Fixing the financial mess

Well, it has certainly been a week, hasn't it? Here's the Register's take on it in today's editorial, for which I owe a great deal (not everything in it, but a good bit) to Bill Niskanen, chairman of the Cato Institute. I always find that Bill sees the big picture much more clearly than most, and brings a certain wisdom to his assessment of economic events. He was gracious enough to talk with me while lunch was being served at a Cato donors event, and he laid out his views in the most concise and organized manner possible.

The three big mistakes by government? Keeping Fannnie and Freddie in business with their inherently flawed business model, creating the market for subprime mortgages, which it did with the Community Reinvestment Act, and especially allowing Fannir and Freddie to securitize subprimes, and the Federal Reserve keeping interest rates too low from 2002-2005, creating the bubble that rather pridictably has burst.In the private sector, besides those who gamed the system, the various credit rating agencies failed completely, which has not been widely enough acknowledged, and they have not suffered any consequences for their failure.

Market discipline better than regulation

Here's a link to the Register's editorial on the Fed's decision to keep the discount window open to investment banks, which could presage a move to regulate them directly. As Bill Niskanen, chairman of the Cato Institute, told me, this could create yet another industry with the moral hazard of knowing the government is likely bail them out if they make bad moves, because they're "too big to fail," like Bear Sterns. In retrospect, it might have been better to let Bear-Sterns fail rather than bail it out earlier this year. The reason market discipline is more efficient than regulation is mainly due to the knowledge that a business could fail, which tends to concentrate the attention mightily. Sending the message that investment banks won't be allowed to fail is an incentive for riskier behavior -- probably not immediately, but a few years down the road, when lessons (like the 1980s S&L failures) tend to be forgotten.