Many commentators have argued that if the U.S. Federal Reserve had followed a stricter monetary policy earlier this decade when the housing bubble was forming, and if Congress had not deregulated banking but had imposed tighter financial standards, the housing boom and bust — and the subsequent financial crisis and recession — would have been averted.
We are skeptical that economists can detect bubbles in real time through technical means with any degree of unanimity. Even if they could, we doubt the Fed would have altered its policy in the early 21st century, and we suspect that political leaders would have exerted considerable pressure to maintain that policy. Concerning regulation, we find that the banking reform of the late 1990s had little effect on the housing boom and bust, and that the many reform ideas currently proposed would have done little or nothing to avert the crisis.
Commentators have also argued that the popularization of financial products such as teaser-rate hybrid loans for subprime homebuyers and credit default swaps for investors is to blame for the financial crisis. We find little evidence for this. Housing data indicate that the majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans. Concerning swaps, although their introduction may increase financial inflows into risky sectors, their execution through a clearing-house or regulation via other means would not necessarily have avoided the mispricing of risks in underlying contracts. Capital requirements for the credit default swaps that were used to insure mortgage-backed securities would have been low because housing investments were not considered risky.
How should we design our financial and regulatory institutions? The lesson from the 1970s was that rampant inflation and unchecked inflation expectations would eventually create obstacles to proper resource allocation and growth. So we established the Fed's mandate to promote maximum growth while delivering price stability. The current episode suggests that the Fed's current policy goals and instruments are not sufficient to prevent "inflationary" asset prices and price expectations.
The knee-jerk response by some observers has been to blame the Fed's conduct of monetary policy. Some observers suggest that the Fed should regulate financial companies more tightly, others that it should broaden the definition of price stability to include asset prices, and yet others that the Fed's objectives should be broadened to include prevention of asset price bubbles.
Some observers, especially European policymakers, have called for tighter regulation of financial institutions under a new global financial architecture. And the immediate response of governments all over the world has been to attempt to salvage the existing financial institutions, instruments, and arrangements by injecting massive taxpayer funds into the financial companies that are skirting economic collapse.
When will this process end and where will it lead? Recent government interventions have now almost certainly created expectations of similar future bailouts during the next financial crisis. That means banking institutions will feel more at ease in expending considerable efforts at skirting whatever new regulations are created to prevent a similar financial crisis from recurring.
Thus, the cat-and-mouse game of regulatory arbitrage in search of profits may intensify, rather than disappear, as a result of adopting stricter financial regulations. But, for a time, stronger capital and risk regulations may stifle financial intermediation and slow the pace of recovery from the current recession.
Some analysts are proposing the adoption of smart regulations that are sequenced and modulated according to movements in macroeconomic variables such as the capital standards that vary with the business cycle. One could call such regulatory measures "financial automatic stabilizers." However, as recent experience with fiscal stimulus packages shows, political pressures prevent politicians from leaving such systems well enough alone.
Any whiff of financial-sector problems will incite Congress and Treasury bureaucrats to tinker with the rules. Which institutions and officials are likely to be sufficiently prescient to correctly calibrate such regulations each time the financial sector hiccups? And would politicians be able to resist calls for regulatory relief when financial sector lobbyists flood their offices as profit opportunities surge? Even more likely, any new regulatory attempt to globally control profit-driven risk-taking will spur new attempts to circumvent regulations.
The key lesson from the current financial crisis and recession is that a government-imposed financial architecture is unlikely to persist for any significant length of time. Global market developments, and the need to channel resources toward opportunities perceived to be the least risky and most profitable, will continue to modify institutional financial arrangements. Imposing onerous financial regulations will only impede the reconstitution of financial institutions, delay the recovery, and dampen the pace of long-term economic growth.