Non-Objective Law Is Smothering the Recovery

Howard Gold recently noted that the economy's failure to thrive is a refutation of the work of two dominant 20th-century economists: John Maynard Keynes and Milton Friedman.

Keynes was the great advocate of massive government spending as an economic "stimulus," which President Obama tried as his first act in office, and which failed to produce the expected "multiplier effect" that was supposed to boost the economy. So this was a failure of the economics of the left. But what about Friedman? While Friedman is usually remembered as one of the great economic defenders of the free markets--which in some ways, he was--he was also one of the chief advocates of monetarism, which promoted the notion that the central planners at the Federal Reserve could manipulate the economy by adjusting the money supply. And as Gold points out, Fed Chairman Ben Bernanke was a self-confessed adherent of Friedman's theories. So along with the Keynesian stimulus, we got an even bigger monetary stimulus from the Fed, and we got it twice: QE1 and QE2. Yet this also failed to produce the expected multiplier effect.

There is some legitimate mystery as to why. I have inveighed against all forms of bailouts and stimulus, arguing that every dollar pumped into the economy by the government eventually destroys more than a dollar of private economic activity. But the key word is eventually. Money pumped into the economy by the Fed usually goes into "bubbles" of malinvestment, putting the capital to an unproductive use (like building houses that people can't afford) and creating destructive inflation over the long term. But we would still expect that a tsunami of cheap credit from the Fed would create some short-term credit expansion, even if we have to pay for it later on.

Yet this credit expansion hasn't happened. The Fed has extended the banks trillions of dollars in easy money, but this hasn't produced a commensurate expansion of lending. Why not?

The answer is a larger refutation of the theories of monetarist stimulus. The Great Recession demonstrates that the money supply is not the ultimate driver of the economy. The ultimate driver is very simple: has the government created a safe climate for investment?

The Obama administration and the Democratic Congress have done the opposite. They have created a hostile climate for investment, and they have done so through one measure that is directly smothering the economic recovery: the Dodd-Frank financial reform bill. Dodd-Frank has injected a lethal dose of uncertainty into the very heart of the financial sector--and we're only halfway through the worst of this effect.

The problem is not any specific provision of Dodd-Frank. The problem is the lack of specific provisions. Despite being more than 2,300 pages long, which would be more than enough space to spell out a comprehensive system of regulation in exacting, concrete detail, this is not what Dodd-Frank did. Instead, as the New York Times noted last year when it passed, the bill "is short on the details necessary for enforcement. Enactment has set off a scramble by financial regulators to write the rules needed to put the bill's broad framework into practice."

"Richard Murray, chairman of the US Chamber of Commerce's Center for Capital Markets and Competitiveness, says the burden placed on regulators is unprecedented. 'It's a law comprised of goals and objectives much like the preliminary blueprints for the design of a very complex building,' he said at a July 27 chamber conference on the bill.

"He noted that the law calls for 530 rulemakings, 60 studies, and 90 reports to Congress. 'The wiring and the piping and the internal decor that will become financial regulation will emerge from that process,' he said.

A financial consultant quoted in the article described the bill as a "blank slate," while another provided the best analogy: we're in "the eye of the storm": "We have been through a great amount of legislative work.... Now we have to wait for the regulations."

A year later, we're still there. Just last week, House Democrats were urging regulators to speed up work on giving actual meaning to the Democrats' vaporous legislation. This probably won't help because "much of Dodd-Frank remains tied-up with regulatory agencies that must abide by a standard process laid out by the Administrative Procedures Act, which mandates a string of proposal requirements, commentary periods, and economic impact analyses before new regulations go into effect. Agencies like the Consumer Financial Protection Bureau, FDIC, and Office of the Comptroller of the Currency still need to finalize half of the approximately 387 rules needed to execute Dodd-Frank-related provisions."

So it will be at least another year at the least before bankers and investors find out what laws they are living under. And it gets worse: the provisions that are yet to be decided are not minor details but go the very heart of the financial industry.

Dodd-Frank formalized the institution of "too big to fail" for companies that are considered large enough to pose a "systemic risk" to the financial sector. In return, these companies are subjected to stringent new requirements intended to prevent them from failing. But it is still not clear which companies will be regarded as "systemically important" and which will not, so hundreds of big financial firms are living under the cloud of restrictive regulation. And to make things worse, Federal Reserve Governor Daniel Tarullo suggested a few weeks ago that systemically important banks should have their capital requirements raised from 7% to as much as 14%.

That's just a wee, tiny little detail that nobody has quite worked out yet.

Capital requirements are the heart of the investment banking business. They determine, directly and mathematically, how much credit bankers can extend. A 7% requirement means that if your bank has $700 million in its own assets, you can lend up to $10 billion of your depositor's money. But if the capital requirement is raised to 14%, you can only lend $5 billion. Double the capital requirement and you halve the credit.

And what happens if regulators can't make up their mind, so no one can tell whether their capital requirements will be doubled or not? Everyone sits on their extra cash, just in case. No wonder the economy is just lying there, flopping and gasping like a fish in the bottom of a bass boat.

Dodd-Frank is a monument to the modern practice of anti-legislation. This has been the pattern of the left's expansion of the regulatory state for decades, but the Obama administration and Democratic leaders in Congress have raised it to an art form. They pass giant, 2,000-page epics which still manage not to spell out any concrete details. What does the legislation do, instead? Mostly, it lays out an organizational chart of regulators and then empowers these unelected bureaucrats to dictate all of the actual details.

Dodd-Frank is not legislation but the abdication of legislative power. In effect, Congress has given up writing laws and instead vested that power in unelected bureaucrats appointed to executive-branch agencies.

Some details may never be fleshed out. One analysis of Dodd-Frank concludes:

"You will soon find that the regulations themselves are secondary to the new measuring stick called 'unfair or deceptive acts or practices.' Under the new environment, being in compliance with regulatory requirements is only a piece of the puzzle. That's the black and white piece so to speak. You will also have to meet the grey matter test of unfair or deceptive acts or practices.... No matter how you slice it, just about any particular act or practice can fall within the grey area of someone's interpretation.

Why create a system of such mind-boggling, stultifying uncertainty? I will evoke the "Law of Intended Consequences." They did it on purpose. The goal of Dodd-Frank was to shift the blame for the financial crisis to the private sector. As the analysis I just quoted notes: "The battle cry for unfair and deceptive acts and practices is born from the mortgage crisis as many consumer and community groups cried foul play after the mortgage bubble burst." In other words, don't blame the mortgage bubble on the politicians who agitated for easy credit and for the reckless expansion of Fannie Mae and Freddie Mac--you know, a couple of guys named Dodd and Frank. No, blame the banks, and then come up with a system to punish those wicked bankers and bring them more fully under the government's yoke.

That the goal is to exact revenge on the bankers is given away by a nasty little "clawback" provision that allows the government to seize the previous two years of a banker's pay if he is deemed to be "responsible" for an institution's failure. It's an excellent way to increase the risks and decrease the rewards of going into the banking business. Yet when a banker sets out to make decisions about how to run his business successfully, he never knows when a regulator will choose to change his capital requirements or decide that his acts or practices are unfair or deceptive. So if the goal was the bring bankers under the control of bureaucrats, mission accomplished.

But this is not a good way to revive the economy or ensure the nation's financial health. By overturning the rule of law, Dodd-Frank's non-legislation legislation has created crippling uncertainty in the heart of the financial sector, neutralizing the Fed's monetary stimulus and smothering the economic recovery.