06.30.10

Disinformation and Financial Reform

Posted in General Musings, Politics and Policy at 5:05 pm

The Heritage Foundation released an extremely disingenuous piece on the Dodd-Frank bill yesterday:

http://blog.heritage.org/2010/06/29/morning-bell-the-dodd-frank-assault-on-economic-recovery/#more-37297

First of all, let me state that they do raise some valid concerns, ones that I raised in my analysis as well – mostly centered on the potential for conflict across regulators and an over-reliance on regulators’ discretion.

They also raise the same old tired groans about stifling innovation and making financial services more expensive for consumers. Completely baseless.

Here, however, I want to focus on one very specific claim they make, and one that has been making the rounds in Republican circles for months. It is the claim that the legislation would establish permanent bailouts. Originally, this criticism was aimed at the proposal to “pre-fund” the resolution authority. That proposal has since been removed. Now the criticism is aimed at the resolution authority in general:

Permanent Bailout Authority: The Dodd-Frank bill creates an “orderly liquidation” process by which regulators are empowered to seize financial institutions that they believe are in danger of failing and liquidate them. While the lack of a broadly accepted process for closing down large financial institutions helped lead to the massive bailouts of 2008 and 2009, this liquidation process is problematic. Federal regulators are granted broad powers to seize private firms they feel are in danger of default, and these powers are subject to insufficient judicial review. Such governmental discretion to seize private property is constitutionally troubling.

This position is extremely disingenuous. Does Heritage also oppose the existing resolution authority the FDIC has over commercial banks? Would they rather these banks just fail outright with depositors either losing their deposits or having the taxpayers directly pay for them? Does Heritage support ending the existing Discount Window, through which troubled banks borrow directly from the Fed? My hunch is that the answer to all three questions is “no”.

What does Heritage propose instead of a resolution authority? Nothing. Some Republicans have suggested simply creating a new chapter of the bankruptcy code, specifically for large financial firms. For the reasons I explained in my entry on Shadow Banking, this would not work. These firms are extremely dependent on short term (sometimes overnight) funding to run their operations. If they cannot roll over funding for a few days, they implode, at great cost to creditors. Bankruptcy courts can’t possibly move fast enough to liquidate these firms in an orderly manner. There was a reason for those all weekend long marathon sessions by the Fed and Treasury in 2008 to resolve failing institutions before the markets opened on Monday morning.

However, there is a much broader issue here. The whole “just let them fail and allow the free market to work” worldview is a canard. Banks are not furniture stores, where a disorderly failure has a limited scope of collateral damage. There are significant, far-reaching negative externalities involved when a large bank fails. Many innocent non-financial businesses will be bankrupted. Individuals with no connection to the bank will be harmed economically. A more apropos comparison is with that of a nuclear power plant. Imagine such a powerplant has experienced a catastrophic failure and is about to have a meltdown. The Heritage argument is akin to “just let them fail, even if it means everyone living within two hundred miles dies and the land in that area all becomes uninhabitable for a few thousand years, so be it, the government must not intervene in private business affairs”. That is an absurd position, yet it is essentially the one they are taking here.

A related argument is that the bill must somehow absolutely prevent another financial crisis to be worthwhile. Unfortunately, this argument is furthered by the bill’s sponsors, who have insinuated that it will do exactly that. It won’t. It is impossible to prevent financial crises. We can, however, take steps to make them less frequent and less severe and provide the regulators with the tools to better fight them when they occur. No reasonable person would argue against having fire safety regulations in building codes on the grounds that they cannot absolutely with 100% certainty prevent fires. Nor would they argue that having fire departments ensures that we will have fires, and so they should be disbanded.

There are many improvements that could be made to the bill. They should absolutely be considered. There are also legitimate concerns about unintended consequences. They should be addressed. Fear-mongering and the spread of disinformation does nothing to further that end, and does a tremendous disservice to the public.

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