Editorials

Like most crises, the recent mortgage mess has prompted calls for increased government regulation. But as the Cato Institute's Steven Horwitz demonstrates, that's not a good idea.

"Like the child who murders his parents and then asks for pity because he's an orphan, the Federal Reserve has a long history of asking for more regulatory powers to clean up messes for which its action or inaction is the primary cause," Horwitz says. "The recently proposed changes to its mandate that would give it broader regulatory powers over institutions other than traditional banks, along with its unilateral decision to provide the equivalent of discount window services to Bear Stearns and other similar firms, simply continue that pattern."

The housing credit crunch that resulted in the collapse of Bear Stearns "was another in a long line of financial crises that were the fault of government followed by the regulators saying 'if only we had these new powers, we could prevent this from happening again,'" Horwitz adds. "History suggests, however, that it is the regulatory powers themselves that are the primary problem and that less regulated financial markets are in fact more stable than the overly regulated status quo."

The Federal Reserve has a history of limited effectiveness.

"Faced with a steep increase in the demand for money after the stock market crash in 1929, the Fed failed to do the exact job it was designed to do, which was to ensure the 'elasticity' of the money supply," Horwitz points out. "In fact, it allowed the money supply to fall 30 percent in the early 1930s, which was the primary reason what would have otherwise been a short, and perhaps moderately severe, recession became a very severe depression lasting over a decade."

Predictably, the Fed's response was to say it didn't have enough power. And over time, Congress obliged by increasing the Fed's control over currency supplies.

"The increased money supply powers of the Fed sowed the ground for the inflation of the 1970s and early '80s, which in turn put savings and loans with fixed-rate mortgages into financial turmoil," Horwitz contends. "The response was again to increase the degree of government involvement by increasing the deposit insurance coverage for banks and savings and loans. The result was the S&L crisis of the 1980s, as S&Ls used the higher insurance coverage as a green light to take even more risky loans to gain back their losses."

Horwitz says the Fed, particularly former Chairman Alan Greenspan, bears substantial responsibility for the current problems faced by housing lenders.

"A few years back, Greenspan said that the Fed could, and would, do nothing to stop 'asset bubbles' from happening, but would stand by to cushion the fall if such bubbles occurred," Horwitz points out. "In ways much like the expansion of deposit insurance, the so-called Greenspan Doctrine encouraged banks to engage in excessively risky loans under the belief that if those loans went bad, the Fed would come to their rescue. This is the problem of moral hazard: when you insure someone against a negative outcome, the insured has less reason to take precautions against causing that outcome."

But the Fed is again claiming it needs more authority.

"In the wake of the housing crises and the troubles at Bear Stearns, the Fed has asked for expansive powers to regulate non-bank financial intermediaries to avoid such problems in the future," Horwitz says. "Once again, financial regulators are asking for more powers to avoid messes for which they themselves are largely responsible. Such expansions of power have, in the past, only served to create new problems that could have been avoided by stepping away from the temptation of new regulations."

Congress must resist the call for new powers for the Fed.

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