MARCH 28, 2008 by SHELDON RICHMAN
Thud. That was the sound of the other shoe dropping.
In response to severe problems in the credit markets, thanks to years of government intervention, the Federal Reserve–the government's counterfeiter and chief culprit in the current crisis–has opened its discount window to the investment banks. Interest rate: 2.5 percent. Until recently, only commercial banks could borrow money from the Fed. But now investment banks may also–and here's the kicker: They can put up shaky mortgage-backed securities as collateral. That means the American people are potentially on the hook for those loans. Should they go bad, we will pay either in inflation-induced higher prices or in higher taxes.
Investment banks that may have invested in bad mortgages are already taking advantage of the new opportunity. Is this a great country or what?
The Wall Street Journal says the banks' willingness to borrow comes as relief to government officials who had worried that the stigma of borrowing from the Fed could keep firms away.
Yes, that would have been a shame. Thank goodness the stigma of high-rolling Wall Street firms' going on the dole has disappeared.
The Journal reports:
Morgan Stanley borrowed $2 billion Tuesday [March 18] from the Fed using pretty liquid assets as collateral, said Chief Financial Officer Colm Kelleher. We didn't need to, but I felt we should to show there was no stigma, and show support for what the Fed had done, he said. [SR: How gallant of them.]
Goldman Sachs Group Inc. tapped it for $100 million Tuesday. Lehman Brothers Holdings Inc. also used it.
Come on in; the water's fine. By this week the Fed had lent out tens of billions of dollars.
The Other Shoe
The opening of the loan window was the first shoe. The other shoe is the demand for new regulations on the investment-banking industry in return for Fed's help. Democrats Rep. Barney Frank and Sen. Charles Schumer say that if the investment banks are going to have the same access as commercial banks to the Fed's discount window, they should have to live by the same, or similar, rules as commercial banks. Those rules would govern things like reserve requirements but would likely go beyond that and include new oversight by regulators.
If investment banks are able to borrow from the Federal Reserve's discount window, then they must be subject to greater regulatory scrutiny, Schumer writes this morning.
A central bank acting as a lender needs to be able to evaluate the solvency and liquidity of a borrowing institution, said Eric Rosengren, president of the Federal Reserve Bank of Boston. Knowing how likely it is that an institution's sources of funds will evaporate during times of financial stress requires a significant understanding of the institution's liabilities and its counterparty relationships.
What can the banks say to Frank, Schumer, and Rosengren? If one accepts the principle that the government agency ought to be ready to rescue these institutions, how can one also object to the quid pro quo of regulation? Granted the premise, the logic is sound.
It's the bailout premise that has to be challenged. The Fed should not have opened the window to the investment banks if for no other reason than that new regulation would inevitably follow. (Of course, there should be no Fed in the first place. But that's for another column.)
Widening the Fed's scope for rescue and regulation only asks for trouble. In the first instance, government rescues breed irresponsibility. This is the moral-hazard principle, discussed last week. As Herbert Spencer said, The ultimate result of shielding men from the effects of folly is to fill the world with fools. Rescued once, why wouldn't a lending institution expect to be rescued again–especially if it saw itself as too big to fail?
Laissez Faire to Blame?
Second, the quid pro quo regulations will make things worse. People prone to blame deregulation and even laissez faire (!) for the current economic mess point out that the evolution of complicated investment instruments occurs so quickly that people in the industry itself have trouble understanding them. Maybe so. Will the regulators understand them better? No way. Markets move too quickly for regulators to keep up with because the participants make spot decisions in part using tacit knowledge that is never articulated. (F.A. Hayek's classic paper The Use of Knowledge in Society is must reading.) It's a bit like the knowledge one uses to keep a bicycle balanced. Try explaining that to someone who has never ridden a bike.
The only way for bureaucrats to even attempt to keep up would be to assert the authority to approve innovations before they are introduced. But that would be destructively inhibiting. Wealth-creation would be stymied, and we'd all be poorer. Why should anyone believe that regulators know what they would need to know before they could pass judgment on new ideas? If they're so smart, why aren't they rich from innovating?
This is not to deny that reckless–and even shady–activity can take place and hurt innocent bystanders. The point is that regulation, believe it or not, makes such activity more not less likely. Adam Smith famously wrote in The Wealth of Nations that People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.
He wasn't calling for regulation of economic affairs, because he immediately added, It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice.
But, significantly, he added, But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary (emphasis added).
What most critics of free markets overlook is that the corporatist state in fact does facilitate such assemblies and renders them necessary. Regulation, which forces standards across an industry, reduces the vigor of the competitive process by removing the factors subject to regulation from contention. A regulatory regime to some extent cartelizes industries.
Yet anything that reduces competition is harmful to the public because competition is what disciplines market participants. To the extent the competitive process is blunted, businesses are granted license to engage in the activities that Adam Smith had in mind.
Here's the response to those who blame financial deregulation for the current predicament: Deregulation has been only partial and therefore rigged. Remember the Samp;Ls? They were deregulated too–but not all the way. Restrictions were moved from the kind of investments they could make, but deposit insurance guaranteed that the taxpayers would cover the losses. That's not real deregulation; that corporatist favor-granting by another name.
Capitalism versus the Free Market
Today, establishment voices of capitalism (which is not to say the free market) have little credibility when they oppose new regulation of investment banking. That's because they are all too content with the current deeply rooted network of subsidies, bailout promises, and competition-suppressing interventions. If these are the only voices against new regulation, we will surely have it. Ironically, this will be a greater burden for smaller and yet-to-be formed companies.
Finally, favoring government bailouts for connected Wall Street players but not for individual homeowners is a sure path to dismissal for callous hypocrisy. Subsidizing these firms is an insult to Main Street. Many families are losing their homes as part of the mortgage crisis. If they had access to 2.5 percent financing that would not be happening, Thomas Palley of the Economics for Democratic amp; Open Societies Project writes. The only position that is internally consistent and consistent with justice is the no-bailout position. Banks and homeowners should work things out among themselves, aided if necessary by private philanthropic institutions.
Bailouts at the expense of unwilling third parties (taxpayers) are either proper or improper. (I say improper.) Those embracing the bank subsidy program should have the courtesy not to call themselves advocates of the free market. (Listening, Mr. Kudlow?) Some of us are trying to keep that label clean. They already have capitalism. Aren't they happy with it?