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Commentary: What if conventional wisdom about regulation is wrong?

This article first appeared in the St. Louis Beacon, May 30, 2012 - Since 2008, the conventional wisdom is that deregulation caused the financial crisis, that financial institutions lacking sufficient government oversight ran amok, and that the only path to future financial stability requires reinstatement of old rules or creation of a new bureaucracy to oversee the financial industry. What if this conventional wisdom is wrong?

Conventional wisdom demanded that there be changes in how financial firms do business.  This led to passage of Dodd-Frank. Implementing its myriad parts has proven much more difficult than passing the act, however -- and not because banks and other financial firms have lobbied strongly against its provisions. Rather, after the storm passed and the act was passed, it is not exactly clear what should or can be done to minimize risk in what is inherently a risky business.

Although it took several years, we also now have the Consumer Financial Protection Bureau. Given the task of protecting your financial safety, much of what the new agency will do probably falls under a number of existing acts and the purview of existing agencies.

How to proceed? One approach, suggested by Elizabeth Warren, the Democratic candidate for the Senate in Connecticut and the one-time maven of the CFBB, is reinstatement of regulations akin to Glass-Steagall. Passed following the Great Depression and repealed in 1999, Glass-Steagall separated commercial and investment banking. In theory, Glass-Steagall prohibited banks from using depositor funds for their own speculative investments.

Would re-instating Glass-Steagall prevent another crisis? Those who favor governmental intervention answer yes. After all, they argue, wasn’t the 2008 crisis an outcome of repealing Glass-Steagall? That type of post hoc ergo propter hoc argument is inadequate, however.

Others, even Fed officials, are not convinced that reinstating Glass-Steagall would accomplish the desired outcome. The New York Times reports that Richard Spillenkothen, the former director of the Fed’s division of banking supervision and regulation opined in Politico’s Morning Money that Glass-Steagall, if still in place, “would not have prevented the financial crisis.”

How can the probability of future financial crises be reduced? Research indicates that one approach is to disregard conventional wisdom and reduce regulation.

Economists have studied financial crises long before the 2008 upheaval. Looking for underlying causes of financial crises around the world, one factor that continually asserts itself is the presence of deposit insurance. Deposit insurance protects depositors from loss should their bank fail. Depositors love these programs because they no longer need to monitor their bank’s actions. If their bank makes bad loans and becomes insolvent — the most likely reason for bank failure, not speculative trading — the government swoops in and deposits are unaffected.

This of course allows some banks to behave in a riskier fashion since they are no longer on the hook for potential deposit losses. In such a world, why not take a flyer on that risky shopping mall loan?

Research also shows that financial sector regulation is another key ingredient in predicting a financial crisis. Clemson University economists Scott Baier and Matthew Clance, together with Atlanta Fed economist Gerald Dwyer report in a recent study that after controlling for other possible influences, a decrease in economic freedom -- more regulation -- is a significant predictor of future financial crises.

The Baier study also finds that a reduction in economic freedom generally follows a financial crisis.; In the United States, Dodd-Frank and the CFPB are evidence that more government regulation and calls for restricting the activity of financial firms comes on the heels of financial crises.  History suggests that such reactions do not prevent future crises but reduce the efficiency of the financial system in performing its economic function.

As we enter the maelstrom of presidential politics, the two sides will stake out their position on financial regulation. One side will tout conventional wisdom and pit Main Street against Wall Street.; Let’s hope that the opposing view will rely more on research and analysis.

Rik Hafer is a distinguished research professor in the Department of Economics and Finance at Southern Illinois University Edwardsville and a scholar at the Show-Me Institute.

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