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Editor’s note: The following is from a symposium of views around the question: “Is regulation, or the lack thereof, risking a second great financial crisis?”
First of all, the question posed, “Is regulation, or the lack thereof, risking a second great financial crisis?” needs to be corrected. Crises are quite frequent in financial history—they occur about once every ten years on average, according to the economic historian Charles Kindelberger. Or as Paul Volcker said, “About every ten years we have the biggest crisis in fifty years.” So the appropriate question is whether regulation is risking “yet another,” not a “second,” financial crisis. The answer is that oppressive regulation is indeed increasing this risk, but indirectly, through its effects on the central bank financial manipulation.
An utterly predictable part of financial cycles is that following each crisis, there will be a political and regulatory overreaction. Congress always feels the political compulsion to Do Something—so it does. Also entirely predictable is that the new multiplication of rules and regulatory bodies will be accompanied by confident predictions that “Now this can never happen again.” Such pronouncements go back at least to the creation of the Federal Reserve in 1913. But the crises always happen again anyway.
In the aftermath of the Great Housing Bubble of 1999-2006, and the crisis of 2007-2009, the typical political cycle repeated once again. An onerous and very expensive regulatory inflation was launched and still continues expanding. The new regulations have made mortgage lending, in particular, much more difficult and costly and created a lot more regulatory and legal risk for lenders. Surprise! This constrained mortgage lending and made it much more difficult for many people to obtain mortgage loans. Moreover, the costs of this regulation are disproportionately high for smaller banks.
Either the Federal Reserve, which wanted and wants to expand the mortgage lending which the onerous regulation has constrained, in order to try once again (as it did in 2001-2004) to promote higher house prices and thereby the “wealth effect.” This time that goal meant reducing long-term interest rates to far below their market-clearing levels, which led the Fed to its remarkable bond market and mortgage market manipulation. As is well known, the Fed now owns more than $2 trillion of long-term government bonds, and more than $1.3 trillion of government-sponsored mortgage-backed securities.
What will the future effects of this massive manipulation be? Nobody knows, including the Fed itself. It has certainly crushed savers and resulted in many parties reaching for yield. In all probability, it has dramatically increased the interest rate risk for the entire financial system. (This includes the Fed’s own balance sheet, which has a level of interest rate risk which the fed would pronounce unsafe and unsound in any other bank.) In this fashion, the typical regulatory overreaction is indirectly leading to increased risk of yet another financial crisis.
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