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Regulatory Order

The Obama administration's unveiling Wednesday of its plans for financial regulation opened another round in what promises to be a bitter and prolonged battle over the costs and benefits of new rules for the financial sector.

"Surely," said White House National Economic Council Chairman Lawrence Summers in a speech at the Council on Foreign Relations June 12, previewing the president's remarks, "our fellow citizens are right to demand of those of us involved with the financial system greater stability and safety."


But conservatives are already fretting that such concerns will lead to "socialist" interference in the financial free market. Their complaints can be dismissed for what they are: the desperate rhetoric of the proponents of a laissez-faire ideology that has now been discredited by its excesses.

Wall Street is also issuing ominous warnings that overregulation of banks, hedge funds and investment houses will cripple the recovery. Needless inhibition of financial innovation, the argument goes, could kill the goose that might one day again lay more golden eggs.

But such worries are transparently self-interested and, more important, at odds with recent experience with financial innovation.


"The damage caused by financial sector excesses is way out of proportion to whatever gains from financial innovation may have accrued to the wider economy in the last couple of decades," wrote Willem Buiter, former chief economist at the European Bank for Reconstruction and Development, in a paper delivered at a conference in Kiel, Germany, in early May. "The political economy of successful reform dictates that radical, sweeping reform be introduced as soon as possible, before the defenders of the financial status quo are able to collect themselves and launch a massive PR campaign to close the door on radical reform."

"Unlike pharmaceuticals, aerospace, and a host of other technical fields, financial innovations have been allowed to proliferate unscrutinized and untested for safety or effectiveness," observed Adam Posen and Marc Hinterschweiger of the Peterson Institute for International Economics in their May paper. "Yet the negative spillovers on the public at large from faulty financial engineering and toxic products have now been clearly demonstrated to be enormous."

Just a few years ago, the financial alchemy of the Wizards of Wall Street could seemingly do no harm. Innovative financial products, such as credit default swaps and collateralized debt obligations, would supposedly more efficiently spread risk among multiple investors, expand the country's capital stock, promote more productive use of capital and stimulate economic growth.

But it didn't work out that way. Between 2003 and 2008, the amount of over-the-counter derivatives around the world increased by 300 percent and the amount of derivatives held by the 25 largest American commercial banks rose by 170 percent. But the amount of gross fixed capital in the United States increased by only about 25 percent.


"Clearly, growth in new financial products has outpaced fixed capital formation both globally and in the United States by a large margin," Posen and Hinterschweiger point out. So much for the argument that such innovation would expand available capital.

Moreover, financial innovation was sold to an unsuspecting public and asleep-at-the-switch regulators because, in particular, it was supposed to increase the availability and decrease the price of the capital available to manufacturers and farmers. But it turns out that only 11 percent of all the users of over-the-counter derivatives were nonfinancial entities. It seems financial innovation was primarily used to line Wall Street's pockets.

"The record of recent financial innovations acts as a warning to be skeptical about excessive claims that all financial innovation is worthwhile," conclude Posen and Hinterschweiger. "What was advertised as something to redistribute risk, and thereby increase productive investment, generated little capital formation; what was supposed to benefit nonfinancial businesses was mostly used in a speculative game between financial players."

Going forward, Summers told the CFR, "the regulation of consumer issues must put the interests of consumers above the interests of regulated financial institutions."

To do this, the Obama administration must better align private and public interests and thus reduce the likelihood of systemic financial crises. It must also ensure that the introduction and marketing of new financial products and instruments will be subject to testing in ways similar to those used for the regulation and testing of new medical and pharmacological drugs. Financial innovation must first be demonstrated to do no harm.

"If," said Buiter, "overregulation, indeed destructive overregulation is the immediate result, then so be it. It is easier to negotiate sensible modifications to a framework characterized by overregulation than it is to add sensible regulation from a framework characterized by under-regulation."

As Summers concluded in his CFR remarks, "we have an enormous challenge of saving the market system from its current excesses and inadequacies." Let's hope the Obama administration does not wimp out in the face of the ideological counteroffensive now being launched by Wall Street and its conservative allies.

This article appears in the June 20, 2009 edition of NJ Daily.

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