An Economy of Liars

When government and business collude, it's called crony capitalism. Expect more of this from the financial reforms contemplated in Washington.

GERALD P. O'DRISCOLL JR.

Free markets depend on truth telling. Prices must reflect the valuations of consumers; interest rates must be reliable guides to entrepreneurs allocating capital across time; and a firm's accounts must reflect the true value of the business. Rather than truth telling, we are becoming an economy of liars. The cause is straightforward: crony capitalism.

Thomas Carlyle, the 19th century Victorian essayist, unflatteringly described classical liberalism as "anarchy plus a constable." As a romanticist, Carlyle hated the system—but described it accurately.

Classical liberals, whose modern counterparts are libertarians and small-government conservatives, believed that the state's duties should be limited (1) to provide for the national defense; (2) to protect persons and property against force and fraud; and (3) to provide public goods that markets cannot. That conception of government and its duties was articulated by the Declaration of Independence and embodied in the U.S. Constitution.

Modern liberals have greatly expanded the list of government functions, but, aside from totalitarian regimes, I know of no modern political movement that has shortened it. While protecting citizens against force, both at home and abroad, is the government's most basic function, protecting them against fraud is closely allied. By the use of force, a thief takes by arms what is not rightfully his; he who commits fraud takes secretly what is not rightfully his. It is the difference between a robber stealing brazenly on the street and a burglar stealing by stealth at night. The result is the same: the loss of property by its owner and the disordering of civil society. And government has failed miserably to perform this basic function.

Why has this happened? Financial services regulators failed to enforce laws and regulations against fraud. Bernie Madoff is the paradigmatic case and the Securities and Exchange Commission the paradigmatic failed regulator. Fraud is famously difficult to uncover, but as we now know, not Madoff's. The SEC chose to ignore the evidence brought to its attention. Banking regulators allowed a kind of mortgage dubbed "liar loans" to flourish. And so on.

We have now learned of the creative way Lehman Brothers hid its leverage (how much money it was borrowing) by the use of a Repo 105. The Repo 105 meant Lehman temporarily swapped assets (such as bonds) for cash. A Repo, or repurchasing agreement, is a way to borrow money. But an accounting rule allowed Lehman to book the transaction as a sale and reduce its reported borrowings, according to a report by the court-appointed Lehman bankruptcy examiner, a former federal prosecutor, last month.

Are we to believe that regulators were unaware? Last week Goldman Sachs was accused in a civil fraud suit of deceiving many clients for the benefit of another, hedge-fund operator John Paulson.

The idea that multiplying rules and statutes can protect consumers and investors is surely one of the great intellectual failures of the 20th century. Any static rule will be circumvented or manipulated to evade its application. Better than multiplying rules, financial accounting should be governed by the traditional principle that one has an affirmative duty to present the true condition fairly and accurately—not withstanding what any rule might otherwise allow. And financial institutions should have a duty of care to their customers. Lawyers tell me that would get us closer to the common law approach to fraud and bad dealing.

Public choice theory has identified the root causes of regulatory failure as the capture of regulators by the industry being regulated. Regulatory agencies begin to identify with the interests of the regulated rather than the public they are charged to protect. In a paper for the Federal Reserve's Jackson Hole Conference in 2008, economist Willem Buiter described "cognitive capture," by which regulators become incapable of thinking in terms other than that of the industry. On April 5 of this year, The Wall Street Journal chronicled the revolving door between industry and regulator in "Staffer One Day, Opponent the Next."

Congressional committees overseeing industries succumb to the allure of campaign contributions, the solicitations of industry lobbyists, and the siren song of experts whose livelihood is beholden to the industry. The interests of industry and government become intertwined and it is regulation that binds those interests together. Business succeeds by getting along with politicians and regulators. And vice-versa through the revolving door.

We call that system not the free-market, but crony capitalism. It owes more to Benito Mussolini than to Adam Smith.

Nobel laureate Friedrich Hayek described the price system as an information-transmission mechanism. The interplay of producers and consumers establishes prices that reflect relative valuations of goods and services. Subsidies distort prices and lead to misallocation of resources (judged by the preferences of consumers and the opportunity costs of producers). Prices no longer convey true values but distorted ones.

Hayek's mentor, Ludwig von Mises, predicted in the 1930s that communism would eventually fail because it did not rely on prices to allocate resources. He predicted that the wrong goods would be produced: too many of some, too few of others. He was proven correct.

In the U.S today, we are moving away from reliance on honest pricing. The federal government controls 90% of housing finance. Policies to encourage home ownership remain on the books, and more have been added. Fed policies of low interest rates result in capital being misallocated across time. Low interest rates particularly impact housing because a home is a pre-eminent long-lived asset whose value is enhanced by low interest rates.

Distorted prices and interest rates no longer serve as accurate indicators of the relative importance of goods. Crony capitalism ensures the special access of protected firms and industries to capital. Businesses that stumble in the process of doing what is politically favored are bailed out. That leads to moral hazard and more bailouts in the future. And those losing money may be enabled to hide it by accounting chicanery.

If we want to restore our economic freedom and recover the wonderfully productive free market, we must restore truth-telling on markets. That means the end to price-distorting subsidies, which include artificially low interest rates. No one admits to preferring crony capitalism, but an expansive regulatory state undergirds it in practice.

Piling on more rules and statutes will not produce something different than it has in the past. Reliance on affirmative principles of truth-telling in accounting statements and a duty of care would be preferable. Deregulation is not some kind of libertarian mantra but an absolute necessity if we are to exit crony capitalism.

Mr. O'Driscoll is a senior fellow at the Cato Institute. He has been a vice president at Citigroup and a vice president at the Federal Reserve Bank of Dallas.

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved

Back to Basics on Financial Reform

The case for limiting leverage and regulating derivatives is overwhelming, but that doesn't require a new 1,300-page law.

By NIALL FERGUSON AND TED FORSTMANN

A "trilemma" is like a dilemma, only there are three things to choose from and you can have just two. The current debate over post-crisis financial regulation suggests we face such a trilemma: We can choose any two of the following, but not all three: 1) efficient capital markets 2) no bailouts to big banks and 3) a depression-free economy.

From the 1980s until 2007, we essentially opted for one and two. Financial markets operated with more freedom than at any time since the 1930s and the Federal Reserve stood ready to cut interest rates if asset prices tanked. But the idea that big banks might be able to get new capital from the Treasury was scarcely even contemplated. Choosing one and two resulted in a global financial and economic crisis worthy of the name depression.

In the aftermath, congressional Democrats are claiming that we can have three out of three. In effect, the bill introduced to the Senate by Christopher Dodd purports to prevent future depressions without sacrificing the efficiency of our financial markets or committing taxpayers to future bailouts of the banking system. This trifecta is not credible.

Either the bill really does imply future bailouts, as Republicans argue. Or, as seems more plausible to us, it is going to introduce such a wide range of new financial regulations that the efficiency of our capital markets will be significantly diminished.

The public today is in no mood for light-touch regulation. It knows Wall Street has become largely a giant casino creating bets whose only purpose is to create fees for itself—with the difference that taxpayers are expected not only to bail out the casino's biggest losers but also to endure misery in the form of lost homes, lost jobs and lost savings if the casino inadvertently triggers a depression. The charges brought against Goldman Sachs by the Securities and Exchange Commission confirm this view.

Whether or not there is any basis for the SEC's claim that it misled investors, the key point is that the synthetic collateralized debt obligation (CDO) at issue was nothing more than an elaborate wager on the future price of some mortgage-backed securities—a wager with as much economic utility as a gigantic bet on a roulette wheel or a horse race. Facilitating such bets has become a huge part of the business of the world's biggest banks.

For most of the past 20 years the explosive growth of the derivatives market—the total notional amount of derivatives outstanding in June last year was $604.6 trillion—was immensely lucrative for bankers and those who invest in bank stocks. But it increased the instability of the global financial system. And taxpayers have paid a heavy price since the system all but collapsed in late 2008.

The case for some kind of regulation of the derivatives market is overwhelming. There was never a good reason for treating credit default swaps and their ilk differently from commodity futures, which are standardized and traded on exchanges. The lack of market transparency and efficient competition in these instruments indicates that much of the profit made in the current, "over-the-counter" market is simply vigorish extracted by the financial bookies. History shows that competitive markets where standardized products are traded for low commissions do not spontaneously arise. They have to be created.

The problem is that Congress is not content to address this problem alone. On the contrary, the common characteristic of the two bills currently under discussion is their staggering length (both exceed 1,300 pages) and complexity. The nightmare possibility arises: Could the proposed cure turn out to be just another symptom of the same disease? As the rules become ever more convoluted, so the opportunities for the unscrupulous increase—and the efficiency of the financial system as a whole decreases.

There is a widespread but erroneous belief that the financial crisis has its origins in deregulation dating all the way back to the late 1970s. Therefore any steps to restore the pre-Reagan regulatory system are to be welcomed. This is really bad financial history.

First, in the more controlled capital markets of the 1970s, borrowers generally paid more for their loans because there was less competition. Lousy managements were protected from corporate raiders. Savers earned negative real interest rates because of high inflation. Deregulation—such as lifting restrictions on the interest rates banks could pay and charge—and financial innovation delivered real benefits for the U.S. economy in the 1980s and '90s.

Second, it is not at all clear that our crisis was exclusively caused by a failure of regulation as opposed to a failure of monetary policy. A very large part of the responsibility for the housing bubble and bust lies with the Federal Reserve, which underestimated the extent to which inflationary pressures had relocated themselves from consumer prices to asset prices. This was a near-term error of the period 2002-2004. It has nothing whatever to do with deregulation and everything to do with defective monetary theory.

Third, the crisis of 2007-2009 originated in one of the most highly regulated sectors of the financial system: the U.S. residential mortgage market. The mortgage originators, the government-sponsored enterprises that dominate the securitization process, the commercial banks—these were scarcely institutions ignored by Congress over the years. On the contrary, Washington constantly tinkered with the system in a misguided campaign to increase home ownership. That campaign ended in tears.

Still, it took extraordinary forces to turn a subprime bust into a global financial crisis. The key forces were excessive leverage on and off bank balance sheets, and derivatives that allowed massive but opaque side bets on the future value of U.S. homes. And it was these two factors that magnified (and exported) the losses in the mortgage market; legislators should focus on them. Instead, both the House and Senate bills are packed full of scatter-gun regulations that owe more to the prejudices of legislators than to a rational assessment of what actually went wrong.

The best example (there are many) is a provision in the bill passed by the House last year creating a mechanism to police banker compensation—before we even have the results of the bill's projected study on "whether there is a correlation between compensation structures and excessive risk taking."

By all means let us regulate the derivatives market—beginning with a reform that makes it a real market. And let's clamp down on excessive bank leverage. But let us not believe we can abolish both bailouts and depressions, other than by creating another layer of government regulation. That would be to impale ourselves on the horns of a trilemma.

Mr. Ferguson is a professor of history at Harvard University and a professor of business administration at the Harvard Business School. Mr. Forstmann is senior founding partner of Forstmann Little & Company, and chairman and CEO of IMG.

The Lesson of Basel's Bean Counters

Decades of obsession with accounting standards couldn't overcome the perverse incentives created by 'too big to fail.'

By GEORGE MELLOAN

With all this attention to banking regulation, it seems strange that something called Basel III has escaped widespread notice, even though its various new rules have been up for public discussion since January and the window closed on that opportunity on Friday, April 16. Maybe it's because the Basel Accords, a set of rules agreed to by bank regulators around the world, have been something of an embarrassment to the authors.

Basel I was fashioned in the charming old Swiss city of that name in 1988 by banking regulators from the International Monetary Fund's Group of 20 leading industrial nations. The idea was to give an increasingly globalized financial-services industry a common set of rules so that bankers could have more confidence in the solidity of their global counterparties.

The main achievement of Basel I was to set risk-based capital standards for banks. A complex formula was devised to define what value could be given various forms of capital outside "core" forms such as common stock and reserves.

The designers also tackled the more challenging task of assigning degrees of risk to a wide range of potential bank investments. In an unsurprisingly generous gesture toward national treasuries, banks were allowed to regard government-issued securities as zero risk, meaning they would require no offsetting capital. Since expanding capital is expensive, banks had a new incentive to buy government bonds.

But while this was a noble effort at international regulatory coordination—and was in fact folded into the regulatory systems of the major industrial powers—it didn't do much to ensure bank safety. Japanese banks were boasting that they were over-compliant with Basel standards right before they tanked in 1990. It seems that some of their "capital" was marked-to-market Japanese stocks and a lot of their risks were in real estate. When both stocks and real estate collapsed as a result of the decision by the Bank of Japan to prick the credit bubble, the Basel standards might just as well have not existed.

So the Basel Accord drafters went back to the drawing board and came up with Basel II, which some member states have adopted over the last few years. The standards were toughened and broadened in an attempt to take account of the changes in banking, especially increased trading in securities and derivatives. But the Basel standards proved to be largely irrelevant to the factors that caused the fall 2008 near-meltdown of global finance. For example, Lehman Brothers had close to triple the core capital required by the Basel standards when it crashed.

The international banking tumult of 2008 was not a result of insufficient rules or even primarily of noncompliance with the rules. Banking is perhaps the world's most regulated major industry. As in Japan in 1990, the imperatives of politics simply overrode what the rule makers and rule enforcers were trying to accomplish, turning their labors to dust.

The 2008 crisis resulted when the Fed-created credit bubble collapsed and soaring housing prices deflated as well. To promote "affordable" housing, Bill Clinton had excused the two giant government-sponsored housing finance agencies, Fannie Mae and Freddie Mac, from normal banking rules, allowing them leverage ratios far in excess of the limits on ordinary lenders. Banks were forced to write risky mortgage loans, a large number of which were then folded into mortgage-backed securities that Fannie, Freddie and others sold internationally with triple-A ratings.

This business seized up, crippling banks throughout the world, when holders began to realize that the assets that backed the securities, home mortgages, were going under water at an alarming rate. One of the great ironies of our times is that the two strongest defenders of the Fannie-Freddie shell game, Chris Dodd and Barney Frank, are now in charge of reforming banking regulation.

Through all this the Basel Accord designers have been soldiering on, this time coming up with Basel III, which further tightens and broadens risk-based capital rules. This new effort to raise the cost of banking is not going down well with bankers and even some central banks. At any rate, implementation is years off at best and the main state of play at the moment is the Dodd bill.

Aside from giving Washington an even tighter grip on the banking industry, the Dodd bill partly institutionalizes what Ben Bernanke at the Fed, Henry Paulson at Treasury, and Timothy Geithner at the New York Fed did ad hoc in the fall of 2008. It permits backdoor bailouts and gives enormous additional powers to the same Fed that created the housing bubble.

Like the Basel Accords, it assumes that the bank regulators will some day get things right before the industry wrecks itself by depending too much on rule compliance and not enough on sound banking judgment. Even a 1,336 page bill is not sufficient to guide the government in its endeavors to micromanage banking, as the prodigious efforts of the Basel committee have demonstrated.

An assessment of Basel III is provided on the Web site of a London based organization called the Asymmetric Threats Contingency Alliance (ATCA), which came into being in 2001 to promote online discussion of global issues. It concludes, quite plausibly, that "Despite promises that regulators will be vigilant and central bankers more watchful, banks are certain to get into trouble again, as they always have throughout history. The way to protect taxpayers, the Basel III argument goes, is to compel banks to have buffers thick enough to withstand higher losses and longer periods of extreme volatility in financial markets before they call for government intervention."

As the ATCA paper notes, in the days before banks could rely on governments to save them they carried large capital buffers, with core capital sometimes as much as 15% to 25% of assets, as opposed to as little as 2% under current rule. Of course, that made banking more expensive, and bankers were choosier about risks than in today's world, where the U.S. government has chosen to treat some banks as worthy of taxpayer help because they are "too big to fail."

One thing seems certain, the promise of bailouts and better regulation is unlikely to restore better risk judgment to the profession of banking. The opposite is more likely.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved