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The Post-Madoff, Post-TARP Future of Financial Regulation

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We have reached a historic juncture in the regulation of American financial markets, and not just because Mary Schapiro will soon become the first female chair of the Securities Exchange and Commission. She inherits an agency that missed the Bernard Madoff scandal, not to mention Enron and WorldCom. At the same time a scathing Congressional Oversight Panel (COP) report excoriates the US Treasury Department for its ad hoc disposition of the $700 billion Emergency Economic Stabilization Fund, questioning whether it even has a strategy for repairing the financial system.

As the SEC and Treasury are taken to task for these systemic failures, there is an even bigger failure and bigger question for regulators to grapple with: the apparent failure of regulation itself, and the question of how to reform financial markets so they never again inflict such damage on the wider economy.

The financial system provides a valuable service: it collects and mobilizes savings in order to channel them into productive investments, which in turn give rise to economic growth and higher incomes. But it does no more than that, and should really be thought of as subservient to the needs of the real economy of production and employment.

Making sure the financial sector served the real economy, not the other way around, was the impulse behind the creation of the Securities and Exchange Commission in 1934. But today, judging from the disposition of bailout funds, financial markets are treated like an end in themselves, and seem to trump automakers, homeowners, job seekers and the rest of the real economy.

There is nothing wrong with robust, diverse, innovative financial markets. They are and should be deep. For them to function well, savers must have a deep reservoir of different ways to make their funds available to potential lenders. Borrowers must also be able to choose among numerous mechanisms for accessing funds. When the system is working, savers are encouraged to save, and their funds find productive outlets.

But depth can also be excessive and dysfunctional. Today we are suffering the consequences of too much of a good thing: deep markets with too many complex instruments encouraging too much risk-taking.

The quest for deeper markets led us down the path of "securitization" - packages of mortgages and other loans that were collected together and sold, becoming so opaque as to be unintelligible. Investors, driven by herd behavior, nevertheless bought them without understanding their terms. Too late they discovered that what they owned contained loans that would default when the housing bubble burst. This misjudgment was so extensive it resulted in credit all but drying up; lenders ceased making credit available as doubt was cast on repayment of existing loans.

When investors can make system-threatening bets without even knowing what they're buying, it is clear that regulation has failed, and needs rethinking. It is no longer adequate to ensure that financial transactions are done in an arms-length manner, which was the innovation of New Deal-era regulation. Regulators today must protect the real economy from the existential threats that financial market depth itself can pose.

That's why we need to start thinking of and regulating the financial system less like a key sector of the economy whose mission is to grow and deepen in its own right, and more like a public utility whose mission is to serve the public good by encouraging wider economic growth and fuller employment.

Regulating financial markets more like a public utility would mean, among other things, imposing some reasonable limits on market depth. When financial instruments become so complex and inscrutable that it's impossible to make a reasonable assessment of their risks, it isn't enough to just watchdog how they are traded; they should not be traded at all. They should be banned. Packages of opaque mortgages should be the first among the financial "products" to go.

In this age of deregulation, it has been unfashionable to regulate even such things as power plants like public utilities, let alone financial markets. But it is time for that sort of regulation to come back into style. Even in a free market system, when a sector is so critical to the wider economy or to national security that its failure becomes a potential threat, regulators need to do what it takes to safeguard the overriding public interest, even if it means imposing some limits.

Admittedly, treating financial markets this way would constrain them to a level below their theoretical growth potential. But that is a small price to pay to stop the financial tail from wagging the economic dog, and to protect against more meltdowns like the one we're living through.

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