The deregulation delusion

According to the received wisdom in many Washington policy circles, most notably those inside the White House, last year's financial crisis arose from either insufficient regulation or even alleged deregulation. The problem with that narrative, however, is that it's awfully difficult to square with the facts. As Ryan Young writes:

In a December 3 article in Politico ("J-O-Bs should come before GDP"), Rep. Phil Hare argues that "reckless deregulation" is one of the causes of the current economic crisis. That isn't actually true. This year's edition of the Competitive Enterprise Institute's Ten Thousand Commandments report found that 3,830 new regulations came into effect in 2008 alone.

Over 30,000 total new rules passed during the Bush years. Hardly any were repealed. Businesses currently dole out the equivalent of Canada's entire 2006 GDP - about $1.2 trillion - just to comply with federal regulations.

Where is the deregulation?

263,989 people make their living working for federal regulatory agencies, according to research from the Mercatus Center. That's an all-time high. 12,190 of them regulate financial markets from Washington. More are based in New York and other financial centers. None of these figures include state and local rules and regulators. Those cost extra.

To what Young points out I would also add this:

Indeed, finance is one of the most regulated sectors in the private sector (along with health care -- any coincidence both suffer from so many problems?). So what has all of these rules, regulators and money spent on enforcement provided us? Clearly not financial stability. In fact, it appears misguided regulation actually contributed to the 2008 financial crisis.

Witness today's New York Times article on the role of credit rating agencies:

Without question, the credit rating system is one of the capitalism’s strangest hybrids: profit-making companies that perform what is essentially a regulatory role. The companies serve the public, which expect them to stamp their imprimatur on safe securities and safe securities alone. But they also serve their shareholders, who profit whenever that imprimatur shows up on a security, safe or not.

To make matters more complicated, rating agencies are deeply entrenched in millions of transactions. Statutes and rules require that mutual fund and money managers of almost every stripe buy only those bonds that have been given high grades by a Nationally Recognized Statistical Rating Organization, as the agencies are officially known.

Credit rating agencies were at the heart of the financial crisis, assigning solid ratings to various investments which later turned out to be highly risky and near worthless. As this Bloomberg story from April says:

They helped banks create $3.2 trillion of subprime mortgage securities. Typically, the firms awarded triple-A ratings to 75 percent of those debt packages.

“Ratings agencies just abjectly failed in serving the interests of investors,” SEC Commissioner Kathleen Casey says.

Perhaps the solution was to have a government agency determine whether the rating agencies were capable of performing their assigned task. According to the logic of many who believe in an activist government, this was a perfect opportunity for regulators to step in and protect consumers from low quality rating agencies. Except, this is exactly what was happening:

Originally, NRSRO recognition was granted by the SEC through a "No Action Letter" sent by the SEC staff. Under this approach, if a CRA (or investment bank or broker-dealer) were interested in using the ratings from a particular CRA for regulatory purposes, the SEC staff would research the market to determine whether ratings from that particular CRA are widely used and considered "reliable and credible." If the SEC staff determined that this was the case, it would send a letter to the CRA indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff would not recommend enforcement action against that entity.

Think about that: the government mandated that many financial organizations rely upon the grades given by the credit rating agencies and then even signed off on which CRAs were respectable. The CRAs then assigned excellent ratings to scores of financial products which were actually junk. Who in their right mind can believe the real problem here was insufficient regulation?

Like much of the conventional wisdom in DC, the idea that deregulation is to blame for the ills of the financial sector is rooted in myth. Upon closer examination we find a familiar story of regulation, market distortions and a resulting mess. Real reform of this sector, like health care, will consist of freeing the market rather than imposing further burdens upon it.