Sunday, January 10, 2010

Government interference led to financial crisis

Published in The Tennessean, January 10, 2010

Government interference led to financial crisis

by Richard J. Grant

What is the purpose of most government regulations? Answer: To correct the problems created by previous government regulations.

This should be a big lesson of the recent financial crisis. Government regulations, like drugs, have side effects that can accumulate and overshadow the benefits. Also, it is not mere cynicism to note that there are interest groups that support particular regulations precisely because of the side effects.

In politics, there are goals that are publicly stated and that appear, on the surface, to be desirable. There might also be effects that would be extremely unpopular if voters knew about them. From the perspective of stated public policy, these undesirable effects would be seen as “unintended consequences.”

A familiar example is minimum wage laws. The publicly stated, and publicly acceptable, motivation for such laws is to help low income earners by requiring employers to pay them no less than some arbitrarily determined "living wage." Many supporters of such laws have good intentions but do not appreciate the need for productivity. The important thing politically is that they mean well.

Minimum wage laws are also supported by groups whose leaders are not fooled at all. Trade union members generally receive wages that are above minimum wage, so they are not directly affected by the law. But higher-wage workers do compete with lower-wage workers. A sufficiently low wage for any given level of productivity would enable any worker to compete and to find a place in a business that is organized accordingly.

Trade unions can claim to be "helping our lower-paid brethren" by supporting the minimum wage. How nice of them. But at the same time they are ensuring that these lower-paid “brethren,” their competitors, are also priced out of the market. Many of these lower-paid brethren become unemployed brethren.

Why, in the midst of a recession, was the Obama administration so keen to raise the minimum wage? The additional unemployment that resulted from this cannot be blamed on previous administrations.

A government regulatory action that directly contributed to the recent financial crisis was the Community Reinvestment Act. This act created an arbitrary, race-based standard for judging banks’ lending practices. As a result, banks could be sued for discrimination if they did not lend to minorities in numbers that the regulatory authorities determined to be sufficient.

Many banks went with the flow and lowered their lending standards for minority groups. Such breaches of integrity have a way of leading to further breaches, in this case to a lowering of lending standards to everyone. The "subprime" market grew, as did the risk of default.

Did bankers know this could bring trouble? Yes, but their concerns were assuaged by another factor. Decades earlier, the government had created agencies, such as Fannie Mae and Freddie Mac, the explicit purpose of which was to promote home ownership by financing and guaranteeing mortgages. These agencies, even when ostensibly privatized, were always assumed to have the full backing of the US government, i.e., taxpayers.

A government guarantee implies that the mortgages are risk-free to those who finance them. With unburdened consciences, bankers could sell to investors mortgages that they would never have originated in the absence of the regulatory pressures and guarantees.

The whole financial regulatory structure creates a false sense of security, and thereby reduces incentives to innovate and improve real safety. The existence of the FDIC, for example, encourages bank customers to be unconcerned about the managerial prudence of their banks. This reduces the banks' need to compete on the basis of safety. Risk-taking in the banking system as a whole is therefore higher.

These examples do not give a complete explanation of how the recent financial crisis and recession came to pass. But they do warn us not to assume that we need more or "better" financial regulations. Throughout history, financial crises of this magnitude have always had their roots in government interference.

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010