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Tuesday, December 25, 2007

"Preventing the Next Bout of Looting"

Menzie Chinn is worried that the regulatory effort to prevent problems in mortgage markets from reemerging is failing to adequately address part of the problem:

A Thought on the Sub-prime Debacle, by Menzie Chinn: Most of the NYT's recent coverage of the subprime mess focused on Greenspan and the Federal Reserve System. However, it's clear that regulation was deficient along other fronts. From the NYT:

... The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all. ...

Ms. Bair was an exception, especially for the deregulation-minded Bush administration. As a former assistant secretary of the Treasury in 2001 and 2002, she had worked with Mr. Gramlich to raise concerns about abusive lending practices. Indeed, she tried to hammer out an agreement with mortgage lenders and consumer groups over a tough set of "best practices" that would have covered subprime mortgages.

But that effort largely stalled because of disagreement. Though some big lenders did endorse a broad code of conduct, she recalled, they soon began loosening standards as competition intensified. ...

I think that as we learn more and more about the run-up to current situation, we will find out that "looting" was the relevant phenomenon. From George Akerlof and Paul Roemer's 1993 discussion of the S&L crisis, in the Brookings Papers in Economic Activity:

"Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society's expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Bankruptcy for profit occurs most commonly when a government guarantees a firm's debt obligations. The most obvious such guarantee is deposit insurance, but governments also implicitly or explicitly guarantee the policies of insurance companies, the pension obligations of private firms, virtually all the obligations of large or influential firms. ...[B]ankruptcy for profit can easily become a more attractive strategy for the owners than maximizing true economic values. ...

Unfortunately, firms covered by government guarantees are not the only ones that face severely distorted incentives. Looting can spread symbiotically to other markets, bringing to life a whole economic underworld with perverse incentives. The looters in the sector covered by the government guarantees will make trades with unaffiliated firms outside this sector, causing them to produce in a way that helps maximize the looters' current extractions with no regard for future losses...."

Now instead of arguing against Fed intervention to try to mitigate the credit crunch, on the grounds of discouraging "moral hazard", (in Krugman's lexicon, that horse is already out the barn door) I would say we need to think now about how to prevent the next bout of "looting".

That involves a much more complicated and difficult task of insulating the regulatory authorities from political pressures (see "avoiding regulatory capture"). It also probably requires expanding and integrating regulatory charters.

I'm not sure how one would do that. But I know how not to do it. From the WSJ:

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. ...

So, let's think constructively about preventing the next bout of looting, even as we deal with the after-effects of the current bout.

    Posted by on Tuesday, December 25, 2007 at 12:24 AM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (16)

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