Opinion Post: Misguided Regulation

Geithner to push legislation for more involved gov’t regulation
[UPDATE]: The Washington Post today published an article about new legislation soon to be presented to Congress that seems to have some potentially scary implications. Tim Geithner spoke yesterday about a proposal that would allow Washington to seize non-banking financial institutions when the companies show sign of decline and threaten to destabilize the American economy. Specifically, Geithner states that the new document gives the government authority to take partial ownership of the company and break existing contracts (i.e. AIG bonuses). Read the earlier portions of this post about misguided government regulation after the jump.

If the news reports are true, President Obama will release a plan for overhauling the regulation of the financial system with the next week. It appears as though the plan will call for more general oversight of large financial companies like hedge funds, more rules and restrictions on the usage of derivatives and complex financial instruments, new standards and enforcements for mortgage issuers, and, finally, new rules that would limit, or at least oversee executive pay. The first two points are legitimate, the third provision is misguided, and the fourth point is downright ill-considered. Here’s why.

There is no reason why we should not have more regulatory oversight of financial markets. If regulators are all in place to make sure that hedge funds are not executing large decisions that could have devastating consequences for other financial firms and businesses, and oversight makes sure that there is no unlawful repackaging of securities or derivatives, then the regulation is effective. Of course, there is a delicate balance between regulation that protects consumers and property rights and regulation that actively inhibits business activity; regulatory financial institutions must be set up in such a way that they do not inhibit normal activity.

By no means is my advocacy of financial regulation a departure from my normally espoused free market principles. In any industry, if regulation is done for the purpose of ensuring property rights and protecting customers— in essence, for the purpose of producing more efficient market outcomes— then it is a good kind of regulation. Bad regulation, the kind free-marketers do not like, is one that seeks to control and influence a market for the purpose of increased governmental involvement and administration. Of course, supporters of what I would call “bad regulation” would argue that they too are trying to achieve more efficient market outcomes, (more equity, greater fairness, more environmental protection, etc), but this is a debate for another blog post.

The third provision would be misplaced, but it really depends how the administration goes about implementing new ‘mortgage issuing’ policies. If the idea is just to make clearer standards, i.e. make people actually read what kinds of adjustable rate loans they are getting, I see no problem with that. If, on the other hand, the plan is to prevent any sort of sub-prime lending or restrict the kinds of mortgage loans that companies are allowed to issue, this would be completely misguided regulation. Remember that there is nothing really wrong about a bank issuing a loan to a less-than-optimal income earner or charging a variable or high interest rate. In both cases, the bank assesses risk and acts appropriately. Banks should have no reason to do otherwise. A risky loan is a risky loan, and if the government decides what kind of interest rates are unjust, this is a severe restriction on economic freedom.

Finally, while it might be popular these days in light of the AIG bonus fiasco, attacking executive pay is not going to result in a better-run financial sector. This economic mess was not created by high executive pay—it was brought about by the unlawful repackaging of sub-prime mortgages disguised as AAA rated securities and the propagation of these securities through the financial markets. It might appease certain sectors of the uninformed public, but capping executive pay will not be an effectual regulatory tool.