SINGHAM: Deregulatory rush

OPINION:

COMMENTARY:

As the financial crisis unfolds around the world, triggered by the subprime mortgage mess in the House Financial Services Committee claim to have won a victory over the “deregulators” they claim are avatars of a now defunct ideology - free and unfettered markets. Now that Congress has passed the financial bailout package, enquiring minds can try to figure out what climate will exist for financial services businesses in the new post-bailout operating environment.

Has deregulation caused the mess we are in, and will greater regulation ensure that we won’t be here again in 10 years? This really is the wrong question, and the assumptions on which the question is based are also wrong. First of all, the assumption there is (or was) a free market in financial services could not be farther from the truth. The financial services sector has always been massively regulated, sometimes in ways that make sense and sometimes in ways that do not.

The Bank Holding Companies Act subjects banks to rigid capital adequacy requirements, supervised by the Federal Reserve. There was a strict separation between investment and commercial banking under the Glass-Steagall Act, which was mercifully replaced by Gramm-Leach-Bliley in 1999. As noted elsewhere, banks were directed under the Community Reinvestment Act, and its predecessor laws dating back to the 1970s, to grant mortgages in poor communities with very low deposits, in order to spread the American dream of homeownership to many segments of society. These worthy goals took banks ever further from the profit-maximizing mandate that is the core of business activity.

We now see the catastrophic results of this meandering. A series of market distortions were imposed on the industry by changes in accounting practices (post-AIG with spectacular results.

These further market distortions prevented needed corrections that would have occurred in a competitive market.

But perhaps the largest distortion of all was the activity of the government sponsored enterprises (GSEs), Freddie Mac. Not only did they vastly increase demand for subprime mortgages, they were able to create a market for them by their implicit government guarantee that they would not be allowed to fail, no matter how catastrophic their internal decisionmaking.

Congress as usual was a vigorous promoter of these activities, defending these GSEs from meaningful oversight and discipline, and now has little credibility in this whole affair.

It is clear we will move from one type of regulatory environment to another. The question is what will the new regulatory environment look like. When “free markets” promoters talk about deregulation, what they really mean is moving to a pro-competitive regulatory environment, or an environment freer of the kinds of regulations and government distortions that tend to reduce overall consumer welfare. They do not mean all regulation is automatically harmful. They urge a regulatory environment where competition on the merits is the normative organizing economic principle, as opposed to the manipulation of government distortions.

The best way of ensuring we do indeed have this type of regulation is to ensure that competition plays a key role in ensuring that the costs to the market of anti-competitive regulatory distortion are constantly weighed against the alleged benefits. This way legislators can make informed decisions about what costs they believe the consumer should bear in exchange for some public good (price considerations versus safe food or other products, for example).

Too often the market distorting impact is not made clear for legislators to make informed decisions, while the alleged benefits are made very clear. The competition agencies are in a prime position to opine about these issues and their views should be factored into the overall regulatory process. This already occurs in some countries - it would be an important safeguard against anti-competitive regulation, and might have forestalled the very laws and regulations that led to this current crisis. Without it, we are doomed to repeat the mistakes of the past, and set up the next fiscal catastrophe.

Shanker Singham leads Competition Policy Inc. He is the author of a “General Theory of Trade and Competition: Trade Liberalization and Competitive Markets” (published by Cameron, May 2007).