In 2008 Fannie Mae (and its sibling, Freddie Mac) both failed. Their debts were assumed by the federal government. The loss imposed on taxpayers was recently estimated by the Congressional Budget Office at $325 billion through 2011, with additional losses to come.

In the above-mentioned report Stiglitz and his coauthors noted the view that there was an implicit government guarantee that enabled Fannie and Freddie to borrow at below-market interest rates. Their estimates of taxpayer risk were based on the assumption that “the implicit government guarantee on GSE debt is equivalent to an explicit guarantee.” In Freefall, by contrast, Stiglitz declares, “Fannie Mae began as a government-sponsored enterprise but was privatized in 1968. There was never a government guarantee for its bonds; had there been, its bonds would have earned a lower return, commensurate with U.S. Treasuries.”

That statement is seriously misleading. Fannie (and Freddie) had an all-but-explicit guarantee and received other favored treatment from the government. Reflecting the implicit guarantee, their bonds paid lower yields than those of other private financial institutions. Their borrowing-cost advantage was worth billions per year.

The misleading treatment of Fannie Mae and Freddie Mac is just one example of a pervasive feature of Freefall: It often traffics in ideological spin. Stiglitz notices the mote of ideological bias in the eye of “those who have done well by market fundamentalism,” but ignores the beam in his own.

Free of false modesty Stiglitz describes himself as a member of “a small group of economists” who in the years before 2008 “tried to explain why the day of reckoning that we saw so clearly coming had not yet arrived.” He views himself as a courageous outsider, but it is difficult to share Stiglitz’s outsider picture of himself in light of the well-placed insider roles he has occupied during his career: chairman of the President’s Council of Economic Advisers (1995–97) and chief economist at the World Bank (1997–2000).

A major theme of Freefall is that incentive-distorting government regulations had little to do with the financial crisis. The plot line of his narrative is indicated by the title of chapter six: “Avarice Triumphs over Prudence.” The crisis happened in a “deregulated market,” or a market characterized by “lax regulation,” and so “it was something that Wall Street did to itself and to the rest of society.” He writes of “the deregulatory frenzy of the 1980s, 1990s, and the early years of [the 2000s],” and “the current rush to deregulation,” events not evident in the actual historical record.

Stiglitz makes his case for government intervention by holding free markets to the straw-man standard of frictionless efficiency. He touts his own academic research as showing that when the conditions for perfectly frictionless efficiency are not satisfied, “there [are] always some government interventions that could make everyone better off.”

This is argument by existence proof: The brief for government intervention is that we can imagine a case in which it improves things. It could make everyone better off—assuming an ideally omniscient and benevolent intervener. Might not actual government interveners fail to meet the conditions for their own perfection? Might they fail to know just where and how to intervene?

At least Stiglitz recognizes that government policies played a crucial role in creating the housing bubble. He notes that the Federal Reserve’s loose monetary policies under Greenspan fueled the housing boom and acknowledges the role of the moral hazard fostered by too-big-to-fail policies. He points out the cronyism involved in bailouts to Wall Street, particularly from the Federal Reserve Bank of New York.

Stiglitz offers a straightforwardly Keynesian analysis of the Great Recession, blaming it on insufficient aggregate demand. Therefore the government should “attack with overwhelming force” in the form of massive stimulus spending, an approach he suggests might be called “the Krugman-Stiglitz doctrine.”

Overall the book is a patchwork of nonscholarly accounts of historical events beside attempts to render scholarly economic theories into plain language. In many places the book disappointingly reads as though the author lacked the time to state his case systematically and coherently, to anticipate the strongest objections to his arguments and state them fairly, then address them carefully with evidence.

The authors’ criticisms of the Fed’s response to the crisis are no less trenchant. “In its rush to prop up the financial system,” they observe, the Fed rescued insolvent financial institutions, exposing taxpayers to losses on toxic assets while helping to “sow the seeds of bigger bubbles and even more destructive crises.”

But although Roubini and Mihm draw attention to some ways in which the government contributed to the crisis, they go seriously wrong in claiming that the boom “was primarily underwritten not by Fannie Mae and Freddie Mac but by private mortgage lenders like Countrywide”: Although Fannie and Freddie didn’t originate any subprime loans, they bought and (implicitly) guaranteed plenty of them, including a very large share of Countrywide’s Community Reinvestment Act (CRA) “Best Practice” loans. What Fannie and Freddie didn’t buy other lenders did, to meet their own CRA requirements. Such facts undermine Roubini and Mihm’s conclusion that “the significance of government intervention was dwarfed by the significance of government inaction.”

Roubini and Mihm’s reform proposals also fail to properly weigh government policy’s contribution to the crisis. They start well again by insisting on the need to restore to financial services “the creative destruction that Schumpeter saw as essential for capitalism’s long-term health.” Although Lehman Brothers’ failure revealed the shortcomings of ordinary bankruptcy as a means for resolving large and heavily leveraged financial firms, Roubini and Mihm note how those shortcomings could be avoided by means of “living wills” or by splitting ailing firms into “good” and “bad” parts, so that the latter might be declared bankrupt without raising Cain.

But some of Roubini and Mihm’s other proposals appear useless at best, including their endorsement of a “beefed-up” Glass-Steagall that would forcibly break up enterprises that become too big to fail, with its implicit suggestion that Gramm-Leach-Bliley contributed to the crisis. In fact that 1999 “repeal” of Glass-Steagall merely allowed commercial banks to affiliate with investment banks and played no important part in the insolvency of Lehman Brothers and other independent broker-dealers that was at the heart of the crisis.

A beefed-up Glass-Steagall Act might of course spin a much tighter web of firewalls than the original did. But as Roubini and Mihm themselves suggest, many TBTF firms exist only thanks to “heavy helpings of government largess,” including guarantees and actual bailouts, and could be left to break up naturally once improved bankruptcy procedures are in place. Perversities in executive compensation might likewise vanish on their own once imprudent decisions lead to bankruptcy rather than bailouts.

The most disappointing part of Crisis Economics is the second chapter’s hackneyed history of thought. Here Adam Smith is portrayed as a Walras-Debreu manqué who blinked at capitalism’s “vulnerabilities,” while Marx is credited with the “hugely important insight” that crises are “part and parcel of capitalism”—as if he’d predicted occasional financial panics rather than a steady decline in firm profits. The incomprehensible parts of the General Theory are treated, per usual, as proof of Keynes’s genius rather than of his being, well, incomprehensible. Finally and most disappointingly, by confusing the Mises-Hayek view of the business cycle with Schumpeter’s notion of creative destruction, Roubini and Mihm overlook the one theory of crises that best fits the housing boom-bust story.

Crisis Economics’s occasional references to the Great Depression must also be taken with a pinch of salt. It wasn’t Hoover but FDR who, in February 1933, stood by while “thousands of banks” went under; and it was growth in the money stock rather than fiscal stimulus that fueled the post-1933 recovery. The deflation of 1937–38 was mainly caused not by FDR’s belated attempt to balance the federal budget but by the Fed’s doubling of bank reserve requirements. Finally, corrected statistics show that World War II brought further stagnation rather than sustained recovery.

In short this “crash course in the future of finance” has both strengths and weaknesses. Although it contains much useful information about the subprime debacle, it understates the government’s contribution to the crisis, and although it suggests some desirable reforms, it suggests others that could prove counterproductive. Readers looking for straight A’s are advised to cram with caution.

Dowd offers a classical-liberal perspective on macroeconomic policy and specifically central-bank policy. Having written extensively on free banking, he concludes that a thorough decentralization of the banking business is essential to enduring macroeconomic stability. Hutchinson is a seasoned investment banker turned financial journalist. His firsthand, nuts-and-bolts knowledge of modern financial markets undergirds his broader perspective. Together, they provide an enlightening account of the long-run trends and short-sighted policy actions that culminated in the worst financial crisis since the Great Depression.

The “alchemists” in their story are the architects and practitioners of modern finance. Given the perverse regulatory environment, buying and selling derivatives can yield short-run profits to hedge funds and other traders while virtually guaranteeing that in the longer run the owners of the underlying real assets will suffer losses if not bankruptcy. The careful reader will understand that speculation, whether on a long-term or short-term basis, is an essential and healthy feature of a market economy. But, if anything, the authors’ likening of speculation to alchemy when it is based on the techniques of modern finance and carried out in the context of a regulated economy understates the perversity. On reflection we can see that turning future long-run losses (of other people) into current short-run profits (for yourself) is triply more disruptive than trying to turn lead into gold. We can note 1) that lead, unlike long-run losses, has a positive, though modest, value; 2) that it is your own lead; and 3) that given the laws of nature, you’re unable to turn the trick.

But if the laws of nature keep people from turning lead into gold, why don’t the laws of the marketplace preclude the financial alchemy that characterized most of this century’s first decade? The answer, our authors make clear, is government intervention. A toxic mix of interventions (regulatory, fiscal, and monetary) perverted the coordinating market forces by removing considerations of long-run systemic risk. The result was a systemic discoordination whose increasing severity eventually turned systemic risk into a crisis. The laws of the marketplace, if allowed to exert themselves, can preclude financial alchemy (or at least put strict limits on it). But government intervention, including loan guarantees and the too-big-to-fail doctrine, open a window in which short-run profit-taking in financial markets is pitted against long-run viability of the financial institutions.

While the Federal Reserve is recognized as an essential accommodating element in the most recent episode of boom and bust, Dowd and Hutchinson focus on the inherent perversity of modern finance theory in the context of the long-running efforts of the government to redistribute income and to encourage homeownership. Since the 1930s the government has used the tax code to redistribute incomes downward. Over the years the income tax—and over the generations the inheritance tax—has reduced the number of families that oversee their long-run business interests. The old partnerships (Dowd and Hutchinson’s term), which kept the owners’ skins in the game, have been supplanted by limited-liability corporations, which effectively separate management and ownership. This critical separation, which left-leaning authors take to be characteristic of capitalism, is shown by the authors to be a consequence of government systematically overriding the market-governed distribution of income. Whereas we once had business families that were in it for the long run, we now have financial managers and traders in derivatives markets who are in it for the short run, ultimately to the detriment of the financial system and the real economy.

Alchemists of Loss provides a multidimensional account of the nature and magnitude of our long-brewing economic woes. But the book provides us with little hope for the future. The authors’ suggestions for reform range from the radical (reinstating the gold standard and eliminating the central bank) to the not-so-radical (redrafting the Fed’s mandate to exclude concern about unemployment) to the superficial (moving the Fed’s headquarters to St. Louis). Even the casual reader will see that this extends from the virtually impossible to the not-worth-doing, with no promising midrange option. The implicit conclusion is that we should brace ourselves for more booms and busts.

Magic is harmless fun, but the government is not. It squanders vast amounts of money while simultaneously whittling away at people’s freedom. Instead of solving problems, it makes them worse, often creating brand new problems. Why don’t more of us rebel or at least denounce the State? In his latest book, political scientist and Freeman contributing editor James Payne explains why not: Most Americans have fallen for six political illusions. Although opinion polls show that a large majority of the population is fed up with the government, most think we must continue to rely on it for a wide array of “services.” They just want better politicians in charge. Those people aren’t stupid; they’re under the spell of the following illusions:

• The Philanthropic Illusion: the idea that government has money of its own.

• The Voluntary Illusion: the impulse to want to believe that government action is not based on force.

• The Illusion of the Frictionless State: the idea that the State can transfer resources with negligible overhead cost.

• The Materialistic Illusion: that money alone buys public-policy results.

• The Watchful Eye Illusion: the idea that the government has greater knowledge and wisdom than the public.

• The Illusion of Government Preeminence: the belief that the government is the only problem-solving institution in society.

In short, Payne admonishes people to start examining government as it really is, not the way children see magic. The book’s cover, a reproduction of an 1842 painting by Thomas Cole, gives a visual analogy to its thesis. In the painting a lad in a boat on a river is entranced by an apparition in the sky—a gleaming temple. Unfortunately, he is oblivious to the reality that his boat will soon go over a waterfall unless he gives up on the apparition and grasps the truth confronting him. That’s an excellent depiction of modern America.

Payne does a superb job of explaining and illustrating each of his illusions. I will focus my comments on the last two of them, as they are particularly critical at this juncture.

In the wake of the financial meltdown following the collapse of the housing bubble, politicians have been trying to capitalize on Payne’s “watchful eye” illusion by telling voters that the debacle was all due to inadequate powers of supervision by the government. What we needed, they cry, was more federal oversight to prevent short-sighted and greedy decisions. Give us more regulatory authority and nothing like that will ever happen again!

Payne shows that there were in fact regulators whose job was to blow the whistle on excessive risk-taking by the federal housing giants, Fannie Mae and Freddie Mac, but politicians paid no heed to their warnings. Payne then takes the analysis a step deeper, arguing that people should never put faith in government officials to foresee danger and protect them. That is because government officials don’t suffer the losses when they’re wrong. Instead of expecting a watchful eye from the government, it’s far more intelligent to rely on individuals and private institutions to detect and avoid undue risks because they will suffer adverse consequences if they are wrong.

Payne’s sixth illusion encompasses the others. It is the erroneous view that we must look first (and perhaps exclusively) to government for the solutions to problems. Politicians encourage that illusion since they want citizens to regard themselves as impotent while the State possesses almost limitless capabilities. When a social problem arises, politicians almost never say, “The government should do nothing about that; it’s a problem that should be dealt with by the voluntary sector.” Saying that would be almost suicidal in a nation caught in the grip of the illusion of government preeminence. Instead, politicians seldom miss an opportunity to show their great “concern” by introducing new legislation they claim will take care of everything, from the harm supposedly done by incandescent light bulbs to the drug trade.

Wise individuals, Payne contends, will look at the merits of the voluntary sector rather than leaping on the bandwagon for government activism. Currently, for example, many people are concerned about the possibility of catastrophic climate change and automatically assume that the only way of responding is to give government officials tremendous new regulatory powers. Anyone who reads Payne will contemplate both the possibility that voluntary responses might work better and that government will botch the job.

Tracing the government’s ever-greater role in financing and encouraging housing debt, especially since the 1960s, Kling observes that regulation-fostered securitization of mortgages necessarily obscures risk. A bank exercises the best oversight over loans that it awards directly; in an unhampered market, loan officers have little incentive to prefer an indirect or “securitized” method of lending. But by rigging the housing market for decades to promote the holy grail of home-ownership, politicians fostered and even mandated many dubious mortgages that wouldn’t otherwise have passed muster. Kling draws on his background as a former Freddie Mac economist to highlight the specific problems of the rickety financial structures that were only made possible by governmental assumption of risk. “Without the [government] guarantees [of mortgage-based securities]—or apparent guarantees—indirect lending would not have been possible,” he concludes.

In Kling’s view, bad mortgage regulations, a spate of mortgage loans requiring unrealistically low down payments, and what he calls a “suits vs. geeks” divide were the main causes of the housing bubble. But the last two “fundamental” causes stem from the first. So the author’s explanation of the housing crisis boils down almost entirely to the welter of incentive-skewing mortgage regulations.

The book surveys and critiques several alternative explanations for the crisis, including the oft-heard but historically unintelligible claim that it resulted from “deregulation.” Unfortunately, this tour does not investigate the role of the Federal Reserve. Economist Robert Murphy is among those of Misesian-Hayekian persuasion who point to the malinvestment-encouraging effects of the credit splurge of 2001–2003, the period during which the Fed lowered the federal funds target interest rate from 6.5 to 1 percent. The omission is odd since Kling elsewhere acknowledges the importance of the Austrian analysis.

A more fundamental discrepancy between knowledge and power than that exemplified by the suits/geeks divide is that exemplified by the hubristic power-grabbing of government officials, both before and after the economic blowout. Instead of arguing that in 2008 officials should have abstained altogether from such interventions as using tax dollars to buy “toxic” assets, the author suggests that the government might have instead tried the stopgap measure of “impos[ing] penalties on firms that make extravagant demands for collateral to back repurchase agreements” and other financial instruments. Limiting a fresh bout of intervention in that way would have been better than the blundering and direct central planning the federal government undertook, but it would still have amounted to giving economic actors orders, discouraging reliance on local knowledge and conditions. “Extravagant” terms of contract may be the only ones on which a trade can be conducted that satisfies both parties.

The second chapter considers the syndrome of force-wielding politicians and bureaucrats pretending to know better than individuals their own unique circumstances, values, goals, and options. The conflict between the individual’s knowledge and freedom, on the one hand, and coercive rules which preempt that knowledge and curtail that freedom, on the other, lies at the heart of the 2008 debacle (and many other economy-wide slumps). Markets are characterized by price signals and other coordinating mechanisms that enable human beings to make effective use of widely dispersed knowledge, very little of which we can ever grasp firsthand. Kling observes that modern economies are becoming ever more specialized and complex even as political power becomes more centralized and resistant to calls for reform. He tries to come up with empirical gauges of both trends, although that isn’t strictly necessary to refute the fallacies and expose the hazards of central planning.

The problem of how to prevent or ameliorate the blunders of the commissars is tackled in the final chapter. The author suggests various half-measures that proponents of fully free markets will be less than satisfied with: proposals, for example, to merely decentralize government functions that would be better delegated altogether to the private sector. Still, most of Kling’s proposed reforms—including a scheme that would enlist “competitive governments” to jockey for the chance to collect your garbage, and another to dispense vouchers rather than Medicare-style reimbursements to pay medical costs—might make it easier to achieve thoroughgoing restoration of markets than leaving things as they are.

The book is somewhat bloated, but the tale is compelling. It starts as Bear Stearns, the smallest of the five Wall Street investment houses, wobbles on the edge of bankruptcy. Treasury Secretary Henry Paulson and the Federal Reserve facilitate JP Morgan’s takeover of Bear, leaving Lehman the smallest of the remaining investment banks. Its stock drops precipitously.

From a huge cast of characters, one man emerges as a tragic figure—Lehman chief executive Richard Fuld. He became obsessed with short sellers (traders who borrow and sell shares to profit from a future price decline), blaming them for spreading malicious rumors about Lehman instead of confronting the bank’s real weakness. That was one in a series of dreadful mistakes. With Fuld’s backing, Lehman president Joseph Gregory had pushed the bank into mortgages, commercial real estate, and leveraged loans. He put inexperienced managers in charge of those activities and got rid of specialists who warned of danger. Catastrophic losses from the real-estate slump were killing Lehman by 2008. Short selling the stock was a symptom rather than a cause of the disease.

Sorkin recounts Lehman’s destruction, which occurred despite Fuld’s increasingly frantic efforts to raise capital or sell the company. Bank of America bought Merrill Lynch instead of Lehman, with the blessing of the Treasury and the Fed. A deal was worked out with Barclays Capital but scuttled at the last minute by British regulators, a debacle their American counterparts could almost certainly have prevented.

Timothy Geithner, then head of the New York Federal Reserve, was fixated on merging other banks. During a tense phone call, he effectively ordered Morgan Stanley chief John Mack to sell his company to JP Morgan for almost nothing. “I just won’t do it,” Mack said and hung up. There was no good business reason for the merger, and JP Morgan chief Jamie Dimon did not want it either.

Mack managed to save Morgan Stanley by getting capital from the Japanese bank Mitsubishi. Had Geithner succeeded in bulldozing Mack into selling, tens of thousands of employees would have lost their jobs and the too-big-to-fail problem would have been exacerbated. The incident does not inspire confidence in Geithner, currently Treasury secretary.

Another bad shotgun marriage was arranged by Sheila Bair, head of the Federal Deposit Insurance Corporation, who decided to sell Wachovia to Citigroup with a government guarantee for toxic assets. Fortunately, Wells Fargo chief Richard Kovacevich, who was interested in Wachovia all along, took action just in time. Wells Fargo was willing to pay a higher price without a taxpayer guarantee.

These events raise the question of why government agents can dispose of other people’s property. They certainly don’t seem to worry about preserving the value of businesses or reducing taxpayer liability.

What’s the lesson in this? Unfortunately, Sorkin doesn’t make the big picture clear. The boom-and-bust happened because the Fed opened the floodgates to easy money. That’s what got everybody, from the second-mortgaged homeowner to Lehman Brothers, to leverage up. Our supposedly expert government players apparently never realized this: Their conceit that they know how to manage the economy is the root of our trouble.

They might avoid fueling bubbles, but let’s leave that aside, since Sorkin doesn’t dig that deep. He describes interventions notable, among other things, for their sheer arbitrariness. The Fed and Treasury backstopped Bear Stearns debt in the acquisition by JP Morgan, but would not do the same for Lehman. The first action created expectations that the same support would be available for other banks and led to a false sense of security. There is no obvious reason why two sets of bond holders should be treated differently. It would be vastly better if government officials were deprived of the authority to bail out anyone.

Our financial system has suffered tremendously as a result of capricious interventions by government officials who themselves never bear any costs from the adverse effects of their decisions. If anything, they benefit. Though the entire boom-bust cycle provides evidence that government agencies, from the Fed on down, should have far less discretion, the massive financial regulation law passed this year rewards them with greater powers and wider room to do whatever they want. We should be afraid of the economic and social damage their arbitrary actions will wreak in the future.

How indeed?

Two years in, if there’s any noticeable difference between Bush’s policies of corporate privilege, endless warfare, bailouts, executive power, and bureaucratic expansion, and Obama’s policies of corporate privilege, endless warfare, bailouts, executive power, and bureaucratic expansion, I’d like to know where to find it. The difference between me and Dionne is that Dionne is apparently surprised by this outcome—why hasn’t Obama done better? At issue is what used to be called “Good Government”—the problem of ensuring that a centralized managerial State, with expansive powers to intervene in all matters economic, social, or hygienic, will be run cleanly, and competently, by qualified experts. Dionne insists that financial market meltdowns, oil spills, and coal-mine disasters reveal the catastrophic results of a few years of Bush-era government neglect. Those of us who remember the Bush administration may have a hard time accepting the claim that it was an era in which government was not doing enough; and we see these headline-grabbing catastrophes as only the tail end of a decades-long crisis—a bipartisan, politically created crisis of institutional incentives and industry “best practice-ism,” generated, nurtured, and protected by government itself.

So when Dionne reviews a few headlines—the financial-market meltdown, the Gulf oil spill, the coal-mine explosion at Upper Big Branch—he suggests that “It’s hard to argue that the difficulties we confront were caused by an excessively powerful ‘big’ government.”

Really? Let’s try.

“Deregulated” Wall Street collapsed in 2007 after years of unsustainable bubbles and malinvestment by a handful of immensely powerful big players. The real crisis was not just the “crunch,” but the shell game and misallocation that preceded it. The shell game flourished through a private-public partnership between government central banking, cartelized financial industry incumbents, and the industry-connected regulatory enforcers of the government money monopoly. The crash certainly revealed powerful corporations acting recklessly. But how did they get so powerful, and why were they willing to take those risks? Because government has, for decades, as a matter of policy, encouraged their dominance, invited their investments, subsidized their loan markets, put them near the inflation spigot, and subsidized their risk-taking with the promise of tax-funded bailouts. In a freed market, “deregulated” Wall Street’s concentrated wealth and reckless business model would not exist.

British Petroleum (BP), as a corporation, exists because governments created it—the Shah of Iran granted a company owned by the government of the United Kingdom a monopoly concession. The UK government kept its ownership stake until the 1980s. Like all other Big Oil companies, BP extracts the oil it sells mainly from government-controlled land and sea, through monopoly concessions, bureaucratic bidding processes, and politically granted leases. Oil companies use government protection, liability caps, and escrow funds to insulate their businesses from paying the economic and social costs of their actions. In a freed market BP’s concentrated wealth and reckless business model would not exist.

Massey and other Big Coal companies also depend on government leases and use government permits to absolve them of the environmental costs they inflict on their neighbors—including the damage that mountaintop removal mining causes to downstream property owners. They also rely on a regulatory structure that has taken control over workplace safety disputes out of the hands of workers and given it to a politically appointed, industry-dominated bureaucracy, the Mining Safety and Health Administration (MSHA). Where miners’ unions reacted to unsafe conditions by walking out and crippling production until issues were resolved, the MSHA issues an ineffectual fine and tells workers to keep on working in hope and faith. In a freed market Massey’s concentrated wealth and reckless business model would not exist.

Dionne may present his article as a commentary on recent news, but the headlines are only carelessly chosen illustrations for a message that seems copied out of a children’s civics textbook circa 1948. Elected government’s task is to “stand up for the many against the few,” to “make sure that corporations are properly supervised,” and to “protect those with weaker bargaining positions . . . against the harm that those in stronger bargaining positions might inflict.” Our problem is simply that we do not trust the political means enough. According to Dionne, if we are ever to solve these politically created crises, we need to know “that government in a free society is not a distant force but, rather, something that all of us influence and shape.”

To be sure, government is not very distant from the downtown offices of the Washington Post. For the rest of us, though, access is somewhat more limited, and not “all of us” have the same influence in shaping government policy. That is done by political insiders and economic incumbents: As scholars like Gabriel Kolko and Butler Shafer have repeatedly shown, government regulatory bodies from the FTC to the MSHA to the SEC have consistently been captured by the incumbents in the industries they are supposed to regulate, systematically rigging government regulations in such a way as to build up cartels, exclude competition, and protect businessmen from liability for harmful practices.

Even with the record of regulatory capture and industry-driven policy, Dionne, like many Progressives, simply insists that politicians need even more trust and fewer restraints on action to give them the independence to do the right thing. You might call this kind of Progressivism a theory of trickle-down politics: When government devotes the overwhelming majority of its power and resources to foolish or destructive programs directed by concentrated interests—subsidies, bailouts, anticompetitive regulations, or an ever-growing military-industrial “National Security” complex—the proposed solution is to give that same government even more strength and greater resources to dispose of, hoping that some of the surplus will eventually make it through the net of insider control to reach programs that offer a pittance to the little guy.

Individualists know that when you reward the institutions that created crisis, you are going to get more crises. Greater regulatory powers will only make government more attractive to industry incumbents; the more politics is involved in industry, the more that political pull pays off for the industrialists. The root causes of the crises we’ve faced in recent years are not problems of competence or corruption. They are problems of cartelization and capture. The solution is not more trust in government; it’s to realize there are things that just cannot be accomplished politically, which should instead be addressed through decentralized, peaceful social cooperation.

Bank failures were among the most dramatic and devastating aspects of the Great Depression. A wave of failures swept the country in 1930. A second and stronger wave followed in 1933. In all some 9,000 banks failed, taking with them all or part of the savings of millions of individuals and businesses. Perhaps the most significant response to this crisis was the Glass-Steagall Act, officially known as the Banking Act of 1933. (Glass-Steagall originally referred to a measure enacted in 1931 that was concerned mainly with powers of the Federal Reserve System, but that name now generally refers to the 1933 act.)

Glass-Steagall was a far-reaching measure that established federal deposit insurance (see The Freeman, June 2010) as well as separation of investment banking from deposit, or commercial, banking. Although it is rightly classed as one of the New Deal reforms, the bill had been debated before Roosevelt’s assumption of the presidency in March 1933 and the bank holiday the same month. In fact, Senator Carter Glass had long made known his opposition to “universal banking,” in which single firms could conduct deposit banking, investment banking, and other financial activities. Glass had been a sponsor of the Federal Reserve Act of 1913 and by 1933 was without doubt the most respected and powerful politician on matters related to banking.

The Glass-Steagall separation of investment and deposit banking was generally repealed by the Gramm-Leach-Bliley Act of 1999, during the administration of Bill Clinton. However, in response to the financial crisis of 2008, there has been much discussion of whether repeal was a mistake and whether some or all of its restrictions should be reinstated. We can gain valuable perspective on the current situation and calls for reform if we know a little about Glass-Steagall. What problems was it supposed to solve? What political incentives were at work? What new problems might it have caused?

Investment banking seems quite different from commercial banking. We might even wonder why both are called banking. Deposit banks accept deposits and make loans. They provide benefits to savers who couldn’t reasonably find and assess borrowers on their own, and to borrowers who would have a hard time finding lenders. Investment banks underwrite securities, meaning they help companies issue new equity (shares of stock) or debt securities (bonds). They perform similar services for state and local governments that wish to issue bonds. They set an offering price, line up buyers, and sometimes guarantee to absorb the securities themselves should any remain unsold. Unless they keep some of the new securities on their books, their work is finished once the securities are sold.

Some of the skills and practices of investment bankers are quite similar to those of bank-lending officers. Lenders must investigate the creditworthiness of prospective borrowers. Investment bankers must perform the same sort of due diligence in deciding whether to underwrite a proposed security offering and if so, how to price it. Firms that combine commercial and investment banking under one roof thus tend to be more efficient, a situation that economists call “economies of scope.” If they successfully exploit economies of scope, combined firms provide lasting benefits to their corporate clients and indirectly to consumers, as well as higher profits to themselves—at least until competing firms bid away those profits.

Pecora Hearings

The main impetus for the separation aspect of Glass-Steagall was a series of congressional hearings known as the Pecora hearings, named for the chief counsel of the Senate Committee on Banking and Currency. The hearings took place in 1933 and 1934 and generated some 11,000 pages of testimony. Ever since that time the Pecora hearings have been cited as firmly establishing the abuses that can and did arise when a single firm is allowed to engage in both deposit banking and investment banking, and as justifying government intervention to curb those abuses. This belief, by now something of an urban legend in financial and regulatory circles, is summarized in the following congressional testimony given in 1986:

[The Pecora hearings] on the securities practices of banks disclosed that bank affiliates had underwritten and sold unsound and speculative securities, published deliberately misleading prospectuses, manipulated the price of particular securities, misappropriated corporate opportunities to bank officers, engaged in insider lending practices and unsound transactions with affiliates. Evidence also pointed to cases where banks had made unsound loans to assist their affiliates and to protect the securities underwritten by the affiliates. Confusion by the public as to whether they were dealing with a bank or its securities affiliate and loss of confidence were also cited as adverse consequences of the securities affiliate system.

Who said that? None other than Paul Volcker, former chairman of the Federal Reserve System, who was given credit (perhaps exaggerated) for stopping the inflation of the late 1970s and who has reentered public life as an adviser to President Obama. (More about Volcker and the proposed Volcker Rule below.)

For years Glass had been frustrated in his attempts to legislate separation of commercial and investment banking. Revelations of supposed abuses by National City Bank (NCB) of New York and its president, disclosed in the Pecora hearings, provided the spark to ignite the issue and give Glass his victory. Senator Burton Wheeler thundered, “The best way to restore confidence in our banks, is to take these crooked presidents out of the banks and treat them the same as they treated Al Capone when Capone avoided payment of his tax.”

The Witch Hunt

The press got on board to the point where the Literary Digest reported that “Apologies, even resignations, do not satisfy listening editors.” Heywood Broun, a leading columnist and perhaps the Paul Krugman of his day, piled on with, “The only thing that some of our great financial institutions overlooked during the years of boom was the installation of a roulette-wheel for the convenience of depositors.” The hearings and their aftermath, it is fair to say, had become a witch hunt.

NCB was a leading New York bank, restrained by law to operate only within the city. Its subsidiary, National City Company (NCC), had become the largest and most prominent commercial-bank-related securities underwriter, with offices in many cities besides New York. National City and its president, Charles Mitchell, were charged with numerous misdeeds. Mitchell allegedly arranged his affairs so as to avoid income tax. It was also alleged that the bank paid high salaries and bonuses and made special lending facilities available to executives.

These are scarcely criminal offenses. But among the more serious charges, executives allegedly profited from the firm’s own securities underwritings. For example, National City bought a large block of stock in the new Boeing Corporation. Rather than sell this stock to the public, Pecora charged that NCC “retained a large block for itself and allotted the remainder to Mr. Mitchell and a select list of officers, directors, key men, and special friends.” But an internal NCC memorandum concerning this stock says,  “[O]n account of the fact this industry is still somewhat unseasoned, even though we regard this particular company as sound and having a very bright future, we were not quite ready to make a general offering to our customers. It would have been next to impossible to avoid taking orders from the type of investor who should not buy this stock. Therefore, our own family and certain officers and employees of the Boeing Co. and affiliations have taken the entire issue.”

Not only does this not sound improper, but in fact it sounds like just the sort prudent regard for customers’ best interests that was supposed be lacking in combined firms such as NCB/NCC.

The committee produced a Mr. Brown, a witness who claimed to have lost $100,000 as a result of an NCC salesman’s bad advice. Bankrupt and in ill health, Mr. Brown was an ideally sympathetic witness, but it turned out that he had been a successful businessman and not a novice. NCB was forbidden to call rebuttal witnesses.

In his 1990 book, The Separation of Investment and Commercial Banking, Professor George Bentson investigated numerous other charges against NCB and showed that none had any substantial basis in fact. Similar charges were brought against the Chase Bank, its president Alfred Wiggins, and the affiliated Chase Securities Corporation. Bentson also showed that these charges were mostly unsubstantiated—and added a thorough critique of the supposed theoretical problems of universal banks such as conflicts of interest.

Caveat Emptor

But what about conflict of interest? It is certainly possible that a banker in a combined firm might steer customers into ill-suited investments or insurance products. This is a hazard we face whenever we deal with professionals, such as physicians who advise treatments and also provide them, or lawyers who advise lawsuits and offer to file them. Such hazards are manageable: We can always get a second opinion or consult a fee-based financial planner or simply rely on the professional’s incentive to maintain a reputation for ethical service.

Financial institutions have widened their offerings considerably in recent years without any apparent problems. At the website of Wells Fargo Bank, for example, one finds not only traditional deposit and savings accounts and loans of all sorts, but also stock brokerage, mutual funds, automobile insurance, homeowner’s insurance, and even pet insurance. (But the Wells Fargo branch in a nearby Safeway store didn’t catch on and was closed.) Similarly, Charles Schwab, which began as a discount broker, now offers a full range of investment products and advice as well as banking services through its affiliated bank. Customers enjoy expanded services and lower prices as a result of the widening of competition among traditionally distinct firms. There is no sign of significant or widespread problems arising from conflicts of interest in such firms.

Combined firms are not assured success. Sears, Roebuck, for example, once decided to get into financial services. Sears as such couldn’t just start accepting deposits and making loans, nor could any commercial bank start selling underwear. But it formed a holding company, and the combination was effected. For a brief time customers in a nearby Sears, clutching their underwear purchases, could wander across the aisle into an alcove where smiling agents offered banking services through Allstate Savings and Loan, insurance policies from Allstate Insurance, and securities from Dean Witter—Sears subsidiaries all. Customers, not regulators, showed that no economies of scope were to be found in the Sears approach: The alcoves were returned to retail use, and the subsidiaries were sold. By the time Sears recovered from this excursion, Walmart was riding high and Sears was headed for the ropes.

Another failed expansion of scope was Citicorp’s acquisition of The Travelers, a major insurance firm that had previously acquired the Smith Barney brokerage. The resulting combination was christened Citigroup but the hoped-for synergies never appeared and Travelers was sold. This happened long before Citigroup was rescued by a federal bailout. Citigroup, incidentally, is the successor of the National City Bank of Glass-Steagall fame.

The End-Around

Sears and Citigroup aside, some firms achieved a substantial degree of financial integration in the 1980s and ’90s. Banks had figured out how to dodge the Glass-Steagall prohibition on ownership of firms “engaged principally” in underwriting and securities dealings. They simply formed subsidiaries that conducted a large enough volume of other business that they could legitimately claim they escaped the “engaged principally” clause. This avenue was not available to smaller institutions that could not marshal the required volume of business to employ this dodge. Thus by the 1990s Glass-Steagall was fast becoming a dead letter. The Gramm-Leach-Bliley Act of 1999 acknowledged the situation and provided a straightforward path toward financial integration as opposed to the variety of side routes that had been taken.

Incidentally, no other developed country has ever seen fit to separate commercial banking from investment banking. Banks in Germany and Switzerland have always been free to engage in underwriting and securities holding to no obvious harm. British banks are slightly more regulated: They are not allowed to sell insurance.

Backed partly by the reputation and stature of Paul Volcker, the Dodd-Frank act is now law. A provision that at least echoes the Volcker rule prohibits “high risk” proprietary trading by banks (trading for their own account). However, the distinction between proprietary trading and similar but supposedly benign forms of trading is left to regulators. Thus the effects of this and the act’s other loosely related provisions won’t really be known until a passel of regulations are written and implemented. Very likely the full effects of Dodd-Frank won’t be apparent until the next financial crisis. It is disturbing that the urban myths that backed Glass-Stegall have survived like a dormant virus in the person of Mr. Volcker, as his quoted testimony suggests, and have re-emerged in Dodd-Frank.

Glass-Steagall tore investment banks out of the arms of their commercial banking parents. After that they stood alone, first as partnerships and then, starting with Merrill Lynch in 1971, as corporations. More recently they began to convert themselves into bank-holding companies. In September 2008 the last two major stand-alone investment banks, Goldman Sachs and Morgan Stanley, took the plunge. At a stroke these institutions gained certain advantages such as borrowing privileges at the Fed’s Discount Window, while subjecting themselves to stricter regulations on leverage and borrowing. Most important, their explicit status as banks gives them greater assurance of a future bailout should failure loom again.

Scapegoat

The timing of the repeal of Glass-Steagall makes this deregulatory move a convenient scapegoat for the financial crisis. But the crisis began with the housing collapse, a result of government encouragement of unsound lending practices. Financial firms took too much risk with mortgage-backed securities, in part because of moral hazard engendered by government guarantees and partly because bond rating firms were not as independent as was once thought. The limited liability that the investment banks gained when they became corporations may also have amplified moral hazard. There is no good reason to believe that Glass-Steagall, had it remained in effect, would have prevented any of these problems.

A panoply of myths grew up around the Great Depression, many of which are only now being debunked. Sadly, the current Great Recession may spawn a new set of myths, among them the supposed role of Glass-Steagall’s repeal. We have seen how 1930s congressional hearings produced scapegoats that led to Glass-Steagall’s separation of investment banking from commercial banking. Is history repeating? Last April the Securities and Exchange Commission filed securities fraud charges against Goldman Sachs. The civil complaint, since settled for $550 million, contended that the firm stacked the deck on billions of dollars worth of mortgage securities in favor of insiders and at the expense of outsiders. At this writing the Manhattan U.S. Attorney’s office is conducting an investigation that could lead to criminal charges. And Goldman executives were subject to some 11 hours of intensive questioning in front of a Senate committee, during which they largely stood their ground.

We do not know whether the charges against Goldman Sachs have merit, but the parallels between that firm and the National City Bank of 1933 are eerie. We may well be seeing the manufacture of another scapegoat.

Economists are prone to write turgid prose and employ a jargon-filled style. Not these two gems. Each author is a deservedly well-regarded economist, eminent in his field, but their books are written for the layman. Both draw on detailed academic research, but neither requires the reader to wade through thickets of citations.

Taylor poses these questions: “What caused the financial crisis? What prolonged it? What worsened it dramatically more than a year after it began?” His answer in each case is first and foremost “specific government actions and interventions.” The heart of his argument is a criticism of Fed monetary policy under Alan Greenspan in the aftermath of the collapse of the dot-com bubble. The Fed cut interest rates and continued cutting aggressively, taking the short-term interest rate under its control (the federal funds rate) down to 1 percent. The rate stayed at 1 percent for a year. Other market interest rates fell as well. The artificially low cost of borrowing fueled the housing boom.

Taylor uses a figure to compare housing starts as they actually occurred in the boom with a counterfactual simulation—as they would have occurred had the Fed adhered to policies that began in the early 1980s and continued into the 1990s. The result: “No Boom, No Bust” in housing. Not everyone agrees that monetary policy was so benign throughout the period dubbed the “Great Moderation.” But the Fed’s cheap money policy after 2000–01 brought back volatility in housing and the economy last seen in the 1970s.

Taylor explains how the Fed exported its easy money to other countries (especially the European Union), drawing them into the crisis. He also examines the many other complications, including such issues as the actions of Fannie Mae and Freddie Mac, and the role of securitization. His analysis of the many policy missteps in response to the crisis is masterful. These policy errors prolonged the crisis.

While Taylor covers a broad array of issues, focusing particularly on monetary policy, Sowell focuses
on the housing market itself, chronicling the “skyrocketing rise” in home prices. From 2000 to 2005 the median sales price of a single-family home rose 53 percent, from $143,600 to $219,600. In the priciest markets, like New York City, Los Angeles, and San Diego, prices escalated at an even more rapid rate (79, 110, and 127 percent, respectively). How could home prices have increased so much in such a short period, then fallen so fast?

Sowell also asks the commonsense questions. “When it comes to the home mortgage boom and bust, who was to blame? The borrowers? The lenders? The government? The financial markets?” He answers yes to all the above and notes that “economics cannot explain such things.” Politics drove the housing boom, and he turns to the politics.

First, there is the wonderfully misnamed policy of “affordable housing.” Never precisely defined, it is
a complex combination of misguided policies. They include policies to lower borrowing costs, down payments, lending standards, and, generally, costs of homeownership. Instead they have together combined to increase housing costs. As Sowell observes, it is precisely where government intervention in housing is the greatest that housing costs are highest.

Government housing policies have been at war with themselves. Sowell cites the case of housing in coastal California, now one of the highest-priced markets in the country. As late as 1969, however, home prices there were affordable by a number of measures and in line with home prices in the rest of the nation. In the 1970s California began introducing land-use restrictions that drove up costs for lots and their development. He examines alternative explanations for the rapid escalation in prices and concludes it was the land-use policies that were responsible for astronomical housing costs in coastal California.

California’s land and housing policies were extreme, but not unique. So we have longstanding policies restricting the supply of land and homes meeting policies to stimulate demand. When demand is stimulated and supply restricted, prices will necessarily increase. Land-use restrictions, affordable housing, and easy credit caused the housing boom and bust.

For the full story, I recommend these two estimable books to Freeman readers.

Meanwhile, Congress put the finishing touches on a mammoth regulatory bill called the Restoring American Financial Stability Act of 2010. (Editor’s note: It was passed and signed in mid-July.) As I write there is no way to know what final shape it will take. But considering how it was shaping up, what are the probable effects?

The rationale for this vast expansion of government oversight is to prevent, or at least reduce, financial instability, as the bill’s title declares. Therefore it is useful to remind ourselves of why and how markets became so unstable in the first place.

There are two fundamental reasons why markets gyrate. One is human emotion, in particular a penchant for over-optimism about financial prospects, which turns into panic once things go downhill—a pattern known colloquially as greed and fear. Business cycles are unavoidable to the extent they’re rooted in human behavior. On top of this, governments have caused normal cycles to become extreme and destructive with a multiplicity of interventions and their own financial woes—as with Greek sovereign debt.

Thus the boom in the American housing market was set off by optimism that property prices would keep rising and the bust initiated by the panic that ensued when prices faltered. But the cycle became monstrous because the Federal Reserve kept money creation too loose in 2001–2004. To make matters worse, Congress pushed the two government-created entities, mortgage buyers Fannie Mae and Freddie Mac, to go easy on less creditworthy loans.

As a result of these policies, taking out a mortgage became child’s play. People who might have otherwise been more prudent mortgaged up to the hilt, and enormous piles of mortgages became available to be bunched together and turned into securities—a lucrative activity that drew the attention of Wall Street, but was done largely by Fannie Mae and Freddie Mac.

When real estate turned, it took down banks that lent heavily to developers, homeowners who borrowed beyond their means, and financial companies that held or insured mortgage-backed securities. As for Fannie and Freddie, they continue to suck down billions of dollars of taxpayer money every month, with no end in sight.

Human nature has not changed, and the government is becoming more interventionist, not less so. So the conditions that produced the dramatic bubble-and-bust remain in place. How, then, will the Financial Stability Act prevent crises?

Since it is not practical to analyze all the disparate elements that constitute a 2,300-page grab bag of a bill, I will focus on the centerpieces that were most likely to become law. These are from the version of the bill introduced April 15, sponsored by Sen. Christopher Dodd.

The first is the creation of a supra-bureaucracy called the Financial Stability Oversight Council, with nine voting members who are to make decisions by majority vote. Among them are the Treasury secretary, the Federal Reserve chairman, the Securities and Exchange Commission chairman, the director of the Federal Housing Finance Agency, and an independent member appointed by the president.

Almost all council members are heads of departments and agencies that have been around for decades and shown not the slightest ability to prevent risky behavior by financial firms, the population at large, or for that matter themselves and fellow government entities. Somehow, they are supposed to do together what they don’t do on their own.

The act also adds a new bureaucracy, the Office of Financial Research, with responsibility to collect and process data and conduct studies for the council. This newly created apparatus of the council and research office is to work as “an early warning system to detect and address emerging threats to financial stability and the economy,” according to a congressional committee report.

The research office would get the power to subpoena information from any financial company. It is “to develop and maintain metrics and reporting systems for risks to the financial stability of the United States” and “monitor, investigate, and report on changes in system-wide risk levels and patterns.”

If you ask what the systemwide risks are, you won’t find an answer in the act. The director of the office, appointed by the president for a six-year term, “shall have sole discretion in the manner in which” he or she exercises the authority provided by the bill. Indeed, the wide discretion the bill provides to future bureaucrats is remarkable. What they’re going to do to promote stability is about as clear as how snake oil was supposed to cure cancer, bunions, and lovesickness.

The act says certain bank companies may be required to have a “risk committee” with “at least one risk management expert having experience in identifying, assessing, and managing risk exposures of large, complex firms.” That is like requiring water to flow downhill. Almost every financial business already has risk control people. Even hedge funds have risk managers.

Risk management is a well-established discipline with an ever-increasing number of practitioners who spend their time trying to measure and reduce future hazards. In finance the number of risk management experts has grown tremendously in past years—without any legal mandate. These specialists have been notably unsuccessful in preventing occasional crises, as the past several years demonstrated.

Risk experts constructed the mathematical models that gave misleadingly benign views of the dangers in mortgage-related complex instruments. The models will improve over time, but will occasionally be mistaken regardless of legal requirements. It is not the case that financial companies want to lose money.

The basic reason they sometimes do lose money is that making money requires some risk. This is no different from many other activities, such as drilling for oil. Yes, you can end up with a nasty spill, but no risk, no oil. Similarly, no financial risk, no financial gain.

The object is not to avoid risk but rather to keep it under control, and that has always been a most delicate task. The early twentieth-century economist Frank Knight made a distinction between risky situations, where the possible outcomes and their odds can be estimated, and uncertainty, where there is no meaningful way to know the probabilities. There are known unknowns and then there are unknown unknowns.

Throwing dice exemplifies risk with known odds. By contrast, Fannie Mae (which, along with Freddie Mac, is unaddressed in the new law) is a source of uncertainty; the consequences of its creation were unexpected, and its future is an unknown unknown at this time. It stands as a shadowy but colossal monument to man’s ability to create monsters in the name of doing good.

Dealing with risk is hard enough; we’re lost dealing with uncertainty. This shows up especially with rare but big events—known as the tail risk of a bell-shaped probability distribution. More vividly, Nassim Nicholas Taleb, a trenchant critic of financial industry practices, has dubbed them black swans.

As long as an event like the real estate slump has not yet happened, people make money by ignoring it. Therefore risk managers “play politics, cover themselves by issuing vaguely phrased internal memoranda that warn against risk-taking activities yet stop short of completely condemning [them],” to quote from an earlier book by Taleb, Fooled by Randomness, published a decade ago—when risk managers were already recognized players.

Same Goes for Government

This criticism applies no less to government agents. Nobody has a reliable way to predict rare events, and human nature is all for ignoring them. Regulators don’t do any better—from the chairman of the Federal Reserve on down, officials issue vague warnings but don’t stop risk-taking. After all, they are subject to the same behavioral biases and face similar incentives. Just as shareholders are displeased when a bank does not make money, voters are displeased when a government imposes economic hardship.

Therefore, like banks, governments keep dancing as long as the music lasts. It is hard to imagine that changing. So preventing future crises is the least likely outcome of the Stability Act. But might it have some other benefit?

Emergency measures used by the U.S. Treasury and the Federal Reserve to prop up companies in 2008–2009 left in their wake the absurd problem of too-big-to-fail—taxpayers appear to be on the hook for any large financial concern whose failure might have far-reaching impact. Given that taxpayers also ended up with the vast pension liabilities of General Motors, the problem of bailouts is not really confined to financial companies, though it is widely described as such.

Nobody wants a repeat of the widespread panic and losses caused by the bankruptcy of Lehman Brothers in September 2008. That failure resulted in market chaos in large part because the assets of Lehman clients got tied up in bankruptcy courts, not just in the United States but in the United Kingdom. With their capital frozen in years-long litigation, the clients sold securities to raise money, with the predictable catastrophic effect on prices.

So instituting a process by which large financial companies can be shut down without a lengthy bankruptcy case would both reduce the impact of failures and get rid of the notion that investment banks need to be bailed out. Expeditious, orderly, and internationally coordinated winding down of failed companies is an obvious solution for the too-big-to-fail problem.

The act gives the Treasury, in conjunction with judges from the U.S. Bankruptcy Court for the District of Delaware and other agencies, broad powers to take control of a financial business perceived as a threat to the system and turn it over to the Federal Deposit Insurance Corporation (FDIC) for liquidation. The FDIC, which unwinds failed commercial banks, is to do the same for other financial businesses.

“Once a failing financial company is placed under this authority, liquidation is the only option; the failing financial company may not be kept open or rehabilitated,” says a Senate committee report.

That may sound like a way to prevent bailouts, but the government is given such open-ended discretion that perverse outcomes are possible. To go this liquidation route a company does not need to be actually in default as long as the Treasury determines that it is a sufficiently serious threat. On first read, my primary concern was that companies that were not going to fail might be liquidated.

On second thought, it is just as possible that those which are failing will be bailed out instead of being liquidated. This could happen if there are politically powerful interests behind a company. Think of the unions that came out on top in the government’s handling of GM. In effect, we’re asked to trust politicians and bureaucrats. No doubt they will make politically advantageous decisions, with goodies for the politically favored and sticks for the politically vulnerable.

A better alternative to the creation of this extensive authority would be to streamline bankruptcy to make it simpler and faster. The act calls for studies of bankruptcy and international coordination, the latter of which is necessary because large investment banks are global entities—but the possibility of bankruptcy reform is remote. That could reduce legal fees, not something that a Democratic Congress will allow. Lawyers are a major constituency for the Democrats. They will be among the big winners of the regulatory onslaught, which is bound to increase the demand for legal services.

More Of The Same

It is ironic that the act expands the government’s domain in the name of stability, since public policies have increased instability, public functionaries have been clueless in foreseeing threats, and politicians have created uncertainty—with Fannie Mae, for instance.

One of the members of the Stability Council, the Federal Housing Finance Agency, was set up by a 2008 law to be the successor to the Office of Federal Housing Enterprise Oversight. The latter, the overseer of Fannie and Freddie, presided over debacle after debacle, year after year, from accounting shenanigans to endless taxpayer bailouts. Congress obviously wanted an agency with a different name.

But the new bureaucracy is simply the old one merged with another entity. So the same bureaucrats that did so well ensuring the safety and soundness of Fannie and Freddie are supposed to ensure financial soundness on a wider stage in the new setup! If that does not inspire confidence, neither do other members of the council.

The Securities and Exchange Commission let Bernard Madoff continue his Ponzi scheme year after year despite repeated complaints from a whistleblower and even news stories about the fraud. More recently another astounding SEC failure came to light.

In 2009 Texas resident Robert Allen Stanford was nabbed for an $8 billion fraud—Stanford International Bank had for years sold certificates of deposit promising unachievable returns. An investigation found that the SEC Fort Worth office had known since 1997 that Stanford was likely operating a scheme. Despite examinations indicating this, the enforcement division chose not to take action.

The preferred excuse for numerous government debacles is that the bureaucracies lacked authority, personnel, or information. Yet the SEC in fact repeatedly examined Stanford and had the power to stop his activities.

Here is the punch line to the Stanford affair. In a dramatic instance of the revolving door for former regulators, the SEC lawyer who made enforcement decisions at Fort Worth left and represented Stanford—before he was told that this was improper. That’s how regulation works in reality.

Expanded Crony System

The vast new powers given to regulators will no doubt enhance the fees and salaries that former bureaucrats like this SEC lawyer command. They will have greater opportunities to sell their protection and expertise to the regulated and will also, of course, benefit from enlarged budgets while in public employment. Politicians and political staffers, too, will be able to extract more money from the regulated and get lucrative jobs in the financial industry.

This is already an established trend, with President Obama’s former White House counsel moving to Goldman Sachs and a former aide to Rep. Barney Frank on the House Financial Services Committee taking a job with a derivatives exchange. Such crossovers will no doubt become even more common as firms look to protect themselves while government agents get a broad mandate to intervene and decide which companies to liquidate and which to bail out—who’s a systemic risk and who’s not.

Even as they go “tsk-tsk” chiding business lobbies, the President and Congress are laying the groundwork for an infinite growth in the crony system intermingling government with private interests. The rest of us will pay for the resources that will be redistributed in favor of bureaucrats, politicians, lawyers, and the politically favored. The impact of the act on financial stability is uncertain at best, but its corrupting influence on the Republic is a sure thing.