All Commentary
Wednesday, April 28, 2010

Should Government Control Wall Street?

Easy money and tight regulation?

One of the questions coming out of the current drive to change the regulatory structure of banks and financial institutions has been what do about the ratings agencies, such as Moody’s and Standard & Poors. In Sunday’s New York Times column, Paul Krugman pointed out something that, frankly, is shocking: “[O]f AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.

One would like to say this is a typo, that no agency could have made such huge systematic errors, but the numbers do not lie. One wonders how in the world any venerable and respected rating agency could make errors of this scale. (A dart board could have performed better.)

Certainly it was not for lack of experience or ability or failure to know who was what on Wall Street. Nor was it a lack of regulation or government “involvement and oversight” of the financial markets, since (believe it or not) Wall Street is one of the most heavily regulated entities on the planet. Indeed, the rating agencies themselves are licensed by the SEC.

If there is one word that is linked to the meltdown, it is “government.” Government is not the “solution” to “fixing” Wall Street; government is the entity that not only provided the booze that got everyone there drunk, but it also made sure that the liquor was passed to as many people as possible.

When we understand why this meltdown came about, we will understand why we cannot have a combination of Federal Reserve-supplied easy money plus a strict regulatory regime, which is what Krugman and others believe will “save the system.” First, in order to “stimulate” the economy during and after the recession of 2001, the Fed lowered interest rates to about 1 percent.

Second, government agencies and quasigovernment companies like Fannie Mae and Freddie Mac, which the federal government created to bolster home ownership, were major buyers of the securities Wall Street firms created to push the “subprime” mortgages. Soon these securities became a huge part of numerous investment funds and even went international.

As noted, many of these securities, which were “backed” by the ability of people with spotty or bad credit histories to pay their mortgages on time, were rated AAA by Moody’s and S&P, a classification that once was given only to the most stable of firms and organizations. The simple question is this: How could they have been so wrong?

The answer comes in two words: easy money. As long as the Fed was pumping easy credit to Wall Street and the banks, and as long as the government was directing money toward the housing market, nearly anyone could receive a loan, and in those early days there was lots of money to be made. Moreover, with housing prices rising apparently without end, refinancing a onerous mortgage was a piece of cake. Anyone who resisted the loose standards was left behind.

Take away the cheap-money regime and suddenly business discipline would take hold again. Take away the possibilities of bailouts, and financial professionals would act like professionals again.

The “success” of the housing market and the financial instruments pushing it along was like the “success” of a Ponzi scheme in the first stages. However, it became clear that this market could not be sustained. When interest rates went up the boom turned into a bust.

The problem now is that many economists and government officials are calling for both strict regulation and easy money. In other words, they want the government to continue to supply loads of liquor, but this time they will direct it to only those people who drink responsibly.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.