NBU: Regulatory Illusion by Thomas Brewton , 4/22/08

Today’s clamor for more regulation of financial institutions to prevent another subprime mortgage meltdown is an exercise in self-deception.

Congress, led by Representative Barney Frank, is planning to overhaul regulation of the financial community, and Treasury Secretary Paulson has already proposed a broad program for that purpose.

No doubt, much of what is proposed is needed. But it should be obvious from repeated experience over the decades that regulations alone will not prevent periodic economic booms and busts.

Only by dealing with the root cause will we moderate economic cycles. And that root cause is the ineluctable human tendency to over-expand bank credit when the money supply is artificially enlarged.

Today’s proposed subprime mortgage regulations may prevent tomorrow’s repetition of that phenomenon, but they will have no restraining impact upon whatever the next speculative bubble may be. Sarbanes-Oxley regulation was instituted after the dot.com bubble-burst and the corporate collapse of Enron, but it had no restraining effect upon the speculative housing bubble, of which subprime lending is merely a symptom, not a cause. Before that, we had the speculative explosion of commercial real estate over-building that ended with the collapse of the savings and loan institutions in the 1980s.

Beginning with our nation’s first financial panic in 1819, similar boom-and-bust patterns appear every five to ten years, except in extraordinary circumstances such as wartime.

In one respect, Karl Marx’s economic analysis was on the mark. Before the advent of commercial banks, there were no economic recessions or financial panics. In a basically agrarian economy, good and bad crop years increased or reduced incomes, but there were no mass collapses of businesses.

The coming of industrialization in the late 18th century brought about the beginnings of modern banking, and with it the periodic over-expansion of credit that led to periodic over-investment in long-term, fixed productive assets. As bank credit expanded, businessmen responded by investing in more productive capacity than available real savings could support.

In every such cycle, the end point must be retrenchment: failure of some business ventures, liquidation of inventories at fire-sale prices, layoffs of excess workers, and strenuous efforts to reduce other costs until businesses can again produce at a profit.

The one and only really effective thing government can do is to maintain restraint upon expansion of the money supply, which is the fuel that banks use to build the fires of speculative over-expansion. Bankers, being human, will always seek ways to invest money when it is injected into the economy by the central bank. Businessmen, being human, will always find new ways to employ readily available bank credit.

The process is self-reinforcing, as early business expansion proves to be wildly profitable. As it continues, however, the effect of over-expansion of the money supply is evidenced increasingly in general price inflation and depreciation of the currency.

That is the stage of the Federal Reserve-created bubble we are experiencing today. In those circumstances, when the Federal Reserve continues to expand the money supply in order to lower interest rates, as it is doing today, all the wrong signals are given to businesses and consumers.

Carried forward too long, the end point is the massive inflation, double-digit short-term interest rates, high unemployment, and low economic production that was dubbed stagflation in the 1970s.

Thomas E. Brewton