The Financial Crisis of 2008 is often portrayed as a failure of free markets. The reality is that bad government policy was its primary cause.
The underlying cause was loose monetary policy, which inflated housing prices and increased the appetite for risk. This was abetted by housing finance policies that greatly encouraged sub-prime lending. The impact of all of this was magnified by a financial sector where market discipline was totally absent, due to government guarantees and the doctrine of “too big to fail,” and where bankruptcy law did not allow for the orderly recapitalization of distressed financial institutions.
The response has been the Dodd-Frank legislation. But this has been almost entirely misguided. First, it has, out of political cowardice, done almost nothing to stop the subsidizing of mortgage credit, including risky lending, and the housing market. Second, it has attempted to micro-regulate banks, which simply invites circumvention and benefits Wall Street behemoths over community banks and the small businesses they serve. Third, it has done virtually nothing to change the perverse incentives of “too big to fail” or to make it easier to resolve troubled banks without resorting to a bailout.
We need to get the government out of the business of subsidizing and distorting the housing market. Fannie Mae, Freddie Mac, Ginnie Mae and the FHA should be shut down and the tax deductibility of mortgage interest should be eliminated. The private sector is perfectly capable of providing housing finance and will do so on a safer and more economical basis without government interference.
Instead of attempting to micro-regulate banks, which will inevitably fail, we need to require them to hold much more capital. This was, in fact, the usual situation of banks before the Federal Reserve, deposit insurance and “too big to fail” eliminated market discipline. The best solution would be to remove these policies and simply allow the market to dictate. Since this is politically infeasible, the second best solution is to require much more capital.
Lastly, we need to reform the bankruptcy laws so that, if a bank gets into trouble, the losses will fall on lenders and not the public. This will eliminate the need for bailouts and ensure that lenders are incentivized to control banking risks.
To make all of this robust, however, we need a firmer understanding of the role of the Federal Reserve during the Financial Crisis of 2008. For this reason, we need to audit the Fed. We cannot successfully reform the financial system without learning from recent history.