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The Dodd-Frank Wall Street Reform and Consumer Protection Act: The Triumph of Crony Capitalism (Final, Part 4)

Econophile's picture




 

From The Daily Capitalist

Until I began to examine the Dodd-Frank financial overhaul bill I had no idea that it would so significantly change the direction of the United States. It's scope is so vast and pervasive that it is difficult to grasp its totality. I wrote this article to try to explain this and why I believe it is so important for us to understand it. Because of its complexity it was not possible to do this briefly, so I wrote this major "white paper" and divided it into four parts to make it easier to digest. This is the final part of this four part series.

Final, Part 4

Why Regulators Will Always Fail

Why should new regulations work when the old ones failed?:

"We failed completely to understand the complexity of what the impact of the national decline in housing prices would be in the financial system," said Ms. [Janet] Yellen, currently president of the Federal Reserve Bank of San Francisco [and recently nominated as Vice-Chair of the Fed for financial risk]. "We saw a number of different things, and we failed to connect the dots."

The problem with this kind of regulation is that new laws are always looking backward in an attempt to prevent the last bust from happening.

While the origins and outcomes of boom-bust cycles behave similarly, as Rogoff and Reinhart point out in their research, the asset classes and mechanics of the boom are different. As the Fed pumps money into the economy, money follows different paths and inflates and distorts different asset classes each time. In the Dot.com boom-bust cycle money flowed into high-tech companies and the stock market. Before that cycle, money flowed into real estate, mainly multi-family housing. The current cycle pushed money into housing, and more importantly, new forms of debt based on housing that hadn't previously existed.

It is obviously more complicated than this, but the point of this paper is that regulators will never keep up with the next asset class boom and bust because they will be looking backwards. Will they know the "next one" when they see it? I doubt it.

What They Forgot

I discussed in the Part 1 of this article that there is almost nothing in the Act that actually prevents the Fed from creating new boom-bust cycles or that inhibits the federal government’s policies favoring, and thus distorting, the housing market. Here are things that they should have tackled but didn’t.

Fannie and Freddie

The Act failed to deal with Fannie and Freddie. Recall my question at the beginning of this article about why lenders would make unsafe loans. There is no question that the primary movers in the housing boom and bust were Fannie Mae and Freddie Mac, government sponsored housing financing entities (GSEs). Fannie guaranteed one-half (53%, or about $5.5 trillion) of the U.S. housing market’s $10.7 trillion of mortgages; about 10% ($500 billion) of those were  subprime (“toxic”) mortgages. Countrywide, the largest subprime lender, eventually taken over by BofA, sold 90% of its loans to Fannie, and Countrywide’s loans comprised 25% of Fannie’s purchases.

Fannie and Freddie were nationalized in September, 2008 and the federal government assumed their liabilities without limits. As of Q1 2010, Fannie had lost double its profits made for the previous 35 years. They have already cost taxpayers about $85 billion. Estimates of bailout costs range as high as $1 trillion, assuming home values decline another 20% and foreclosure rates continue to climb.

It is interesting that the Republicans tried to introduce provisions in the Act that would reform Fannie and Freddie. But Barney Frank blocked this reform:

Republicans repeatedly tried to attach amendments that would rework government-run mortgage giants Fannie Mae and Freddie Mac, but Mr. Frank repeatedly disallowed Republicans from offering the amendments. At one point, he slammed his gavel down violently out of frustration.

There is no need for the government to be involved in the housing market. It is purely a political play. As Douglas Holtz-Eakin, former Bush II economic advisor and CBO director, said, “Republicans and Democrats love putting Americans in houses, and there’s no getting around that.”

Even FDIC Chair Sheila Bair, said:

"I think a properly regulated and functioning private securitization market perhaps could provide liquidity sources that we need to fund mortgages."

To be fair to the Administration, they and Mr. Frank have said that Fannie and Freddie need “dramatic reform” but they have no political will to get rid of them or let the market function properly.

Meanwhile, the federal government loan guarantee machinery is still roaring along. The FHA has guaranteed about one-half of all new home loans since 2009. Its minimum down payment requirement is 3.5%. About 24% of loans it guaranteed in 2007 and 2008 are in default. Overall delinquencies are 8.3% of their $865.5 billion of loans, up 35% over June last year.

The government continues unabated to favor and distort the housing market despite their role in causing the financial crisis.

Federal Reserve Boom-Bust Generator

The other question I asked at the beginning of this article is, why all of a sudden did we have a boom? No economist, other than Austrian theory economists, answers this question satisfactorily. Keynesians believe that our excesses are caused by our “animal spirits,” i.e., greed. Monetarists and other neo-Classical economists attribute it to the usual factors of an "excessive" money supply (Milton Friedman believed in a steady state monetary inflation of around 4% per year), greed, and perhaps legislative policies such as those favoring housing.

The Austrians have placed the cause of booms and busts at the proper source, and that is the Federal Reserve, the only authority which has the power to “print” money. Nothing in the Act changes the Federal Reserve’s power over interest rates and money supply. The Fed’s dual mandates are still to maintain steady interest rates and maximize employment.

The Fed’s role in the housing boom-bust is shown as follows. From 2000 to 2004 the Fed Funds rate went from about 6.5% to 1.0% and money supply shot up:

M1 vs. Fed Funds rate

And so did the housing market:

Housing Starts

When the Fed floods the economy with new money it doesn’t create wealth; if that were the key then we would all be rich. What it does by artificially reducing interest rates is to distort the entire entrepreneurial process and sends capital to places where it isn’t really needed. In this cycle it went into housing, drove prices up, created an unsupportable debt structure, and, as we are now finding, housing was massively over-produced. The result was the greatest expansion of debt in history. In Austrian economics terms this result is called “malinvestment.”

To the Fed’s consternation, money supply is now declining as the above chart shows. The Fed desperately wants to cause inflation because they believe it will rescue the economy. They believe they can cause inflation by pumping money into the economy and expanding money supply. But they have a problem. As a result of malinvestment and the huge amount of debt built up to support it, money supply is now declining even though interest rates are effectively zero. A declining money supply is deflationary. They will eventually find a way to inflate which will lead to stagflation. (See, "Anti-Deflationists Win The Day At The Fed," and this and this.)

Too Big To Fail and Moral Hazard

The most important lesson of this financial crash is that large financial companies now know that they will be bailed out if the Fed and Congress believe it is necessary to “save the economy.” While the President says we’ll never bail out these companies again, the Act, as noted previously, actually does allow the government to bail out “industries.”

The only reason the language in the Act was inserted to “prevent bailouts" was to attempt to placate the general public who believe that bailouts of TBTF companies was wrong. If the government really wished to prevent bailouts, they would have done so explicitly, but they didn’t. They believe bailouts are absolutely necessary to "save the economy."

The expectation of bailouts is what economists call a “moral hazard.” That is, if you bail companies out it encourages risky behavior because of the knowledge that they will be bailed out. Capitalism, as many have pointed out, is a system of profit and loss. The loss part of that equation is essential to capitalism. Austrian economist Joseph Schumpeter called the failure of firms a process of “creative destruction.” Not only does failure wipe out the mistakes of a failed business, but more importantly it is a necessary signal to entrepreneurs, banks, and venture capitalist to not waste their valuable capital on similar ventures. If you remove the concept of loss from TBTF businesses, the signal are you sending is to encourage risk-taking with the taxpayers’ money.

The system of bailouts isn’t new. The federal government has created an entire structure to prevent or cushion failure in those industries which it favors. Professor Russ Roberts in his paper, “Gambling With Other People’s Money: How Perverted Incentives Created the Financial Crisis,” details this process eloquently and in detail. From the fractional reserve banking system allowing banks to back their loans with only 10% of Tier 1 capital, to deposit insurance (now raised to $250,000), to Basel II capital rules, to CRA rules, to Fannie, Freddie, and the FHA, the entire system is skewed toward cushioning the risk-takers from the consequences of their actions.

This has created a system of “crony capitalism,” a system which favors the government’s friends. I call it the Wall Street-Washington Financial Complex. In an article from the City Journal, Nicole Gelinas points to a book, 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, by Simon Johnson, MIT entrepreneurship professor, and James Kwak, a former McKinsey consultant, of which she notes:

What Washington has created, then, is best summed up in Johnson and Kwak’s title. The “13 bankers” are the CEOs of the surviving big banks, whom President Obama summoned to the White House just weeks after his inauguration. Obama had convened the bankers to show the public that he was firmly in command of the institutions that the government had rescued. But what markets perceived was protection. “It was clear that the thirteen bankers needed the government,” Johnson and Kwak write. “But why did the government need the bankers?” In pumping trillions of dollars in cash and guarantees into the financial system without demanding change, Johnson and Kwak say, we risk creating a “uniquely American oligarchy”—one that will harm America’s growth, just as similar oligarchies have harmed other nations’ growth throughout history.

The Stifling Hand of the Financial Risk Czars

In August, 2008 I wrote an article predicting the coming creation of a financial risk czar:

Can you imagine [the] financial risk commission at the birth of Wall Street? They would have argued, correctly, that stocks are too volatile and market booms and busts present too great of a risk for the economy. Only bonds would be suitable to keep the economy stable. They would, of course, ignore the benefits of raising capital for enterprise and the dynamic American economy would have never gotten off of the ground.

 

The new czars will stifle innovation and economic growth because their mandate is to prevent disruption to the economy, not to promote growth.

Because these crises are never quite the same, they won’t see the next one coming, but they will see a lot that aren’t.

 

*****


To see previous parts of this article: Part 1Part 2Part 3.

To download a PDF of the entire article, go here.

 

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Wed, 08/18/2010 - 11:28 | 528161 alexwest
alexwest's picture

I wonder this guy 'Econophile' is he really idiot?

...
It is interesting that the Republicans tried to introduce provisions in the Act that would reform Fannie and Freddie. But Barney Frank blocked this reform:
..

 or he assumes cause he writes for my fellow Americans only , they're idiots and nobody will check / know facts..

dear ''Econophile' I understand you don't like OBAMA, Barney etc etc.. I understand you think Democrats is 
THE REASON for everything is bad in USA.. but why you even didn't consider USING HEAD & LOGIC in your writing..
you know round object that can be used for thinking before/after munching next McDonald.. 

here's the facts .. Mr. Frank heads committee only from 2007 ( 1 year away from fin crisis).. 
since 1995 committee was headed by 2 REPUBLICAN guys.. see ttp://en.wikipedia.org/wiki/United_States_House_Committee_on_Financial_Services

so ,my point is don't you think is NOT Mr. Obama's democrats, Mr. frank's fault ?? 
don't you you think previous administration has some something to do w/ current ongoing crisis in housing , at least ??

good luck
alex

Wed, 08/18/2010 - 12:43 | 528389 Econophile
Econophile's picture

Why do you assume I am a Republican? I detest both parties equally. Well, perhaps Democrats more since they generally believe more in the Nanny State.

Tue, 08/17/2010 - 11:12 | 525951 Winston Smith 2009
Winston Smith 2009's picture

Post moved.

Tue, 08/17/2010 - 10:46 | 525902 old_turk
old_turk's picture

Thank you very much for doing the heavy lifting.

 

And I agree, they bought the time dearly for an opportunity to fix at least some of the more egrious issues but the solutions, such as they are, will not achieve anything of merit.

Tue, 08/17/2010 - 10:19 | 525821 Cognitive Dissonance
Cognitive Dissonance's picture

Thank you for your huge effort. It is, and was, much appreciated.

Tue, 08/17/2010 - 09:38 | 525719 crzyhun
crzyhun's picture

Good job. It shows what a little effort can produce done by the common man- not an Ivy league type economist. Of course, whose to say what your bona fides are. Nervertheless....

Tue, 08/17/2010 - 09:14 | 525656 Moonrajah
Moonrajah's picture

Thank you for a wonderful series. Thoroughly enjoyed it, and yes, it goes better with a side dish of the recent Taibbi articles about the inception and birth of the Dodd-Frank monster lovechild.

"Where is the beginning of the end that comes at the end of the beginning?" (C) Kozma Prutkov

Tue, 08/17/2010 - 08:53 | 525615 LeBalance
LeBalance's picture

EP, in your first part you indicated a PDF link for the series enmass would be forthcoming.  I would be very interested in that if you still plan on issuing it.  Thank you for digging into Donk.

Tue, 08/17/2010 - 10:21 | 525826 Cognitive Dissonance
Cognitive Dissonance's picture

The very last sentence in the article, easily overlooked, directed you to this link. I for one have come to appreciate the portability and flexibility of the all-in-one .PDF file.

http://dailycapitalist.com/downloads/doddfrank.pdf

Tue, 08/17/2010 - 08:32 | 525597 Amsterdammer
Amsterdammer's picture

Great series of articles, that anyone interested

in the subject should complement with the two

very good pieces written by Matt Taibi's two articles 

on the 'horse trading' and lobbyist's gaming of the

proposed amendments of the bill.

As both S.Johnson and Yves Smith pointed out, the

final bill does not eliminate nor really curb 'systemic

risk', which one could think would have been one of the

primary goals, if your country had another Treasury

Secretary....

Tue, 08/17/2010 - 07:30 | 525548 MarketFox
MarketFox's picture

Quoted:

The problem with this kind of regulation is that new laws are always looking backward in an attempt to prevent the last bust from happening.

......................................

The above says it all....and is the sole reason that politics are bad economics and prescriptions....

The only way to minimize politics ....IS TO MINIMIZE THEIR MONEY AND POWER....

......................................

It is also imperative that the cost of government be no greater than 10 to 15%...because taxes and legal largesse are always reflected in prices....

.....................................

To look forward...the simplest way to do this is a 15% consumption tax....and the elimination of individual and corporate taxes....

......................................

Furthermore the problem is the enabling of an economy that will grow much larger than it is...and be better distributed than it is...

So the question becomes this....

Which of the following two economies would be much larger in 10 years ?

1) Current and proposed tax system

2) A simple 15% consumption tax....no other taxes...

The revenue from a simple 15% consumption tax would dwarf the tax take from the current system many fold...and the economy would be many times larger....

.............................

Another misunderstood point is that there are those that believe that a consumption tax would be harder on the poor....as if the poor do not pay the taxes built into current prices of all goods and services....

I can assure you that all taxes simply show up in all prices....and everybody including the poor pays them across the board....

...................................

The real issue here is to grow the economy such that more people can have jobs.....and a sole 15% consumption tax ...would do just that.....producing an economy many times the size which is now being constrained by the current tax system....

 

Tue, 08/17/2010 - 08:00 | 525574 Sean7k
Sean7k's picture

A 15% consumption tax is a tax against the poor and middle class. How about a 15% tax against corporations and those with incomes in excess of 200,000? Since the majority of government costs go to protect the property of the elites- they should be the ones that pay for that protection. 

Prices are set by supply and demand in the markets. Taxes are only included if the demand for the good is enough to allow the producer to include it. That type of statement ignores reality. It is pure propaganda. 

The elites use a smaller proportion of income for consumption. Thus, a consumption tax favors the wealthy. 

Better yet- no taxes at all. Minimum government and the dramatic downsizing of the military industrial complex to simple defense of the US proper only.

Great piece, Thanks for the hard work.

Tue, 08/17/2010 - 09:07 | 525612 MarketFox
MarketFox's picture

Incorrect....

Taxes are a portion of all prices....

All the forms of taxes....The Fed tax is not separated out for the poor or middle class....

.....................

However....you like most commentors miss the main point....

....................

The goal is to increase the size of the economy....such that more middle class and the poor CAN have jobs....

.................................

Look in the mirror and think for yourself....

..............................

Which tax structure would allow for a much larger economy ?

1) 15% Consumption tax only

 

2) Current and proposed tax structure....

.............................

What if America woke up tomorrow ....never to file any sort of tax forms whatsoever....never again....

And in return received an economy whereby prices were lower....and jobs were plentiful ?

...................................

Ask any businessman....or individual which they would prefer....

And better yet....ask any businessman....which system would provide for a much larger economy....

...................................

But that's ok pal....

The likes of Summers....Bernanke....every politician....are more likely to share your point of view....and already have....

This is why the US has the current problems that it has....and will continue to have them....Lots of intelligent individuals have totally missed the boat on this one....

 

Tue, 08/17/2010 - 09:32 | 525701 chrisina
chrisina's picture

Let's see:

consumer spending is 70% of GDP

15% consumption tax means 10.5% of GDP as Govt revenues.

Current Govt spending is Federal 24.8% of GDP + states and municipalities 5% ie 30%.

How do you balance a budget with 10% of GDP in revenues and 30% of GDP in expenditures?

If you wanted to balance budget with current level of expenditures you'd have to charge a consumption tax of 43% and not 15% (43% of 70% of GDP = 30%)

Moreover a consumption tax hits far more the poor and middle classes than the rich. Ask someone who makes less than $3000 a month if he'd like to see a 43% tax added to everything he buys. 

The problem is obviously not the tax structure, but the level of spending of government.

I agree that the current tax code is far too complicated but a flat consumption tax is even worse, and your assumption that it would generate a much larger economy is without merit.

 

Tue, 08/17/2010 - 09:39 | 525717 MarketFox
MarketFox's picture

Nope...

I agree that the current tax code is far too complicated but a flat consumption tax is even worse, and your assumption that it would generate a much larger economy is without merit.

..........................

Everyone pays the Fed tax through purchases...

And the fact is that the US already has a progressive consumption tax....

People have to earn different levels to buy the same products...

ie 

toothpaste

$1.00

$1.10

$1.20

$1.38

Now apply this across the board....

..........................................

All product prices contain Fed taxes....they are just not separated out and renamed....

If a poor, middle, or upper class buyer buys something....they pay for more in taxes than the price describes.....

Look in the mirror ...and think about it....

................................

And the economy of a 15% consumption tax....no other taxes would dwarf the current system's economy....

Go do a little more homework on this one....

Tue, 08/17/2010 - 09:49 | 525748 chrisina
chrisina's picture

as I said, a 15% consumption tax generates 10.5% of GDP in Govt revenues. With current Govt spending at 30%, you get 20% deficits every year, ie a Govt debt that increases by 200% of GDP in a decade. You must be joking.

With current level of Govt expenditures, it would have to be a 43% consumption tax. You think that would improve demand for products and services?

I repeat : the problem isn't the tax structure, but the level of spending of government. 

 

Tue, 08/17/2010 - 10:10 | 525797 MarketFox
MarketFox's picture

Exactly...

But the issue is this....

The current structure suggests the cutting down of more trees in the orchard while demanding more fruit....This ends badly....

...............

There must be an allowance for the replanting of the orchard....and the actual expansion of it....

...................................

The previous commentor seems to have an even better idea than the consumption tax....

ie ...a small monthly tax on all money....collected by the depository....

This would be even broader based...and more efficient....

No more tax forms...individual or corporate taxes period.....

.............................

And absolutely correct....part of the equation is to mandate a much smaller government portion of the economy.....1000% correct....

Tue, 08/17/2010 - 09:16 | 525661 MurderNeverWasLove
MurderNeverWasLove's picture

Consuption tax?  What's so evil about consumption that we ought to tax that?  Almost  as bad as taxing income and profits.

 

The only sort of reasonably fair tax I've come accross is the APT tax.

 

If we sum up the "value of transactions" that went into squeezing a mere $15T in GDP, we'd find that number to be around $4Q.

 

How about no taxes, and a tiny fee on the use of money.  You say 15%, and Dr. Fiege says 0.24%.

http://apttax.com/faq.php#pie

More current figures can be estimated from:

http://www.bis.org/publ/cpss88.htm

 

 

Tue, 08/17/2010 - 09:32 | 525702 MarketFox
MarketFox's picture

A tiny fee on the use of money could be very interesting....it would certainly be the simplest....and most broad based.....

Good point....

........................

Perhaps a constitutional max of 5%...which would be cumulative for state and fed....

........................

Some third world countries do this with checks...but do not include the cash portion....

.......................

Perhaps a monthly take on all savings ...cash....any deposit form ....in all banks...ie 41 basis per month....

The caveat being....who would keep money in a bank....unless interest was over 5%.....

 

Very interesting idea and premise....

Certainly better than what is being done currently.....and perhaps much better than a 15% consumption tax....

 

Congrats to you.....

I really like this idea....

 

Tue, 08/17/2010 - 18:57 | 527212 MurderNeverWasLove
MurderNeverWasLove's picture

Thanks for your thoughts.

I personally think a suitable MAX would be 0.5%.

Let's say half the economic activity flees or dies off, only leaving a taxable base of $2Quadrillion.  That's $10 Trill for the budget.

You completely got why I think this is the most fair.  When there is no value judgement on anything--no exemptions--then no distortions/social engineering by polititians looking to hand out favors.

Perhaps a monthly take on all savings ...cash....any deposit form ....in all banks...ie 41 basis per month....

The caveat being....who would keep money in a bank....unless interest was over 5%.....

But so long as money was sitting in an account somewhere, it wouldn't incur the fee.  The fee only happens when the money moves.

So savings are safe from taxation.  Only when it gets pulled out and used for something else does it get taxed.

It's a new spin on "tax anything that moves" -- and an interesting answer to HFT?

 

Tue, 08/17/2010 - 04:43 | 525510 Conrad Murray
Conrad Murray's picture

I enjoyed this series.  Thank you and please keep up the solid work.

Bills like this are just plain shameful.  Power grabs shrouded with only the thinnest veil of feigned interest for the common man.  Those at the top are playing a very dangerous game as more and more people wake up and become educated about economics and American history.  It will be interesting to see how things turn out for the bought and paid for traitors.

The one part of this steamroller to destruction that really hits home for me is moral hazard.  I see so many disturbing trends among my peers.  I know a good deal of individuals who are on the dole for no other reason than they can be, but not realizing being out of work for nearly two years does not bolster employment prospects when the gravy train ends.  Grants for college are seen as free party money.  The student loans they take out are used for everything except education.  Credit card bills are ran up because, "Fuck it, I'm gonna file for bankruptcy".  Strange times ahead for America.

OT: I just checked out your "Reading List", and I like it.  Been through most of it, but not The Forgotten Man.  Honestly, I hadn't heard of it before.  I looked it up and it seems a worthy read.  I've been away from the economic stuff for a couple months, as I shifted into the likes of Blackstone, Mill, Hume, Locke, and the Founders.  Time to switch gears again and that will be my first read.  Also, I keep hearing about the Larsson novels, but have yet to be convinced their worth my time.  Your recommendation just may push me to dive in this winter.  Anyhow, here's to self-education and coming out on the other side of the crack-up boom intact, cheers!

Tue, 08/17/2010 - 14:05 | 526472 Econophile
Econophile's picture

Conrad:

Thank you for the kind words. And thanks to everyone who waded through all four parts. 

And, Conrad, I think you'll enjoy Stieg Larsson. And, Forgotten Man is a wonderful book.

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