Solution to Government Failure: More Government

Posted by on May 24 2010 | Government Largess, PPC

In the May 12 Denver Post, President Barack Obama wrote that the financial crisis “forced taxpayers to foot the bill for irresponsible practice on Wall Street” and that the financial regulation bill (what the president calls “Wall Street reforms”) moving through Congress will, among other things, end the “worst abuses and irresponsible practices we’ve seen in recent years.”

In other words, the financial crisis demands a massive new dose of government intervention.

Independence Institute Senior Fellow Barry Poulson begs to differ.  From the May 23 Denver Post opinion page:

Re: “Reforming Wall Street is essential,” May 12 op-ed by President Barack Obama.

President Obama makes the case for Sen. Chris Dodd’s financial regulation bill that will end “too big to fail” bailouts of financial institutions. He writes that the cost of this proposed financial market regulation will be paid for by financial institutions, not taxpayers.

But the president’s arguments are incorrect. The financial crisis was the result of flawed governmental institutions and financial market policies. So what we need are some reforms in Washington, D.C.

The origin of the financial crisis can be traced to policies encouraging unqualified borrowers to assume risky mortgages, and to mandates that financial institutions extend loans to these borrowers. The Federal Housing Authority loosened standards applied in non-prime lending. Through the Community Reinvestment Act and Department of Housing and Urban Development, the government pressured lending institutions to extend credit to unqualified borrowers.

The crisis was exacerbated by the quasi- governmental institutions Fannie Mae and Freddie Mac, which created a moral hazard by implicitly guaranteeing mortgages. By the time they collapsed in 2008, they together held $5 trillion in mortgages and mortgaged-backed securities. They continue to incur billions in losses, requiring taxpayer bailouts. The regulation the president favors does nothing to reform these institutions.

The mortgage bubble was also exacerbated by the cheap money policies pursued by the Federal Reserve System. Following the recession in 2001, the Fed reduced the federal funds rate to 1 percent. This policy fueled an unsustainable growth in liquidity, ending in the credit market collapse.

The Dodd bill would give the FDIC expanded powers, including the discretion to take over financial institutions, using the “orderly liquidation fund.” In fact, the bill provides for unlimited bailouts of financial institutions. The funding for these bailouts would come from assessments levied on financial institutions. But in reality, Americans invested in the markets would pay for these bailouts through higher costs on financial transactions and fees levied by these financial institutions.

The FDIC should not be given this expanded power over financial markets. Private markets are best at signaling when financial institutions are insolvent or illiquid, and a new bankruptcy code is the best way to address failed financial institutions.

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