Financial reform exemplifies why debate should be on quality, not size of government

As we wind down to the end of the US election season, I want to use financial reform as an example of why the debate should have been focused on the quality and not size of government.

Regular readers know that your humble blogger championed bringing transparency to all the opaque corners of the financial system from the very beginning of the financial crisis.

On this blog, I have documented how for the financial system transparency and the market discipline it enables are a better solution than complex rules/regulations and regulatory oversight.

As a result, I have highlighted why with the exception of the Consumer Financial Protection Bureau and the Volcker Rule, the Dodd-Frank Act should be repealed.  I have also highlighted why Basel III and ring-fencing should be abandoned.

Each of these is a case of "quality" of government trumping "size" of government.

In a recent post on Naked Capitalism, Yves Smith focuses on the need for quality of government.

Even before the crisis, polls showed that the public overwhelmingly favors regulation to protect ordinary citizens from shoddy products and sharp practices. The spectacle of failure being rewarded during the financial crisis while the rest of us suffered in the resulting economic downdraft has led even people who are cautious about regulation in goods markets to acknowledge that finance is different and needs vigilant oversight.

Please recall that the FDR Framework on which our financial system is based combines the philosophy of disclosure with the principal of caveat emptor.

Disclosure is necessary so that market participants can see and steer away from shoddy products and sharp practices.

Disclosure is necessary so that vigilant oversight by market participants can be transformed into market discipline.

The Massachusetts Senate race provides a reminder. Scott Brown has been playing up the bankster caricature of Elizabeth Warren as a power-mad, business-hating Commie. If anyone bothered checking her calendar during her time as a consultant to the Treasury launching the CFPB, it shows that Warren bent over backwards to meet with bankers and solicit input. 

And the idea that the sort of regulation that Warren favors is bad for the public (or anyone other than overreaching businessmen) is a stretch (remember, Warren was once a Republican). And of course, this sort of attack serves to reinforce the canard that regulation is bad (as opposed to “bad regulation is bad” just as “bad Scotch is bad”)....

Please re-read the highlighted text as Yves does a wonderful job of explaining why the focus should be on quality government.

Bad regulation is not just bad, it is worse because it carries its own externality.  Specifically, it gets in the way of what could be better regulation.

Financial reform since the crisis has been dominated by Wall Street and the City.  As a result, it is long on bad regulations and short on quality regulations.

Does anyone beside me wonder why a financial crisis that began with opaque, toxic securities and interbank lending markets that froze because lending banks could not determine if borrowing banks were solvent has not yet brought ultra transparency to these two areas?

More generally, the case for government intervention is strong when externalities are involved. “Externalities” is economese for “when the parties to a transaction impose a cost on an unrelated party.” The prototypical example is pollution: the factory in your town that sells all its output to bigger companies pumps out particulate garbage and you get a lung disease as a result. 

Economists often rely on the work of Martin Weitzman in determining how to deal with this sort of problem, since there are two broad courses policymakers can take. One is to tax the polluter, to make his cost of goods reflect the true social cost. The other route is prohibition or regulation, so simply forbid him from doing certain things unless he meets certain standards. 

Weitzman’s argued that the government can never get this perfect, so the question of which approach to use depends on social costs versus private costs. ... If the costs to the public are higher than the private gains, then regulation and prohibition are preferable. 

Given the massive costs of the crisis (just look at how the periphery countries in Europe are being ground down so as to keep from exposing the insolvency of French and German banks, one of the results of the crisis, as well as the costs of the pump and dump housing game in America and the lousy employment market), it’s not hard to see that regulations are the right remedy as far as the financial services industry is concerned.

Remember, transparency is the result of regulations.

While it is theoretically in the bankers' best interest to provide ultra transparency, it requires a regulation to force them to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

While it is theoretically in the issuers' best interest to provide observable event based reporting for all structured finance securities from covered bonds to securitizations, it requires a regulation so these securities report all activities like a payment or a default on the underlying collateral before the beginning of the next business day.

So Warren’s and Barofsky’s successes aren’t special cases; they are the sort of outcomes you’d see regularly if we had regulators who didn’t see their stint as an employment agency for big ticket bank jobs (and don’t tell me people like that don’t exist; I can name two dozen capable people who have the right skills and mindset without thinking very hard. The issue is not the inability to find “talent”; it’s that the current political apparatus keeps them away from those positions). 

It’s annoying to hear the simple-minded anti-regulatory trope getting so much play.