Ferguson’s Policies are the Problem
The rest of Ferguson’s speech was actually worse and more dangerous than his effort to smear Keynes. In the rest of his speech he urged the resumption of the regulatory race to the bottom that produced the three “de’s” (deregulation, desupervision, and de facto decriminalization) that in conjunction with modern executive compensation produce the increasingly criminogenic environments that produce the recurrent, intensifying epidemics of accounting control fraud that drive our recurrent, intensifying financial crises. Ferguson rightly warns that crony capitalism now characterizes the U.S. and much of Europe, but fails to see that it is his favored policies that have created that scourge.
Here are the key portions of the reporter’s notes on Ferguson’s discussion of regulation and supervision. Again, the notes are from the reporter who expressed no criticism of Ferguson.
Regulatory Excess
“One of the major constraints to economic growth and the second pillar of the degeneration of our institutions is excessive regulation.
‘Unlike my arch enemy Paul Krugman’….who believes that the financial crisis was not caused by deregulation – the reality that there was plenty of regulation over the financial institutions. (Enforcement of those regulations is another issue entirely) that ultimately were at the epicenter of the crisis.”
Given Ferguson’s disdain for one Nobel Laureate I will cite the findings of another about a different crisis. George Akerlof and Paul Romer chose this paragraph to end their article (“Looting: The Economic Underworld of Bankruptcy for Profit”) in order to emphasize these points.
“Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer.1993: 60).
Note the strength of their conclusion – deregulation was “bound to produce looting.” Thanks to those who shared Ferguson’s animus towards regulations and effective regulators we failed to “learn from experience.” Instead, we made the three “de’s” (deregulation, desupervision, and de facto decriminalization far worse) by generating a global regulatory “competition in laxity” compounded by a “race to the bottom” among U.S. federal regulators and the creation of massive regulatory “black holes” (mortgage banking, the shadow financial sector, credit default swaps, etc.). As a result, history did not merely “repeat itself” – we made the environment so much more criminogenic that we produced the recurrent, intensifying epidemics of accounting control fraud that drove our recurrent, intensifying financial crises.
The Financial Crisis Inquiry Commission (FCIC) agreed with Akerlof & Romer’s unheeded warnings.
“We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts …due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves” (FCIC 2011).
“This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk….
In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor” (FCIC 2011:xviii).
“This [regulatory] failure was caused by many factors, including beliefs that regulation was unduly burdensome, that financial institutions were capable of self-regulation, and that regulators should not interfere with activities reported as profitable” (FCIC 2011: 308).
Federal examiners were ordered not to take action on the basis of undue risk.
“The OCC Large Bank Supervision Handbook published in January 2010 explains, “Under this approach, examiners do not attempt to restrict risk-taking but rather determine whether banks identify, understand, and control the risks they assume” (FCIC 2011: 307).
This (anti) supervisory philosophy called itself “risk-focused” examination and supervision – an oxymoron developed by regular morons that “focused” on “risk” by ordering federal regulators “not [to] attempt to restrict risk-taking.” Yes, I have been a member of a credit committee at a major bank.
Yes, I know that risk is an inherent component of life and lending. But not all risks are acceptable. Creating adverse selection as a home lender is never acceptable because it makes lending a negative expected value transaction. Bank examiners knew that a bank inherently cannot “identify, understand, and control the risks” when it does not underwrite loans prudently because underwriting is the essential process that allows a lender to “identify, understand, and control the risks.” Liar’s loans, therefore, were inherently imprudent and suicidal – to the lender. Liar’s loans, however, were ideal for accounting control fraud (what Akerlof and Romer termed “looting”). Their article explicitly discusses in detail why loans with a negative expected value optimize looting and describes the adverse selection that led to the negative expected value (Akerlof & Romer 1993: 2-3, 10-11, 16-18).
The FCIC dissent disagreed with these conclusions, but the logic of the dissent adds to the strength of the FCIC’s conclusion.
“The majority says the crisis was avoidable if only the [U.S.] had adopted … more restrictive regulations [and] more aggressive regulators…. This conclusion … ignores the global nature of the crisis. For example:
A credit bubble appeared in both the United States and Europe” (FCIC dissent 2011: 414).
But the crisis was not truly global, it was concentrated in the U.S. and Europe and the competition in regulatory laxity was most severe where the crisis was most severe initially. (Subsequently, austerity, the inherently flawed euro that exposes nations to the “bond vigilantes,” and the reluctance of the ECB to transform the euro into a quasi-sovereign currency combined to become the primary driver of the gratuitous über-Depression in the Eurozone’s periphery.)
The Nation that “won” the global race to the bottom was the U.K., so it is no surprise that banks and bank operations based in the City of London have had the most shameful record for fraud for over a decade. An investigation of the Irish financial crisis noted endemic weak regulation in Europe.
Ireland Report 2010:
“Four main failings of supervision: (i) Supervisory culture was insufficiently intrusive, and staff resources were seriously inadequate ….”
“On-site inspections were infrequent. Supervisors … imposed no penalties on banks at all.”
“Ireland’s mounting financial vulnerabilities meant that strong action was called for to over-ride the prevalent light-touch and market-driven fashions of supervision: to call a spade a spade….”
“failure to identify, recognise the gravity of, and take tough remedial action to correct such serious governance breaches was a cardinal error of supervision ….”
“Light touch” financial regulation became infamous in the U.S., U.K., Ireland, Germany, Greece, Italy, and Iceland. The reports on the Irish crisis explicitly conclude that Ireland’s “light touch” regulation was characteristic of “generic weaknesses in [EU] regulation and supervision.” Spanish financial regulation initially got a far better press, but over time it has become clear that the initial media praise was based on the fiction that Spain was a tough financial regulator.
Every nation loses when there is a regulatory Gresham’s dynamic in which weak regulation drives good regulation from the marketplace.
Ferguson Is One of the Drivers of the Regulatory Race to the Bottom
Ferguson’s speech decried U.S. deterioration in the World Economic Forum’s (WEF) measures of global competitiveness and urged the U.S. to reverse its falling rankings. Many of the WEF scales, however, give high ratings to nations who are inhumane and who weaken vital regulations. I have explained this in Davos while awarding the annual “shame prize” last year to Goldman Sachs and in a paper, so I will not repeat the arguments here, beyond noting that WEF explicitly urges businesses to use their WEF ratings to lobby their governments to weaken regulation and job protections under the extortionate threat that if the businesses do not get what they want they can always move to a nation with weaker protections for workers. This is another variant of a Gresham’s dynamic that puts every nation on the “Road to Bangladesh.”
In U.S. terms, WEF acts like a global ALEC to degrade the safety net and workers’ protections and rights. The recent mass murder of Bangladeshi workers in the collapse of their factory should remind us that we are often talking about protections that save many thousands of lives.
Ferguson Does Not Understand the Interaction of the Three “De’s”
According to the reporter’s notes, Ferguson made two primary claims about financial regulation. First, the crisis occurred where regulation was heaviest. Second, if there was a problem involving regulation, it was that violations of rules did not lead to effective enforcement. The crisis occurred where regulation was weakest – in the regulatory black holes that bankers’ political power (with the aid and comfort of ideologues like Ferguson) created. Control frauds seek out weakness and they found it in the shadow financial system, in mortgage banking, in mortgage brokerage, in CDS and CDOs, in investment banks, in S&Ls regulated by OTS (the weakest federal regulators – of Countrywide, WaMu, IndyMac, and AIG). They found it in the generic weakness of Europe and the overly friendly confines of the City of London.
Ferguson is on to something important when he speaks of the failure of enforcement (and should of spoken of “too big to prosecute”) the second (and third) of the “three de’s.” Yes, one can have good rules and if the regulators leaders are chosen by cronies of the banks there will be no effective regulation. Again, it is the Fergusons of the world who encourage the three “de’s.” But Ferguson misses the more subtle, critical part. Regulators self-select as well as bankers. When you have a regulatory race to the bottom that creates massive black holes and makes effective regulation impossible the causality runs in both directions. The political allies of the control frauds will not appoint or hire people like me who have records of regulatory effectiveness.
People like me and my colleagues who contained the S&L debacle and prevented the first wave of “liar’s loans” from causing a crisis in 1990-1991 also will not stay in an organization in which we are ordered to refer the banks as our “customers” or “clients” and to treat them as our “customers” or “clients.” I happily led and participated in a great deal of intelligent deregulation (there are always some stupid rules). The deregulation led by the like of Alan Greenspan, Al Gore (“reinventing government” was premised on the advice not to “waste one second … worrying about fraud”), Bob Rubin, Larry Summers, Timothy Geithner, Jacob Lew, Hank Paulson, “Chainsaw” Gilleran (OTS), D. Dochow (who reprised his disaster at Lincoln Savings with his disasters at Countrywide, WaMu, and IndyMac), is designed by the worst elements in banking to destroy effective regulation and supervision. People who are effective regulators will leave the regulatory ranks in disgust when regulatory policy is set by anti-regulators with track records of failure and sleaze. You cannot have a regulatory race to the bottom without also producing a race to the bottom in the quality of supervision, enforcement, and prosecution.
There is an academic literature on effective financial regulation written by public administration scholars that transcends the concept of “regulatory capture,” but I doubt that one economist in five thousand who writes about financial regulation has read it. Because hope springs eternal I will provide these references.
See: Chapter 2 of Professor Riccucci’s book Unsung Heroes (Georgetown U. Press: 1995), Chapter 4 (“The Consummate Professional: Creating Leadership”) of Professor Bowman, et al’s book The Professional Edge (M.E. Sharpe 2004), and Joseph M. Tonon’s article: “The Costs of Speaking Truth to Power: How Professionalism Facilitates Credible Communication” Journal of Public Administration Research and Theory 2008 18(2):275-295. (And you could read my book, which is in part an analysis of the regulatory history of the S&L debacle. I taught Public Administration at the University of Texas’ LBJ School of Public Affairs before joining UMKC.)