Obama Administration Plans Major New Controls Over Economy

Barney Frank charged by Obama to draft new regulatory scheme for financial companies.          

The Obama Administration is poised to implement radical new financial controls over the US economy. Instead of financial and banking decisions being made by many individuals acting in the free market, an elite group of bureaucrats will issue edicts that will affect the well being of all Americans. These new rules will change the way our financial markets operate, especially relating to risk. The ability of commercial banks, investment banks, equity partnerships, and hedge funds to create innovative financial products will be severely restricted.

Fed Chairman Bernanke, and, at the behest of President Obama, House Financial Services Committee Chairman Barney Frank are now working on a plan to regulate the economy to control financial institutions in a way not seen since the days of FDR’s New Deal.

According to news reports from the Wall Street Journal:

Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets, reflecting the Fed’s evolving view that a more aggressive government hand is needed to ensure the future safety of the financial system.

Among his recommendations were tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily.

… The recommendations were largely consistent with measures being pushed by House Financial Services Committee Chairman Barney Frank (D., Mass.), who is expected to be a key architect of the new financial regulation. There was one exception. Mr. Frank has said any changes would have to discourage “excessive risk taking” by executives, which he argues helped fuel the financial crisis. Mr. Bernanke didn’t touch on compensation practices in his speech.

Mr. Frank said he was supportive of Mr. Bernanke’s proposed outline. He said the speech reinforced for him why the Federal Reserve should be given powers to broadly oversee the safety of the entire financial system. Currently, various regulators oversee discrete parts. “I don’t know who else could do it,” Mr. Frank said.

President Barack Obama has charged Mr. Frank with developing an outline of how a new system would work in time for the Group of 20 meeting in early April.

These political leaders are using this crisis to further their long held desire to increase federal control of the economy. This is no secret: liberals such as Mr. Frank have strong beliefs about the positive role of government in the economy. They believe capitalism is inherently unstable and that the guiding force of the government is necessary to protect citizens from its perceived ravages. They believe they are capable of making certain economic decisions that should not be entrusted to its citizens, such as bankers and investors.

While many commentators brand this as socialism, it is in fact more akin to Italian fascism. This system is often referred to as “national corporatism,” and exists when a government with unlimited power harnesses private industry and labor to perform their political goals.

We have pointed out on this blog that the current economic problems were caused  by government action and the very politicians who now wish to gain further power. Accepting the fact that our current leaders will not change course, and that they don’t understand economics or the consequences of their actions, we should explore the implications of their proposed new economic rules.

1. Appointment of a financial czar.

As I predicted in my August, 2008 article, a czar will be appointed to oversee what Mr. Bernanke calls the “future safety of the financial system.” The czar will be given broad, undefined powers to regulate financial markets. This regulation will cover commercial banks, investment banks, insurance companies, non-bank mortgage lenders, rating agencies, hedge funds, equity investment companies, money managers, pension funds, mutual funds, and any person, entity, or scheme they think will present a “systemic risk” to the economy.

2. Activities of financial companies will be subject to increased supervision and restrictions.

Certain activities will come under special regulation. Specifically innovative instruments such as credit default swaps, derivatives, and other “complex products” will be sharply curtailed, inspected, and regulated before they are allowed to be sold. This regulation scheme will be similar to SEC rules governing the issuance of securities but companies will be required to meet strict rules regulating risk-taking, risk management standards, and will be held to “high capital and liquidity standards.” They have no idea whether or not meeting these standards will prevent systemic risk or prevent another financial crisis.

3. The newly regulated institutions will be required to meet debt to capital ratios like banks.

Hedge funds and equity investment funds no longer will be allowed to leverage investments beyond certain debt-capital ratios even though private investors are risking their own capital. Also, executive pay will be restricted so they are not perceived as to be taking unwarranted risk with their investors’ capital (read: “rolling the dice”). This is a substantial change for these funds which are basically unregulated because they are private partnerships with sophisticated investors. This will reduce capital for these funds and, consequently, to the U.S. investment market.

4. A substantial new regulatory bureaucracy will be created to implement these mandates.

The new czar will hire hundreds, if not thousands, of financial experts, lawyers, economists, and bureaucrats. New products would have to be run by the czar for approval. Companies would have the burden to show that their offering or financial structures would do no harm based on rules and regulations established by the czar. There would be lawyers specializing in getting products through. There would be administrative judges and appeals to federal courts. CCH and WestLaw would publish volumes of rules and regulations, decisions, and opinion letters. This system used to be called “byzantine” after the heavily bureaucratic, and now dead, Byzantine Empire. It’s harder to see this concept when it’s in your own backyard.

5. Commercial banks will not be allowed to undertake investment bank functions.

Nouriel Roubini and other commentators believe commercial banks will in the future operate more like utilities. They will undertake only the money, savings, checking, credit cards, and personal loan banking functions. Something similar to Glass-Steagall will be enacted. Now that many investment banks are becoming banks, they will undertake many of the riskier activities that banks had been performing in sophisticated financial transactions. Hedge funds and equity firms will emerge as the new investment banks, taking over the functions of the likes of Goldman, Morgan, and Merrill. Insurers will go back to performing insurance functions.

6. Financial innovation will be stifled and the U.S. and the U.K. will gradually lose their status as the preeminent financial centers.

As Nasim Taleb put it, in the last 10 years financial centers are becoming more distributed worldwide. Dubai, Mumbai, and Shanghai have emerged as powerful centers of finance. If the U.S. over-regulates its financial markets, it is likely that innovative financial products will emerge from other money centers. Companies and entrepreneurs from around the world will, as they always do, go to the money. Don’t bet on worldwide cooperation for unified financial regulations.

This new regulation will be another example of the law of unintended consequences. This is the idea that well intentioned actions, such as these proposed regulations, often result in consequences quite different from what was intended. It happens so often with economic regulations. In this case, our political leaders see an economic crisis without understanding its causes and figure that if they pass the right laws, all will be well. Hoover and FDR thought they were doing the right thing and we ended up with a depression that didn’t lift until well after WWII when many of the New Deal rules were repealed. The leaders of Japan thought they were following the correct Keynesian remedies to pull out of their crash in the ‘90’s and Japan ended up with 14 years of economic stagnation.

The free market has proven its ability to create and distribute wealth fairer than any other economic system in the history of the world. It has proven its ability to foster and demand political freedom. At what point does the piling on of new controls on top of all the others tip the scale from dynamic capitalism to stagnation and decline? The life blood of capitalism is free access to capital and I feel lightheaded.