July 20, 2010
Dodd-Frank Forum: Reports and studies and rules, oh my!
Posted by Brett McDonnell

Kim and Larry have raised a complaint that is becoming a standard part of the critique of Dodd-Frank.  The Act requires regulators to write countless new rules and reports.  I say countless, but both point to a Davis-Polk memo which does the counting and finds 243 new rules and 67 studies required.  The uncertainty required by these rules will hamstring markets for years, and motivated financial industry insiders will coopt the rules and studies to their own advantage. Plus, have you heard that the Act is really, really long, over 2300 pages?  The horror, the horror.  I'm just hoping that my coffee table, where I'm trying to work through the thing, doesn't collapse under the weight.

This critique has more than a kernel of truth.  All those forthcoming rules and studies really will create great uncertainty for years to come.  Businesses hate uncertainty, and now when we are struggling to emerge from the worst downturn since the Great Depression is not the time to put new obstacles in the way of investing.  And the public choice critique that this vague bill will allow Congress to claim triumph and leave Goldman Sachs to snatch back victory as the details are written may certainly turn out to be right--that's a point on which observers from all sides of the political spectrum can agree.

But before we declare all those studies and rules an unmitigated disaster, we need to ask what are the alternatives.  For the most part, the studies and rules address truly serious, hard, complex problems.  Should we change the business model of credit rating agencies to avoid conflicts of interest, and if so, how?  How can we make regulations more countercyclical?  What sorts of proprietary trading should we allow banks to engage in?  And on and on.  What other basic strategies might Congress have used to address these sorts of questions?

When in doubt, do nothing.  This is a prescription for laissez-faire, since we are in doubt on almost every question that matters.  Laissez-faire is great if you think markets generally work quite well.  But there are loads of reasons in both theory and history to believe that unregulated financial markets are subject to severe instability.  I have lots of qualms about the bailouts and stimulus, but without them there's a very serious chance we would now be stuck in the Second Great Depression (granted, we may be there anyway, but odds are that we aren't).  Although federal policy played a role in getting us here (low interest rates for too long, Fannie and Freddie, the mortgage interest rate deduction), the central cause is quite clearly financial derugalation and innovation.  This is what financial markets eventually do when given half a chance.

There is a less smiley-face but plausible defense for laissez-faire.  Yes, financial markets are quite unstable on their own, and nasty things like depressions will result if we leave them to their own devices.  But, legislators and regulators are so corrupt and/or incompetent that they are likely to make things yet worse.  So better to live with even deeply unstable unregulated markets.  That's basically what Hayek argued during the Great Depression.  I have a lot of respect for that position, but it's not very popular or likely to succeed, and for good reason.

Go ahead and put detailed rules in the Act now.  That would resolve the uncertainty and make Congress responsible for the outcome.  Problem is, Congress has no clue what to do about dozens of crucial issues.  It lacks the expertise, and not enough time has yet passed to really think through what needs to be done.  If it tried to ignore those facts and just merrily legislate away irregardless, it would very likely make many deep errors far worse than the errors which I am sure litter Dodd-Frank.

Legislate what you can now, and then write further legislation (rather than regulations) later when you have studied it more.  On its face, this seems like a good compromise option.  But it rather fiendishly brings together the worse problems of all of the above options.  The resulting uncertainty would be even worse than Dodd-Frank itself, because one wouldn't know what else Congress might eventually do and when it would do it.  The practical result would probably be laissez-faire on most matters not handled now, since starting in January Congress is likely to be far less open to further regulation.  And even if Congress did write some other laws later on, it would still be plagued with the lack of expertise and corruption that are part of Congressional rulemaking.

But if we are going to leave so much to administrative agencies in the future, how do we ensure that they aren't captured by the industry when they write those rules?  Well, we certainly can't ensure that won't happen, and to some extent at least it will.  But we can try to find ways to cabin the problem.  My post yesterday and my comments to Erik's posts today try think about how to do that.  The Office of Financial Research is a part of it.  Required reports to Congress are another.  Erik's suggestions of ways to involve academics in commenting on proposed rules is another.  Beyond that, we need to explore ways to encourage more vigilant and independent agencies through HR practices in the civil  services (something I think Erik is writing usefully about).  And beyond that, we need to think about whether there are any concentrated interest groups which might help in the fight.  One group to consider is smaller regional banks, which have an interest in seeing a level playing ground that doesn't advantage either the giant banks or the shadow banks.

Adding up the costs and risks from these different basic approaches to how to deal with our lack of knowledge and understanding is really, really hard.  I have no confidence that the Dodd-Frank approach of doing a lot, but leaving even more to later rulemaking has gotten it right.  Given our basic ignorance, it seems unlikely that it has.  But my provisional verdict is that Dodd-Frank takes the worst path available, except for all of the others.

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