Erik Hurst on the Risks of Re-Regulation

Erik Hurst is one of the brightest stars among the “new breed” of macroeconomists. He’s my go-to guy for trying to understand the complicated links between macroeconomics and how we actually live our lives.

One of the great joys of being an academic economist is enjoying a vigorous debate over a beer. While Erik and I don’t always agree, he has all the necessary skills — as both a debater and a drinker. Plus, he’s a fellow Dylan-ologist.

While we can’t share a beer on this blog, I thought it might be useful to bring him in on the conversation about the financial crisis.

The Dangers of Re-Regulation

My colleagues Doug Diamond and Anil Kashyap have provided a tremendously insightful overview of the current banking crisis; while another colleague, Luigi Zingales, has emphasized the very real deficiencies of the Paulson plan, highlighting how it will distort future risk-taking by investors and financial institutions.

My concern about the bailout comes from the sudden shift in political discourse towards re-regulating the financial industry. Popular belief holds that if the government had better regulated the mortgage industry, the current crisis could have been avoided. At some level, this must be right: if the government outlawed mortgages altogether, there would be no one to default on a mortgage. But we must not risk throwing out the baby with the bathwater.

Financial institutions are important because they transform our savings into investment capital for productive firms. Without this bridge from lender to borrower, it would be much harder for firms to expand, purchase new machines, or invest in developing workers or new ideas. We must ensure that the new regulatory framework ensures that financial markets continue to generate these enormous productive gains. My reading of the accumulated research (which I will describe in greater detail) is that the worst excesses of previous regulatory efforts throttled these productive gains. We must not repeat these mistakes.

A Little Bit of History

The usual story begins with the deregulation of U.S. banking that occurred in the late 1970′s and the early 1980′s. But it is worth going back to the regulations that Congress enacted subsequent to the Great Depression.

Congress was concerned with limiting speculation by commercial banks in order to prevent bank collapses. Consequently, Regulation Q was passed, capping the interest rate that banks were allowed to charge borrowers or pay depositors. The argument was made that this would limit speculation by commercial banks, as only speculators could afford to pay high interest rates on their bank deposits.

While it may be true that Regulation Q limited banking volatility, it only did so by limiting banking activity. But as Treasury Secretary Paulson and Fed Chairman Bernanke remind us, an active banking system transforms savings into capital, and so a reduction in banking activity likely led to less economic activity.

It is worth thinking through how these regulations stifled economic activity. Suppose that there are two types of banks: good banks and bad banks. Suppose the good banks are very good at identifying profitable investment projects, but the bad banks are less discerning. An efficient banking sector needs to funnel finance through the good banks.

How would these good banks attract the necessary capital? They need to be able to offer higher interest rates on deposits to attract the necessary funds. By capping interest rates, Congress artificially made it easier for the bad banks to compete with the good banks, leading many good projects to go unfunded.

Up through the early 1980′s, most U.S. states had restrictions in place that limited the extent to which their banks could establish branches, and they prevented local banks from being acquired by out-of-state banks. These branch banking laws severely limited banking competition; they prevented the good banks from growing while they allowed inefficient banks to prosper. Unfortunately, the good banks were prevented from driving the bad banks out of the market.

Relaxing these regulations led to massive gains in the efficiency of the U.S. banking system. These aren’t just abstract changes in efficiency; they have touched all of our lives.

Here’s a quick reading list of research showing that this deregulation yielded greater income growth; less volatile business cycles; better access to housing credit; offset racial discrimination in the labor market; and reduced crime.

The common theme of this research is that financial deregulation reduced interest rates and increased efficient lending and borrowing. In turn, people who were constrained from accessing a mortgage were now able to do so more easily, and firms found it easier to borrow, which led them to hire more workers.

With additional access to credit, consumers who lost their jobs during an economic downturn had to slow their spending rather than halt it; this yielded greater macroeconomic stability. And as competition allowed the good banks to prosper, providing productive firms with affordable credit, the economy grew and social externalities such as crime diminished.

The Current Environment

So that brings me back to the current situation. The past decade saw enormous financial innovation and the development of a liquid market to sell mortgage securities for unconventional mortgages (Fannie Mae and Freddie Mac had been securitizing “conventional” mortgages for a long time). Some of these new loans were issued to subprime borrowers: folks with little equity in their homes and lower credit scores.

Yet even as we recognize the costs of the subprime meltdown, we need to recognize the benefits of this innovation.

The homeownership rate in the U.S. increased by 3 percentage points over the past decade — a clear break from the two previous decades of stagnation. Around one-third of these households may ultimately default on their mortgages, but this also means that two-thirds of those who were previously excluded from mortgage markets now own a home.

Access to credit for this historically denied group is a clear benefit of financial innovation. Likewise, even if excessive lending landed us in this mess, the extra investment projects that were funded contributed heavily to economic growth over the past decade and supported the economy during the technology “bust.”

Where to Next?

Knowing what we know now, what is the optimal approach to regulating the subprime sector? Some argue that we should outlaw subprime lending completely. But do we really want to return to the world where the well-off have access to credit, but the historically denied (the poor, the young, African-Americans) can’t access the housing market or other credit markets? Is it really O.K. for only some households to use credit to help them ride out bad times, while others must just do without?

It’s a strange reversal of the usual ideologies, but those of us who care deeply about the poor must care deeply about cultivating a vibrant financial sector to service the subprime market. Otherwise, we truly risk two Americas: the credit-worthy who enjoy the benefits of the capitalist system and a highly developed financial system, and the less credit-worthy, who must live with a level of financial development that we suspect keeps so many third-world nations poor.

These are hard questions, to be sure, and I don’t know the answers. But we need to be careful to avoid the knee-jerk reaction of policy makers to “re-regulate,” which will stifle innovation and competition.

Any sensible proposal must give equal weight to both the costs and benefits of financial innovation. Unfortunately, politicians tend to emphasize only the cost side of the ledger in times of crisis. We must remember that, too often, financial regulation hurts the good banks more than the bad, and the needy borrowers more than the less needy.

Doing nothing, it terms of regulation, may risk a precipitous financial crisis. Doing the wrong thing — and regulating too much — would undoubtedly yield even larger, albeit less immediate, risks.