Risk, Regulation, and Capital Markets

September/​October 2015 • Policy Report

Economic growth — including, importantly, wage growth — is ultimately driven by increases in productivity. The most effective way of driving productivity is a deepening of the capital stock. Capital, however, only multiplies in a hospitable environment — one of liquid, efficient capital markets with a respect for both contract and property.

Has America lost that hospitable environment? If so, can it be regained? In June, the Institute hosted a conference, “Capital Unbound: The Cato Summit on Financial Regulation,” during which a distinguished panel of experts examined the current state of U.S. capital markets regulation and offered proposals for unleashing a new engine of economic growth. The all‐​day event was held at the historic Waldorf‐​Astoria in New York City. Mark Calabria, Cato’s director of financial regulation studies, opened the summit by discussing the foundations of the economic meltdown of 2008.

“Unfortunately, the federal reaction to the financial crisis has been to double down on many of the distortions that drove it,” he said. For instance, policymakers have loaded ever more mortgage risk onto the backs of taxpayers, despite the fact that residential mortgages play a central role in the turmoil. “As unbelievable as it sounds, Washington is again calling for reducing underwriting standards and pushing homeownership as a getrich‐ quick scheme for everybody,” Calabria said. “I thought it would at least be a few more years before we went down that path again.”

Joshua Rosner, managing director at Graham Fisher & Co. and coauthor of Reckless Endangerment, added that attempts to assign blame have prevented policymakers from recognizing the real causes of the crisis. “There’s a false meme in Washington where a lot of the Democrats suggest that it was private markets and a lot of the Republicans suggest that it was government,” he said — when in reality it was both.

Kevin Dowd, a professor at Durham University and an adjunct scholar at the Cato Institute, focused on the problems with the Federal Reserve’s so‐​called “stress tests.” Using risk modeling, the tests subject banks to various scenarios to determine the capital “buffer” banks need to safely weather poor economic conditions. The problem, Dowd said, is that the models themselves suffer from many fatal flaws. Ending the Fed’s stress tests is a necessary first step toward reducing this “carnage by computing,” Dowd concluded.

Other speakers at the summit included Commissioner Michael Piwowar of the Securities and Exchange Commission; George Selgin, director of the Cato’s Center for Monetary and Financial Alternatives; and Thaya Knight, associate director of financial regulation studies at the Institute.

In his keynote address, Commissioner J. Christopher Giancarlo of the Commodity Futures Trading Commission highlighted the fact that a return to traditional American prosperity begins with efficient capital markets. “It’s not a matter of opinion,” he said. “It’s a matter of economic fact that everywhere in the world today where there are free and competitive markets, combined with free enterprise, personal choice, voluntary exchange, and legal protection of person and property, you will find the underpinnings of broad and sustained prosperity.”

“Yet here at home,” Giancarlo concluded, “these same elements are under attack by critics of our financial markets. These critics constantly talk about separating markets from risk, as if they have no idea that risk and prosperity are invariably intertwined.”

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