Until I began to examine the Dodd-Frank financial overhaul bill, I had no idea that it would so significantly change the direction of the United States. It’s scope is so vast and pervasive that it’s difficult to grasp its totality. I wrote this article to try to explain this, and why I believe it’s so important for us to understand it. Because of its complexity it wasn’t possible to do this briefly, so I wrote this major “white paper” and divided it into four parts to make it easier to digest. Please stick with me for the next parts; your eyes will be opened.
The new financial overhaul bill is the greatest government takeover of the financial sector of the economy since the National Recovery Act of 1933 when Franklin Roosevelt attempted to introduce central planning in America.
More than just a new law, the Dodd-Frank “Wall Street Reform and Consumer Protection Act” (the “Act”) gives government a relatively free hand to set prices and wages, to make business decisions, to promote or eliminate businesses, and to break up businesses. It establishes a large new bureaucracy to enable the government to dictate its wishes to the industry.
A major law firm described the Act as follows:
The Act marks the greatest legislative change to financial supervision since the 1930s. This legislation will affect every financial institution that operates in this country, many that operate from outside this country and will also have a significant effect on commercial companies. As a result, both financial institutions and commercial companies must now begin to deal with the historic shift in US banking, securities, derivatives, executive compensation, consumer protection, and corporate governance that will grow out of the general framework established by the Act. While the full weight of the Act falls more heavily on large, complex financial institutions, smaller institutions will also face a more complicated and expensive regulatory framework.
The Act isn’t directed just at the financial sector; because of its vast scope, it’s directed against everyone.
Startling as it may seem, the Act does nothing significant to prevent the real causes of this or any future boom-bust cycle. At best one may analogize this as the doctor breaking the thermometer to cure a fevered patient. At worst it’s a massive federal power grab which will inhibit financial innovation, increase the cost of money, and open wide the gates to a favored few where politicians, politics, and lobbyists, rather than markets, determine the direction of the financial sector of America’s economy.
While the new law has been signed by the President, it hasn’t yet been written. That task will be the job of federal mandarins, the career lawyers and economists inside and outside of government who live off of government regulation. As such the ultimate consequences of this Act are unknown and won’t be fully known until years later after the regulations have been written, agencies are established, and power is distributed among the bureaucrats. In other words, the Act’s advocates have no idea how the new law will impact the economy.
The “Failure of Capitalism”
The Act assumes that the economic bust was caused by a failure of capitalism and a failure of government to properly regulate the economy.
Upon signing the Act, President Obama said:
“For years, our financial sector was governed by antiquated and poorly enforced rules that allowed some to game the system and take risks that endangered the entire economy,” Mr. Obama said.
The new law, he said, would better protect consumers, empower investors and bring transparency to dark corners of the financial markets.
“The American people will never again be asked to foot the bill for Wall Street’s mistakes,” Mr. Obama said. “There will be no more taxpayer-funded bailouts. Period.”
The President and most politicians, Republicans and Democrats, blame the crisis on capitalism itself, and, rather incredibly, on what they view as unregulated “laissez-faire” capitalism. They ignore the fact that the financial industry is one of the most regulated sectors of our economy. When they say “laissez-faire,” what they really mean is that they want to completely control the financial sector.
The President views Wall Street and free enterprise with disdain, repulsed by what he sees as just the latest failure of capitalism and the “old ways and failed policies of yesterday.” He believes, as the benevolent legislator-in-chief, he must step in and protect us from evil predations of Wall Street like a shepherd guarding his flock: Only the guiding hand of government can make capitalism safe for society.
The President, like most politicians, lawyers, and economists, believes that the economic bust was caused by greed, excessive compensation, fraud, speculation, complex securities that no one understood, predatory Wall Street practices, and a lack of sufficient regulatory powers. These factors, they say, allowed financial institutions such as Wells Fargo, JPMorgan, and Goldman Sachs to take unnecessary risks which jeopardized the world’s financial system and almost brought it down.
The problem is that their beliefs are wrong, and they make up data to fit their beliefs. Their conventional wisdom fails to satisfactorily explain the actual underlying causes of this boom-bust cycle and the new law will do nothing to prevent another cycle. The factors they blame for the crash always exist in financial markets, and yet, for reasons they don’t explain, actors on the financial stage suddenly explode into an orgy of greed directed at the housing market.
There are two questions you should consider while evaluating the Act’s impact and scope that help explain this boom-bust cycle:
1. Why did the housing market become a bubble?
2. Why would any lender lend money to a home buyer who (i) had a credit score of 500, (ii) made a down payment of 5% or less, and (iii) didn’t have to prove his or her ability to repay?
I would answer these questions by saying:
- Only cheap money drives bubbles and there’s only one entity that creates cheap money and that’s the Federal Reserve. From 2000 to 2004, the fed funds rate went from 6.5% to 1.0% wildly distorting entrepreneurial behavior. This was the cause of this boom-bust cycle.
- No one would lend so carelessly unless they didn’t care. They didn’t care because someone else, in this case the government (Fannie, Freddie, and the FHA), would guarantee repayment.
Everything stems from these two factors yet there’s nothing in the Act that prevents the Fed from starting a new cycle or that prevents Fannie or Freddie from again distorting the economics of the housing market. The purpose of this article isn’t to go into the ultimate causes of the bust as I’ve discussed them at length in other articles, but these factors highlight the foundational fallacies of the Act.
The Act’s Timing
This chart gives a good picture of the timing for implementing the Act.
This process is described as follows:
Now, the legislation hands off to 10 regulatory agencies the discretion to write hundreds of new rules governing finance. Rather than the bill itself, it will be this process – accompanied by a lobbying blitz from banks – that will determine the precise contours of this new landscape, how strict the new regulations will be and whether they succeed in their purpose. The decisions will be made by officials from new agencies, obscure agencies and, in some cases, agencies like the Federal Reserve that faced criticism in the run-up to the crisis.
The Commodity Futures Trading Commission has designated 30 “team leaders” to begin implementing its expansive new authority over derivatives, and has asked for $45 million for new staff. The Federal Reserve, Federal Deposit Insurance Corp. and Securities and Exchange Commission are also in the thick of the implementation.
Law firm Davis Polk Wardwell calculated the number of agencies involved in the rule making process. In this chart, the “Bureau” is the Bureau of Consumer Financial Protection, the “Council” is the Financial Stability Oversight Council, and the “OFR” is the Office of Financial Research:
Here is the reality: It will take many more years to write and implement the regulations that really define the Act. It may be that some of these regulations will never be written, something that’s not unheard of in Washington.
The Act will be a siren call to lobbyists, lawyers, accountants, and economists.
Regime Uncertainty and Perfect Wisdom
The initial impact of any new and unwritten law is uncertainty, and uncertainty is what business abhors. “Regime uncertainty,” a concept developed by economist Robert Higgs, says that such legislation causes businesses to pause expansion until they know how the law will affect them. This is apparently already happening:
The timing of Dodd-Frank could hardly be worse for the fragile recovery. A new survey by the Vistage consulting group of small and midsize company CEOs finds that “uncertainty” about the economy is by far the most significant business issue they face. Of the more than 1,600 CEOs surveyed, 87% said the federal government doesn’t understand the challenges confronting American companies.
Yet Treasury Secretary Timothy Geithner believes they can regulate us with perfect wisdom:
Treasury Secretary Timothy Geithner vowed the Obama administration would try to avoid choking off economic growth as it implements the financial-regulatory overhaul enacted last month and pursues new reform measures.
In his first public appearance before Wall Street executives since the Dodd-Frank bill was signed July 21, Mr. Geithner said the administration would eliminate old “rules that did not work” even as federal agencies are writing the more than 200 new rules required by the regulatory overhaul.
Mr. Geithner said the changes were needed to curtail “too much freedom for predation, abuse and excess risk,” but said it should still seek to “safeguard the freedom, competition and innovation that are essential for growth.”
Mr. Geithner believes in the “just right” Goldilocks philosophy of regulation. I question that any central planner would have the wisdom to supplant the decisions of millions of economic actors without negative consequences. One might say this is a form of arrogance associated with (almost) absolute power.
“Some Provisions of the Act Are Good”
When we evaluate the Act it would be a mistake to look at its individual parts rather than its whole. To look at one provision and say, “well that sounds reasonable” is a form of political diversion that only serves to obscure the fact that the thousands of provisions in this Act taken together vastly enlarge the power of the federal government and reduce individual freedom. That cannot be good.
I will say that some of the provisions, in light of the Wall Street-Washington Financial Complex’s system of crony capitalism, may actually reduce some risk that we taxpayers will eventually have to pay for. But that ignores the power and influence of Wall Street and its friends within government to influence rule-making to suit their needs (“regulatory capture”).
This revolving door between Washington and Wall Street allows people attracted to power and who are skeptical of the ideals of a free market, to dominate economic policy for their benefit. One way to say this is that it creates a partnership between the financial sector of the economy and the government (which is the controlling partner in this relationship). In the 1930s this type of political system was greatly admired in Washington. Today this system has evolved into “crony capitalism,” an oligarchic structure maintained by the Wall Street-Washington Financial Complex to perpetuate itself.