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The world entered into a severe recession with the Crash of 2008 — a crisis of the type that takes a ‘game-change’ to recover.
A necessary element of such a ‘game change’ would be credible financial reforms that merit investor confidence.
Unfortunately, instead of a ‘game-changing’ confidence-inspiring reform, the Obama administration presented the United States with the Dodd-Frank Act — a legislative miscarriage that has the potential to hold back recovery and impair the position of New York as a world financial center for decades — unless repealed or drastically amended.
Like most major legislation of the Obama administration, Dodd-Frank is a package of indeterminate content, dependent upon the formation of a set of bureaucracies, the promulgation of hundreds or thousands of yet undrafted regulations beyond the reach of Congress, giving rise to a hyper-inflation of legal costs that will drive issuers and institutions to more friendly shores, probably in East and Southeast Asia.
Elements of economic recovery
Here are some causes of the financial collapse of 2008 that might have been examined and addressed in a serious reform package and that would have helped the economy enter on a path to renewed growth:
- Information overload: The investment market has become plagued with too much complex information and has become extremely inefficient. Rating agencies can no longer be trusted. See: Economic Recovery from an Inefficient Market.
- Big bank complexity: Major financial institutions have evolved into organizations for marketing hundreds of complicated, often risky financial products, focusing on short-term profits, while giving inadequate attention to the interests of shareholders and creditors. See: Is big bank complexity irreversible?
- Corporate governance: The question of excessive executive remuneration of public companies, even when stocks are falling and dividends are being cut, is now a front-page item in the news. Intimately tied to this problem is the massive misuse of stock buybacks to give value to executive stock options. See: Soviet-style capitalism on Wall Street.
- Risky financial behavior: From sub-prime lending, to proprietary trading with bank depositor’s money, to extreme leverage of financial institutions, to under-funding of pension obligations — executives of financial institutions and public companies have come to engage in business practices that would have been considered extremely risky by their fathers and grandfathers. See: Jeff Skilling explains US corporate ethics.
- Misuse of derivatives: The derivatives market, which has grown many fold since the 1970s, has become not only overly complex, but also sloppy in terms of clearings, settlement, back office procedures, evaluation of counterparty risk, and the theoretical basis for the valuation of instruments. See: Uncontrollable Risk.
Reforms that restore confidence
Financial reform requires first recognizing the problem and then undertaking necessary studies to find solutions — with attention given to achieving consensus among investors and institutions that a best — or at least satisfactory — course of action has been found.
The five points above are just some (not all) of the areas that deserve attention for reform — however some are not generally recognized as problems and none have had the open, bi-partisan discussion and examination similar to the Pecora Commission of the Great Depression.
In crises of the magnitude of the current situation, the causes of market failure should be addressed so as to reach consensus that at least some of what was broken has been mended and that a healthy market can begin to grow anew.
The deeply flawed Dodd-Frank Act not only fails to provide a basis for this optimistic consensus, but also constitutes, in itself, a barrier to a sound recovery. As most Obama legislation, Dodd-Frank is not a solution, but a problem.
Two kinds of financial reform
There are essentially two types of financial reform:
- Legal Reform: Often financial reform consists of issuing new laws. If these laws are well-written, widely understood and respected, and backed by the public, legislation alone may be all that is needed to effect financial reform. Financial reform may be enacted with or without an economic crisis. However, when reforms are attempted in the context of an economic crisis — especially a crisis that is a ‘game-changer’ — if may be necessary also to reform hearts and minds as well.
- Hearts and Minds Reform: Sometimes, what needs to be reformed goes beyond what can be tweaked by laws and rules, but requires sociological changes in what market participants believe and how they are motivated. This may involve prevailing economic theory as well as questions of business customs, ethics, and morality. It is difficult, perhaps impossible, to change hearts and minds without an economic crisis of such magnitude as to be a ‘game changer’. People must be scared into the recognition that the old ways are no longer appropriate before new ways will be adopted. Reform always involves costs to someone, even loss of benefits, and these costs and losses are strenuously resisted. Some beliefs have been deeply implanted by universities, boosted by Nobel Prize economists, and are so widely shared among everyone’s colleagues, friends, and media sources as to be difficult to change.
Financial reform takes time
Even the simplest reform — for example, the modernization of institutions in a period of non-crisis — require time to be successful. Laws and regulations must be clear and easily understood in order to be implemented by market participants. Opposition to reform must be won over or contained.
In order for a reform to have any effect, it must be implemented. This usually involves hiring people, training, establishment of systems, redrafting contracts, writing operations manuals, arranging financing, acquiring equipment and real estate, and much more.
Hearts and minds reforms usually take years. University curricula must be reorganized, position papers drafted, articles published, speeches given, seminars held, and proponents of the status quo defeated, until, at last, a consensus is reached that such and such must indeed be done and is in the interests of all.
The reform of the European economic system which started after World War II has lasted three generations and is not yet complete. The longer and more entrenched the current system, the longer it takes for peaceful reform.
Of course, if reform is done by a coup d’etat or revolution, such as the Soviet Revolution of 1917, opponents may simply be taken out and shot. However, Barack Obama is not Josef Stalin and his powers of persuasion do not extend to those who understand much about the functioning of financial markets.
As most Obama legislation, Dodd-Frank is a problem for future leaders to solve rather than a solution. If there is no reform of this ‘reform’, the United States will continue to give up ground to other financial markets.
Economic recovery may also move ahead much faster in countries under more fortunate leadership.