On financial regulation, who will you believe, the criminals or the cops?

Last week, Federal Reserve Chair Janet Yellen gave the Fed chair’s traditional speech at Jackson Hole, Wyo. Fed chairs have used the annual conference at this picturesque mountain resort to deliver major messages about monetary policy and financial stability issues for years now.

This year’s speech focused on evaluating how safe our financial system is, 10 years after the meltdown of the market for asset-backed securities in early August 2007 that heralded the financial crisis.

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In brief, the crisis came as the culmination of a frenzy of financial innovation and risk-taking. When traders realized that the complex securities so in vogue were actually composed of rather dubious assets, they turned their backs on these assets.

 

Some securities markets froze up in early August 2007. This put major players into a vicious cash crunch, leading to “fire sales” of a wide range of assets. The fire sales set off a downward spiral of losses for many institutions, leading to major failures and an ever-growing crisis.

Mrs. Yellen’s speech outlines the main causes of the crisis, as well as the main legal and regulatory changes. She explained thoroughly, with data and research, why these reforms were undertaken and what their effects have been to date.

Her critics, however, are far from satisfied. The Wall Street Journal, in a remarkably strident and weakly argued-editorial entitled “Our Political Central Bankers,” accuses Yellen of playing politics and running for president.

The tone and argumentation of the Journal’s piece are noteworthy not for their insight into the financial crisis, nor for the quality of the solutions they propose. The Journal editorial suggests to me that the financial industry smells blood, seeing an opportunity to rid itself of what it considers burdensome restrictions and regulations.

Essentially, the Wall Street Journal's editorial board makes two arguments: The new regulations are too complex and burdensome, and in any case, the Fed was part of the problem. The new regulations are certainly complex, and there is room for some easing and simplification.

Even outgoing Fed Governor Daniel Tarullo, one of the architects of the reforms, has made suggestions along these lines. For example, small banks could be relieved of some of the heightened scrutiny of the Dodd-Frank Act. But a measured recalibration, as proposed by Tarullo, is far from the wholesale repeal proposed by the Journal, bankers and congressional Republicans.

The Journal also makes the basically erroneous argument that Fed monetary policy created the crisis. In 2004, Chairman Alan Greenspan considered it a “conundrum” that Fed interest rate increases did not do their usual job of draining liquidity from the banking system and slowing the home mortgage boom.

In hindsight, we can see that the boom in risky, complex securities and derivatives, unleashed by deregulation and financial innovation, had mushroomed into a new, almost uncontrollable liquidity gusher. Bypassing the conventional banking system, the mid-2000's mortgage and bond bubble could not be controlled by the Fed’s traditional tools.

Only a major extension of the powers of the Fed and other regulators could have put a stop to the “madness of crowds." When Hank Paulson moved from Goldman Sachs to Treasury secretary, he proposed some of the needed reforms, but his ideas got no traction in Congress and no support from the likes of the Wall Street Journal before the crisis.

Putting the blame on the Fed is like blaming a crime wave on the cops. Even worse, in this case, the perpetrators —the private sector — had powerful support from politicians and the media. The Fed and other regulators failed to prevent the crisis, but blaming them alone is cynical at best.

In her speech, Yellen summarizes the reforms, pointing out how banks are now required to hold much higher buffers against losses and to hold much greater stores of liquid assets. Along with new procedures to monitor risk at the system level and new powers to deal with failures of major non-bank financial institutions, the new regulatory architecture should be much better equipped to handle another crisis.

Citing a good deal of data and research, Yellen’s appraisal is that the system is substantially safer than it was. Importantly, Yellen cites research suggesting that the increased capital requirements have not impeded economic growth, a major bugbear for Dodd-Frank opponents.

The Wall Street Journal advocates a dramatic decrease in regulation. When one looks at the specifics that anti-Dodd-Frank forces are suggesting, for example in Rep. Jeb Hensarling’s (R-Texas) proposals to reform the Dodd-Frank regulatory reform act, what one sees is largely a return to pre-2008 laissez-faire, hands-off approaches.

So who are you going to trust: the financial industry that brought the world economy to its knees, or the lawmakers and regulators who stabilized the situation?

Evan Kraft specializes in the economics of transition, monetary policy and banking issues as a professor at American University. He served as director of the research department and adviser to the governor of the Croatian National Bank.


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