Financial Reform Bill And Regime Uncertainty

``But the law is made, generally, by one man, or by one class of men. And as law cannot exist without the sanction and the support of a preponderant force, it must finally place this force in the hands of those who legislate. This inevitable phenomenon, combined with the fatal tendency that, we have said, exists in the heart of man, explains the almost universal perversion of law. It is easy to conceive that, instead of being a check upon injustice, it becomes its most invincible instrument.” Frédéric Bastiat, The Law

Yo-yo Markets And The Financial Reform Bill

Writing in the Wall Street Journal, hedge fund manager and author Andy Kessler seems right; the actions of the US markets, which directly affects other financial markets, will be in a state of a Yo-yo for as long as the US government continually intervenes to suppress market forces from revealing its true conditions.

Mr. Kessler writes[1],

``Call it the yo-yo market—from the top of the wall to the bottom of the pit and back—and you better get used to it. It's hard to tell which market moves are real and based on prospects for better profits, as opposed to moves that are driven by all the extraordinary government measures to prop up the world economy. Until a few things are resolved, you'd better learn the yo-yo sleeper trick—that is, keep spinning at the bottom without going up.”

Mr. Kessler appears to echo what we’ve been saying all along[2]---that politics has and will shape the outcome of the markets.

Mr. Kessler cites the pervasive impact of the Zero Interest Rate Policy (ZIRP), the assorted “crutches” or the guarantees, stimulus packages, and money printing, and importantly, the impact of the changes in the regulatory environment.

Since we had exhaustively discussed on the first two factors, in the light of the passage of the Financial Reform Bill[3], we’d tackle more on the aspects of the regulatory environment.

After having a rather promising start for the week, the US markets fell hard Friday after the ratification Financial Reform Bill. The losses virtually expunged on the early gains made whereby the net weekly result for the US S&P 500 had been a net loss of 1.21% (see figure 1).

Figure 1: US Global Investors[4]: Sectoral Performance

Nevertheless the degree of losses had been uneven, where some sectors of the S&P 500 have managed to escape the clutches of the selling pressures, such as the Consumer staples and the Technology sector.

True, correlation doesn’t automatically translate to causation. The Financial Reform bill may or may not have directly affected Friday’s performance.

However, given that the largest victim of the selloff had been in the financial sector, which is the target of the slew of new regulations, then I must argue that there could have been a substantial connection in the way the markets perceive how these purported reforms would affect the industry.

In other words, markets may have seen more downside risks to the industry, as a result of the law, and these perceptions have filtered into the other sectors.

Yet it’s simply amazing how some mainstream analysts fail to acknowledge of the vital role played by the regulatory environment in shaping the allocation of resources.

They seem to think that investment is merely consequence of waking up on a particular side of the bed which determines their “animal spirits”, or that, confidence is simplistically established as a function of random temperaments or moods—and largely detached from the coordination of consumers and producers in the marketplace.

Thus, many make specious arguments that new regulations won’t affect the business operations.

Importantly, the same experts fail to take into account that entrepreneurs invest with the aim to profit from providing or servicing the needs or desires of the consumers. Thus, a material change in the regulatory environment may affect the fundamental profit and loss equation. And the ensuing changes could also alter the feasibility of the operations of any enterprises, to the point which could lead to either closures, or impair the business operations. The net effect should be more losses and rising unemployment.

In short, business confidence is a function, not of some mood swings, but of property rights. Likewise confidence relative to investment should be predicated not just with the return ON capital, but with the return OF capital.

Regime Uncertainty From Arbitrary Laws

Economist Robert Higgs calls this reduced confidence factor as “regime uncertainty” where he argues[5] (bold emphasis mine)

``To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

Thus, to allege that new regulations will hardly be a factor in the investment environment would redound to utter detachment with reality.

Well, what can we expect from so-called ivory tower “experts” who seem to think that they own the monopoly of knowledge, via mathematical models and aggregates, when their sources of income depends on wages than from wagering on the dynamic trends of the marketplace? (Pardon me for the ad hominem, but perspectives are mostly shaped by interests)

Take the Great Depression (GD) of 1930s, which many prominent bears have anchored their projections as the probable direction of today’s market.

From the monetarist viewpoint, the GD had been all about monetary contraction, whereas from the Keynesian perspective this had been about falling aggregate demand. Both of which has been diagnosed by the incumbent Federal Reserve chief Ben Bernanke[6] as the major causes from which current policies have been designed to address. Yes—the solution? The printing press!

While both did have a role to play, the oversimplistic account of the GD fails to incorporate the havoc generated by the legion of intrusive laws enacted by the US government’s New Deal program, aimed at keeping prices at status quo ante or from adjusting to the realities of the unsustainable misdirection of capital from the inflation boom induced depression. These policies, which threatened property rights, had greatly exacerbated and prolonged the grim conditions then.

These laws included[7]:

1933 Agricultural Adjustment Act, National Industrial Recovery Act, Emergency Banking Relief Act, Banking Act of 1933 Act, Federal Securities Act, Tennessee Valley Authority Act, Gold Repeal Joint Resolution, Farm Credit Act, Emergency Railroad Transport Act, Emergency Farm Mortgage Act National Housing Act, Home Owners Loan Corporation Act

1934 Securities Exchange Act, Gold Reserve Act, Communications Act, Railway Labor Act

1935 Investment Company Act, Revenue Act of 1940, Bituminous Coal Stabilization Act, Connally (“hot oil”) Act, Revenue Act of 1935, National Labor Relations Act, Social Security Act, Public Utilities Holding Company Act, Banking Act of 1935, Emergency Relief Appropriations Act, Farm Mortgage Moratorium Act

1936 Soil Conservation & Domestic Allotment Act, Federal Anti-Price Discrimination, Revenue Act of 1936

1937 Bituminous Coal Act, Revenue Act of 1937, Act Enabling (Miller-Tydings) Act

1938 Agricultural Adjustment Act, Fair Labor Standards Act, Civil Aeronautics Act, Food, Drug & Cosmetic Act

1939 Administrative Reorganization Act

1940, Second Revenue Act of 1940

Figure 2: Wikipedia.org[8]: US Income Tax (left window), Higgs: Government Purchases (Current$) and Gross Private Investment (Current$) Relative to Gross Domestic Product (Current$), 1929–1950

For instance, one should also take into account how the surge in taxation (left window) to fund the explosion in government expenditures during the Great Depression (right window) contributed to stymie investments or production (see figure 2)

As Henry Hazlitt aptly described how taxes affect investment or production[9]

``When the total tax burden grows beyond a bearable size, the problem of devising taxes that will not discourage and disrupt production becomes insoluble.”

In other words, when the expectations for profits are reduced, borne out of the expectations of higher taxes or from other regulatory interdictions which places property rights at risks, then investments will obviously follow—and decline.

Therefore the regulatory and tax regime functions as crucial factors to the conditions of confidence in the marketplace.

Paradoxically, one function of the law is the avoidance of this “regime uncertainty”. But when the state is unclear about the direction of policies and regulation, the “means” can contradict the “end”. So, instead of stability, such laws could engender or promote “regime uncertainty”. Yet, these are commonplace feature of many arbitrary laws.

Take the recently enacted Financial Reform Bill, it has been reported to contain 2,319 pages (see figure 2)

Figure 2: Mark Perry[10]: Major Financial Legislation: Number of Pages

The sheer mountain of pages by itself would make the reformist law seem like a regulatory quagmire and appears appallingly political relative to the enforcement issues.

Heritage’s Conn Carroll explains[11],

``With the single stroke of a pen, President Barack Obama signed the Dodd-Frank financial regulation bill that set in motion 243 new formal rule-makings by 11 different federal agencies. Each of the 243 rule-makings will employ hundreds of banking lobbyists as they try to shape what the final actual laws will look like. And when the rules are finally written, thousands of lawyers will bill millions of hours as the richest incumbent financial firms that caused the last crisis figure out how to game the new system.”

The implication is that where financial firms compete, not to please customers, but to gain the favour of regulators, this essentially represents as the hallmarks of corporatism or crony capitalism.

Thus, the financial reform bill is likely to foster political privileges which entrenches the “too big too fail” institutions, who will profit from economic rent.

The litany of adverse effects from such ambiguous bill will be one of expanded corruption, lack of credit access for consumers, reduced consumers protection (in contrast to the purported letter of the law), regulatory capture, regulatory arbitrages, higher risks to taxpayers on greater risk appetite for the politically privileged firms (moral hazard issue), increased red tape via an expanded bureaucracy, higher compliance costs, more government spending and reduced competition which overall translates to broad based economic inefficiencies.

Yet the reformist law is also said not only to be opaque, but gives undue confiscatory power based on the whims of regulators.

Mr. Kessler writes[12], ``What is even more troubling is the prospect of government seizures built into the Dodd-Frank financial bill. This is much like the seizure of property from auto industry bond holders (denounced as speculators) in the bankruptcy of GM and Chrysler.

``Dodd-Frank also provides government leeway to seize firms it considers a systemic risk, without really defining what that systemic risk is. Why anyone would provide debt to large financial institutions (or auto makers) is beyond me, certainly not without demanding a huge premium for the seizure risk. The cost of capital for the U.S. economy is sure to rise, slowing growth.”

This means that Financial Reform bill also entails that the political favoured institutions are likely to become veiled instruments for political agenda of those in power.

And laws of this nature is what Frédéric Bastiat long admonished[13],

``But, generally, the law is made by one man or one class of men. And since law cannot operate without the sanction and support of a dominating force, this force must be entrusted to those who make the laws.

``This fact, combined with the fatal tendency that exists in the heart of man to satisfy his wants with the least possible effort, explains the almost universal perversion of the law. Thus it is easy to understand how law, instead of checking injustice, becomes the invincible weapon of injustice. It is easy. to understand why the law is used by the legislator to destroy in varying degrees among the rest of the people, their personal independence by slavery, their liberty by oppression, and their property by plunder. This is done for the benefit of the person who makes the law, and in proportion to the power that he holds.”

In short, arbitrary laws, as the Financial Reform bill, can function as instruments of injustice.

Thus, it is NOT impractical or improbable to argue that in the wake of the enactment of the Financial Reform Bill, the ambiguity and arbitrariness of the law and the increased politicization of the financial industry would likely result to greater perception of risks which may be reflected on the “Yo-yo” actions or a more volatile US markets.

At the end of the day, regulatory obstacles will likely compel capital to look for a capital friendly environment from which to flourish.

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[1] Kessler, Andy, The Yo-Yo Market and You, Wall Street Journal, July 16, 2010

[2] See How Political Tea Leaves Will Shape The Investment Landscape

[3] Bloomberg, U.S. Congress Passes Wall Street Regulation Bill, July 15, 2010

[4] US Global Investors, Investor Alert, July 16, 2010

[5] Higgs, Robert Regime Uncertainty, Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War

[6] Bernanke, Ben Deflation: Making Sure "It" Doesn't Happen Here, Speech Before the National Economists Club, Washington, D.C. November 21, 2002

[7] Higgs, Ibid

[8] Wikipedia.org, Income tax in the United States

[9] Hazlitt, Henry Taxes Discourage Production, Chapter 5 Economics In One Lesson

[10] Perry, Mark ‘I Didn’t Have Time to Write a Short Bill, So I Wrote a Long One Instead,’ Part II The Enterprise Blog July 16

[11] Carroll, Conn Morning Bell: The Lawyers and Lobbyists Full Employment Act, Heritage Blog, July 16, 2010

[12] Kessler, Andy Ibid.

[13] Bastiat, Frédéric The Law

Sand Castles From US Regulatory Reforms

“Any fool can make a rule. And any fool will mind it.” - Henry David Thoreau

Among the popular misconceptions about resolving today’s social and institutional problems is the issue of regulation.

For many (particularly for the left), the recent Financial Crisis had been a product of “free markets” or “market fundamentalism”. This notion is totally absurd.(there can be no pure free market in a world of central banking)

For instance many hold that the repeal of the Glass Steagall Act via the Gramm-Leach Bliley as responsible for today’s crisis.

Economist and Professor Luigi Zingales argues otherwise[1], ``In 1984, the top five U.S. banks controlled only 9% of the total deposits in the banking sector. By 2001, this percentage had increased to 21%, and by the end of 2008, close to 40%. The apex of this process was the 1999 passage of the Gramm-Leach-Bliley Act, which repealed the restrictions imposed by Glass-Steagall. Gramm-Leach-Bliley has been wrongly accused of playing a major role in the current financial crisis; in fact, it had little to nothing to do with it. The major institutions that failed or were bailed out in the last two years were pure investment banks — such as Lehman Brothers, Bear Stearns, and Merrill Lynch — that did not take advantage of the repeal of Glass-Steagall; or they were pure commercial banks, like Wachovia and Washington Mutual. The only exception is Citigroup, which had merged its commercial and investment operations even before the Gramm-Leach-Bliley Act, thanks to a special exemption.” (bold emphasis)

On the other hand, the Community Reinvestment Act (CRA), whose regulations forced financial institutions to accept risky borrowers have also been held responsible.

According to Peter J. Wallison of the American Enterprise Institute[2], ``In 1995, the regulators created new rules that sought to establish objective criteria for determining whether a bank was meeting CRA standards. Examiners no longer had the discretion they once had. For banks, simply proving that they were looking for qualified buyers wasn’t enough. Banks now had to show that they had actually made a requisite number of loans to low- and moderate-income (LMI) borrowers. The new regulations also required the use of “innovative or flexible” lending practices to address credit needs of LMI borrowers and neighborhoods. Thus, a law that was originally intended to encourage banks to use safe and sound practices in lending now required them to be “innovative” and “flexible.” In other words, it called for the relaxation of lending standards, and it was the bank regulators who were expected to enforce these relaxed standards.”

Meanwhile, the Cleveland Fed downplays the role of the CRA in this crisis[3].

There has been “no consensus” as to which of the two laws had truly an adverse impact on the markets. Since there has been no perfect correlation, the ensuing tit-for-tat in the media had been reduced into a debate based on ideological slant.

In addition, we also said that the impact of laws tend to be divergent and ‘time sensitive’, where some laws could have positive interim term effects but with negative long term impact, and vice versa.

As caveat, while correlations may not appear to be outright linear, as the debate above holds; it would be misguided to attribute the lack of correlation to a single variable or to one law considering that there are many other laws or variables that also combine and or compete to expand or diminish the effects of a particular law.

Here the underlying general principles or theory will be more dependable than simply relying on statistics or math. Murray Rothard notes of the observation of John Say in distinguishing these[4],

``Interestingly enough, Say at that early date saw the rise of the statistical and mathematical methods, and rebutted them from what can be described as a praxeological point of view. The difference between political economy and statistics is precisely the difference between political economy (or economic theory) and history. The former is based with certainty on universally observed and acknowledged general principles; therefore, “a perfect knowledge of the principles of political economy may be obtained, inasmuch as all the general facts which compose this science may be discovered.” Upon these “undeniable general facts,” “rigorous deductions” are built, and to that extent political economy “rests upon an immovable foundation.” Statistics, on the other hand, only records the ever changing pattern of particular facts, statistics “like history, being a recital of facts, more or less uncertain and necessarily incomplete.” (underscore mine)

In short, trying to pinpoint the effects of one law based on oversimplified statistics to the political economy can be tricky. And this is where the left has used statistics or math to obfuscate evidences.

More of John Say from Murray Rothbard, ``The study of statistics may gratify curiosity, but it can never be productive of advantage when it does not indicate the origin and consequences of the facts it has collected; and by indicating their origin and consequences, it at once becomes the science of political economy.” (underscore mine)

Regulatory Arbitrage And Fighting The Last War

And as we earlier pointed out to the contrary, where laws are lengthy, ambiguous, partisan and subject to political discretion, they tend to be distortive and create imbalances in the system. And the impact of some of these laws indubitably accentuated the crisis.

Nevertheless there had been some policies or regulations that had relatively more material impact among the others (see figure 3).

Figure 3: Bank of International Settlements: Ingredients of the Crisis

The apodictic evidence from last crisis had been the surfacing of the “shadow banking system” (see right window).

As pointed out earlier above, one of the unintended consequences of bad laws or overregulation is to have regulatory arbitrages, where markets look for regulatory loopholes from which it exploits. These are parallel to the emergence or existence of black markets over economies that operate heavily under price controls[5].

So even the multilateral government agency as the UN via its subsidiary the UNCTAD had to admit this[6], ``Recent United States banking regulations, for example, were designed to control risk through the measured capital ratio used by commercial banks, the report says. This attempt backfired because bank managers circumvented the rules either by hiding risk or by moving some leverage outside the banks. This shift in leverage created a "shadow banking system" which replicated the maturity transformation role of banks while escaping normal bank regulation. At its peak, the US shadow banking system held assets of approximately $16 trillion, about $4 trillion more than regulated deposit-taking banks. While the regulation focused on banks, it was the collapse of the shadow banking system which kick-started the crisis.”

The lesson of which clearly is that politics, no matter how heavy handed, can hardly control the fundamental laws of economics.

Another problem with regulation is that it fights the last war.

For instance during the last bubble, the issue of prominence had been the accounting fraud from Enron, Tyco International, Worldcom, Adelphia and others that gave rise to the Sarbanes-Oxley Act[7].

Obviously, from a hindsight bias the regulation failed to make any headway to stop the recent crisis. Again that’s because markets are dynamic and seizes the next loopholes as opportunity to expand.

Nonetheless some has argued that the Sarbox law itself has been a drag to the recovery of the US. An example is this commentary from Wall Street Journal’s James Freeman[8],

``Is Sarbox to blame? Many financial pundits say no, but the SEC survey results point in the other direction. When public companies are asked whether Section 404 has motivated them to consider going private, a full 70% of smaller firms say yes, and 44% of all public companies also say yes.

``Has Sarbox driven businesses out of the country? Among foreign companies, a majority in the survey say that Section 404 has motivated them to consider de-listing from U.S. exchanges, and a staggering 77% of smaller foreign firms say that the law has motivated them to consider abandoning their American listings.”

In short, another unintended consequence of having more regulation is to raise the cost of compliance.

In a globalized market, investors can arbitrage away regulatory burden or the cost of compliance by simply transferring to where there is less onus or costs.

Figure 4 IMF: Sovereign Debt to GDP in the G-7

Yet fighting the last war means attacking past problems which may not be the source of the next crisis.

Another factor that is seemingly ignored is that the leverage, which is now a “prominent” factor, acknowledged by the mainstream seems to be building not in the previous sectors, which suffered from a bust, but instead in government debt.

As in the earlier chart (figure 3 left window) from the speech of Hervé Hannoun[9] Deputy General Manager of the BIS, low interest rates which has allowed for the chasing of yields, low volatility and high risk appetite, were outstanding features of the last crisis. However, practically the same ingredients in the past we are seeing today.

And governments are in a tight fix because, as we have been saying[10], “ governments will opt to sustain low interest rates (even if it means manipulating them-e.g. quantitative easing) as a policy because ``governments through central banks always find low interest rates as an attractive way to finance their spending through borrowing instead of taxation, thereby favor (or would be biased for) extended period of low interest rates”

So governments are operating in a policy paradox.

They pretend to know the main sources of the crisis yet are addicted to it for political reasons. An addict can hardly refuse what’s keeping them going. It’s simply path dependency from what we call as policy “triumphalism”. According to the G-20, ``The global recovery has progressed better than previously anticipated largely due to the G20’s unprecedented and concerted policy effort.”[11]

Again we are being validated.

Agency Problem And Socializing Losses While Privatizing Profits

There is another problematic aspect in regulation; it’s called the agency problem or the principal agent problem.

It’s a problem which emanates from different incentives or goals by those operating within the industry.

For instance during the last crisis, risk monitoring was fundamentally outsourced by risk buyers to the ratings agencies (yes in spite of the army of professionals). On the other hand, originators of risk securities or risk sellers tied fees due the credit ratings agencies on the credit ratings they issued which were then sold to “sophisticated” financial institutions.

Said differently, the job of credit appraisals were delegated to the ratings agencies which incidentally derived its income from the issuers of securities, and not from the buyers. Whereas buyers of securities fully delegated the role of due diligence to the ratings agencies.

So credit risks had been ignored in the assumption that someone else would do it for them. As Charles Calomiris Columbia University recently said in an interview[12], “Agency problem...Ratings agencies were a coordination device for plausible deniability."

Figure 5: The Economist: Reforming Banking

Perhaps the ultimate source of ‘plausible deniability’ comes with attendant with the current structure of the banking system-it’s basically called the fractional reserve based banking platform (see figure 5).

Bank equity as % of assets is now nearly at the lowest level since the introduction of central banking and deposit insurance.

In a BIS paper from Andrew Haldane of the Bank of England[13] writes, ``Over the course of the past 800 years, the terms of trade between the state and the banks have first swung decisively one way and then the other. For the majority of this period, the state was reliant on the deep pockets of the banks to finance periodic fiscal crises. But for at least the past century the pendulum has swung back, with the state often needing to dig deep to keep crisis-prone banks afloat. Events of the past two years have tested even the deep pockets of many states. In so doing, they have added momentum to the century-long pendulum swing.”

This means that the banking system’s ability to take more risks comes under the broadening premise of “privatizing profits and socializing losses” as the guiding policy.

This means that aside from central banking, deposit insurance is another means to “privatizing profits and socializing losses” which allows the banking system to absorb more risks, while on the hand tolerates the expansion of regulatory powers by the central bank.

As Murray N. Rothbard wrote[14], `Under a fiat money standard, governments (or their central banks) may obligate themselves to bail out, with increased issues of standard money, any bank or any major bank in distress. In the late nineteenth century, the principle became accepted that the central bank must act as the “lender of last resort,” which will lend money freely to banks threatened with failure.

``Another recent American device to abolish the confidence limitation on bank credit is “deposit insurance,” whereby the government guarantees to furnish paper money to redeem the banks’ demand liabilities. These and similar devices remove the market brakes on rampant credit expansion.”

So moral hazard and the agency problem seem to be significant factors that had been transforming the developed world banking system.

Of course there are other potential sources of regulatory problems, such as economics and behavioural aspects of enforcement, conflicting laws, a multitude of arcane laws which the public can’t comprehend, Arnold Kling’s legamoron (laws that could not stand up under widespread enforcement) and others, but due to time constraints we will be limited to the above.

At the end of the day, those building up the expectations for more regulations as elixir to the current problem would likely fail them. Why? Because there will be a new crisis down the road and hardly any of the current reforms will stop it.

Until they deal with roots of the problem, bubbles like the game called whack-a-mole will keep reappearing. Yet history says that all paper money is bound to go back to its intrinsic value-zero.

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[1] Zingales, Luigi Capitalism After the Crisis, National Affairs

[2] Wallison, Peter J. The True Origins of This Financial Crisis, American Spectator

[3] Nelson, Lisa Little Evidence that CRA Caused the Financial Crisis, Cleveland Fed

[4] Rothbard, Murray N. Praxeology as the Method of the Social Sciences

[5] An example of this is North Korea, which recently massively devalued her currency to fight the black markets. But unlike before where policies where met with passive resistance, riots broke out from which tempered Kim’s political approach. See Will North Korea's Version Of The 'Berlin Wall' Fall In 2010?

[6] UNCTAD, Shadow banking system that escaped regulation, faith in ´wisdom´ of markets led to meltdown, study says

[7] Wikipedia.org, Sarbanes-Oxley

[8] Freeman, James The Supreme Case Against Sarbanes-Oxley, Wall Street Journal

[9] Hannoun, Hervé Financial deepening without financial excesses, Bank of International Settlements, 43rd SEACEN Governors’ Conference, Jakarta

[10] See How Myths As Market Guide Can Lead To Catastrophe

[11] Wall Street Journal Blog, Text Of G-20 Finance Ministers, Central Bankers’ Statement

[12] Calomiris Charles, Econolog David Henderson: Calomiris on the Financial Crisis

[13] Haldane, Andrew Banking on the state Bank Of International Settlements

[14] Rothbard, Murray N., The Economics of Violent Intervention, Man, Economy and State