The Right and Financial Regulation

by Reihan Salam

Last week, Nate Silver argued that financial sector reform will be the domestic policy issue that dominates the first half of 2010. After making the case for why this issue will take precedence over cap-and-trade or immigration reform or gay rights, Silver suggests that the debate will be between those advocating structural reform and those advocating incremental reform. 

From a 30,000-foot view, the debate will be between the Volckerists and the Summersists, with the Volckerists arguing that large financial institutions need to be broken up — probably through something resembling a modern Glass-Steagall Act – and the Summersists arguing instead for more extensive regulations.

The ‘hard’, online left will almost certainly take the Volckerist position. In fact, I expect this to be the “public option” of 2010, the badge of pride that “movement progressives” will use to distinguish themselves from “kleptocrats”. Like the public option, the Volckerist position (“break up the banks”) is easy and intuitive to understand. Also as in the case of the public option, I suspect the Volckerists will ultimately have the preponderance of polling evidence to show in their favor (although no polling has yet been conducted on the issue). In contrast to the public option, opinion among policy wonks is likely to be a little bit more evenly divided — see for example the difference of opinion between Yves Smith and Simon Johnson, neither of whom have any inherent sympathy whatsoever for the banks.

And Silver offers an astute diagnosis of the dilemma facing the right.

How the right will respond is less predictable, but this may become the issue that tests whether the “tea party” movement is ultimately more libertarian or populist in character. While on the one hand, the zeitgeist within the movement is to bemoan any government intervention in the economy, on the other hand, much of the impetus for the movement was the bailout bill and the deference that both the Obama and Bush administrations have shown toward Wall Street. I really don’t know how they’ll come down on this issue (initially, perhaps, they’ll take whatever position that the White House doesn’t), but it could be a defining one for the movement.

Ultimately, I think there is more political upside than downside for the White House here, although there is plenty of both. I don’t think the Republican Party as a whole can afford to take an anti-regulation stance.

When the House Financial Services Committee voted on a proposal to regulate derivatives trading, only one Republican, Walter Jones of North Carolina, joined with the Democrats. According to the Wall Street Journal,

Republicans on the panel said the agency would amount to a new government bureaucracy intruding on the financial decisions made by Americans. The banking industry has lobbied aggressively to kill or weaken the agency, and Democrats have agreed to curtail some of its powers.

This, however, doesn’t seem like an entirely sound characterization of what this regulation is designed to achieve. One could argue that a ban on insider trading involves intruding on the financial decision made by Americans, yet there is a broad consensus that this regulation helps preserve the integrity of financial markets. Similarly, efforts to shift most derivatives trading to exchanges and clearinghouses is designed to encourage transparency and to establish clear, non-discretionary limits on risk-taking.

Nicole Gelinas of the Manhattan Institute has been writing very persuasively on the need for financial regulation to strengthen free markets. She has made a conservative case for going beyond the Obama administration’s flawed approach.

The Obama administration has taken some positive steps here, with Treasury Secretary Tim Geithner’s reasonable, if imperfect, proposal to set borrowing limits on currently unregulated derivatives. The plan also urges regulators to “reduce their use of credit ratings in regulations and supervisory practices, wherever possible.”

But the White House has delayed taking action on the most obvious way to limit borrowing—new, consistent capital requirements for financial firms and all their investments—directing the Treasury to issue a report by the end of the year. The creation of a systemic-risk regulator in the absence of clear boundaries on risk-taking at financial firms could encourage yet more hubris and complacency in financial markets. A regulatory council that the government thinks smart enough to manage any and all risk might encourage market participants and their lenders to continue to act recklessly, confident that someone is looking out for them.

Clear and simple regulations that apply to all players will help curb the political favoritism that the American public rightly resents. Gelinas’s central view is that we need to revamp our financial system so that even the largest banks can safely fail, thus bringing an end to the cycle of hubris and bailouts that began in the mid-1980s. Ironically, what looks like a laissez-faire approach is actually one that guarantees a steady government takeover of the financial system. I strongly recommend Gelinas’s forthcoming book After the Fall to get a sense of why this is so pernicious.

City Journal also published a wonderful essay by Luigi Zingales on why Republicans need to channel populist anger to what he calls a pro-market politics. 

A pro-market strategy aims to encourage the best conditions for doing business, for everyone. Large banks, for instance, benefit from trading derivatives (such as credit default swaps) over the counter, rather than in an organized exchange: they can charge wider spreads that way, and they can afford to post less collateral by using their credit ratings. For this reason, they oppose moving such trades to organized exchanges, where transactions would be conducted with greater transparency, liquidity, and collateralization—and so with greater financial stability. This is where a pro-market party needs the courage to take on the financial industry on behalf of everyone else.

A pro-market strategy rejects subsidies not only because they’re a waste of taxpayers’ money but also because they prop up inefficient firms, delaying the entry of new and more efficient competitors. For every “zombie” firm that survives because of government assistance, several innovative start-ups don’t get the chance to be born. Subsidies, then, hurt taxpayers twice. A genuinely pro-market party would have resisted more vigorously the Wall Street bailouts, in line with popular sentiment.

Zingales is one of the good guys. He is one of those Chicago economists that Paul Krugman condemns. And in this case he is directly at odds with congressional Republicans, who are surrendering the playing field to the Democrats on the pretty darn important question of whether or not we’re going to be a market economy or a government-dominated economy. This is insane. Politics and principle are pushing in the same direction.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.