to “do something.” After the financial bust in the 1980s, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act in 1989, the Federal Deposit Insurance Corporation Improvement (FDIC) Improvement Act in 1991, and the Federal Housing Enterprises Financial Safety and Soundness Act in 1992. After this, the secretary of the Treasury said, a financial crisis would happen “never again.” A poor prediction.

The Dodd-Frank Act is the latest “do something” proposal—a bill that reorganizes and greatly expands regulatory jurisdiction throughout the financial sector. At the top of this regulatory expansion is the “Financial Stability Oversight Council” (FSOC) established by the Dodd-Frank Act—a cumbersome, very political super-committee whose efforts will likely be spent mainly protecting turf and jurisdiction among its component regulatory bureaucracies.

One of the biggest causes of the bubble and financial crisis was the government itself. How will this highly political body be able to criticize the government? Let us recall the excellent question posed to Federal Reserve Chairman Ben Bernanke by Senator Jim Bunning: “How can you regulate systemic risk when you are the systemic risk?” On the whole, the real role of the committee may end up being for show, to prove that the government is Doing Something, without doing much.

Moreover, the FSOC is unlikely to succeed at correctly forecasting and preventing crises. There is no evidence that regulatory bureaucracies can generate the superior knowledge of the future required to so. Regulators make the same cognitive mistakes as everyone else. They participate with private financial actors in “cognitive herding,” where everyone’s view reflects the same ideas.

If we continue along the trend line, we will reach 2006 peak prices again in 2020.

The financial sector displays fundamental uncertainty: recursively interacting expectations and behavior cannot be accurately calculated. The recursiveness of financial markets means that everything you anticipate and do changes the market—what you believe about the risk distribution changes the risk distribution. A regulatory super-committee cannot change this profound reality.

Although we cannot eliminate financial cycles, here are four suggestions to moderate future cycles.

First, develop counter-cyclical loan-to-value (LTV) ratios. The LTV ratio indicates how much one is willing to lend against the current market value of the asset. Typically, LTVs in housing finance tend to go up as house prices rise, but they should go down when prices rise rapidly. This will help dampen the cycle. Canada has actually just implemented something along these lines, where they have reduced some maximum LTV ratios in reaction to their booming house prices.

Second, the practices regarding loan loss reserves should require building bigger loan loss reserves during the good times. When optimistic loans are being made, we should be building up loss reserves, because loans made during a boom are certain to be the biggest losers later.

Third, the government should encourage new bank creation during the bust. Now, the bond market is booming but the banking market is restricted. New, little banks are needed to work with small businesses and entrepreneurs. Now is the best time to enter the banking business because credit is conservative. Regulators in the United States tend to charter new banks in the boom and close off the creation of banks in the bust, mainly because the FDIC needs the capital for failed banks and does not want to allow it to form new competitive banks instead. This is precisely the wrong policy, and should be reversed to help resume growth following a crisis.

Finally, saving, not just lending, should be encouraged as an essential element in housing finance.

These are things we should be working on in the political wake of the bubble.

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

FURTHER READING: Earlier, Pollock explained “Why the Fed Cannot Regulate ‘Systemic Risk,’” queried, “Is Economics a Science?” and quipped “It’s Easier to Be Brilliant than Right.” He cautions, “Treasury Guarantees Are Too Good to Be Free,” explores “The Future of Housing Finance,” and fears a “Nightmare on Every Street.”

Image by Dianna Ingram/Bergman Group.

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