Making Financial Regulation Work

One of the major debates around President Obama’s plan for reforming the financial system is over who should be given the job of regulating systemic risk. This debate is fundamentally misguided.

We already have an unofficial systemic risk regulator, or SRR: the Federal Reserve Board. The problem is that it did not do its job when it allowed an $8 trillion housing bubble to grow unchecked.

The Fed has always perceived addressing problems of systemic risk as part of its job description. How else can we explain Alan Greenspan’s decision to support the stock market following the crash in 1987 or to intervene in the collapse of the Long-Term Capital Management hedge fund in 1998? Can these interventions be described as the conduct of monetary policy?

We are not experiencing this crisis because no one had the job of dealing with systemic risk. The economy collapsed because Alan Greenspan and his successor, Ben Bernanke, both insisted that everything was just fine, even as the housing bubble grew to ever-more-dangerous levels. Their failure to recognize the risks posed by the housing bubble and to take steps to rein it in is the root cause of our economic problems.

Suppose we rerun history and envision that our systemic risk regulator did its job over the past decade. Would anything have been different?

If the Fed were officially designed as our SRR, the answer almost certainly is no. AIG’s issuance of trillions of dollars of credit default swaps almost certainly would have survived Greenspan’s scrutiny. After all, Greenspan insisted that there was no housing bubble. In the absence of a nationwide housing bubble, the prospect of a large number of mortgage-backed securities going bad simultaneously is infinitely small. Why would Greenspan have been concerned?

Suppose the SRR were someone else. If Alan Greenspan (formerly known as “the Maestro”) had said everything was okay, would that person have had said that he was wrong and there is a dangerous housing bubble?

That is not the way things generally work in Washington. Most people in public agencies are worried first and foremost about advancing their careers. And picking a fight with a Fed chairman who enjoys the support of the financial industry, the media and most academic economists is not how to advance your career. In short, there is little reason to believe things would have been different even if there were a formally designated SSR.

If the problem is the regulators rather than the regulations, then the goal should be to change the behavior of the regulators. There is one obvious way to do this: Fire them.

The point is simple. If the regulators fail to do their jobs, as happened with disastrous consequences in this case, and do not see their careers suffer, then they have no incentive to do anything besides go along. In other words, we have to restore some symmetry to the incentive structure.

The regulators know they take risks when they confront the financial industry. They must also know that they take risks if they fail to confront the industry. Simple economics tells us that if regulators risk consequences only when they confront the financial industry, then they will never confront the financial industry, even if we give them the title of “Systemic Risk Regulator.”

DEAN BAKER is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy.

This column was originally published by The Washington Post.


Dean Baker is the senior economist at the Center for Economic and Policy Research in Washington, DC.