The New Year is likely to bring renewal of financial problems in the European Union. In Greece, the crisis was fiscal in origin and spread to Greek banks and banks in other countries that had lent to Greek banks and the Greek government. In Ireland, the crisis began with problem real-estate loans at Irish banks. That spread to European banks, mainly British, that had lent to Irish banks.

In its year-end issue, the Economist reminds us of the 2008 banking crisis in Iceland.  The Icelandic government responded much differently in that crisis than did the Irish government to its banking crisis. Iceland let its banks go under and to some extent stiffed their creditors. It did so out of necessity. Banking assets there were 10 times the country’s GDP, while they were “only” 2-3 times the Irish GDP. Iceland’s defiance did not cost its citizens more than did Ireland’s acquiescence.

Irish taxpayers are now burdened with their banks’ debt.  The ultimate beneficiaries of the Irish bailout are British banks and, indirectly, British taxpayers. The political irony of that has not been lost on Irish voters, and in the upcoming elections in March the populist political left is likely to gain. Then, whether by necessity or choice, look for calls for renegotiating (i.e., defaulting on) the debt. Calls for that are already being heard in Ireland.

If the Irish domino falls, look for others to topple. Portugal, Italy, Greece and Spain are all candidates. (Together these 5 countries are called the PIIGS.) The Fed has backed EU banks through currency swaps and thus exposed US taxpayers to the EU crisis. In the words of former Fed Chairman Paul Volcker, the Fed continues to operate at “the very edge” of its legal authority. (Words spoken in April 2008 speech after the bailout of Bear Sterns.)

The New Year will be an interesting one.

The New Year and Financial Crises is a post from Cato @ Liberty - Cato Institute Blog

A new AP-Gfk poll reveals that about two-thirds of the American public lack confidence that the financial regulation bill, currently being crafted by House and Senate conferees, will actually help avert future financial crises. 

The public is right to be skeptical, as there is nothing in either the House or Senate bill that ends bailouts or ends “too-big-to-fail.”  In fact parts of the bill, such as the expansion of deposit insurance, will actually increase the likelihood of future crises.  (The IMF has an insightful working paper on the negative impacts of deposit insurance). 

Perhaps the failure of Congressional efforts to end financial crises is the result of Washington’s unwillingness to recognize that government itself was the major driver of the recent crisis.  Fortunately the public seems to get that.  Some 70 percent of the poll respondents believe that government shares blame for the crisis.  Here’s to hoping that Congress will at some point listen to the public, and end many of the distortionary policies that caused the crisis.

Public Sees Past Facade of “Financial Reform” is a post from Cato @ Liberty - Cato Institute Blog

President Obama seems to be slowly waking up to the fact that the American public has grown tired of the endless bailout of Fannie Mae and Freddie Mac.  The public has also rejected the talking point that Fannie and Freddie were simply victims of a 100 year storm in the housing market.  So what’s Obama’s response?  To ask for public comment and have public forums.

This strategy is clearly one of delaying and avoiding any reform of Fannie and Freddie while pretending to care about the issue.  Where was the public comment and forums on the Volcker rule?  Seemingly the standard is that fixing the real causes of the financial crisis should be delayed and debated while efforts like the Dodd bill, which do nothing to avoid future financial crises, should be rushed without debate or comment.

Even more disingenious is couching reform of Fannie and Freddie under the rubic of “fixing mortgage finance”.  This is no more than an attempt to take the focus away from Fannie and Freddie and shift it to “abusive lending” and other non-causes of the crisis.

This isn’t rocket science.  The role of Fannie and Freddie in the financial crisis is well understood.  The only thing missing is the willingness of Obama and Congress to stand up to the special interests and protect the taxpayer against future bailouts.

Obama Proposes Further Delay on Fannie & Freddie is a post from Cato @ Liberty - Cato Institute Blog

1. Additional federal spending transfers resources from the more productive private sector to the less productive public sector of the economy. The bulk of federal spending goes toward subsidies and benefit payments, which generally do not enhance economic productivity. With lower productivity, average American incomes will fall.

2. As federal spending rises, it creates pressure to raise taxes now and in the future. Higher taxes reduce incentives for productive activities such as working, saving, investing, and starting businesses. Higher taxes also increase incentives to engage in unproductive activities such as tax avoidance.

3. Much federal spending is wasteful and many federal programs are mismanaged. Cost overruns, fraud and abuse, and other bureaucratic failures are endemic in many agencies. It’s true that failures also occur in the private sector, but they are weeded out by competition, bankruptcy, and other market forces. We need to similarly weed out government failures.

4. Federal programs often benefit special interest groups while harming the broader interests of the general public. How is that possible in a democracy? The answer is that logrolling or horse-trading in Congress allows programs to be enacted even though they are only favored by minorities of legislators and voters. One solution is to impose a legal or constitutional cap on the overall federal budget to force politicians to make spending trade-offs.

5. Many federal programs cause active damage to society, in addition to the damage caused by the higher taxes needed to fund them. Programs usually distort markets and they sometimes cause social and environmental damage. Some examples are housing subsidies that helped to cause the financial crises, welfare programs that have created dependency, and farm subsidies that have harmed the environment.

6. The expansion of the federal government in recent decades runs counter to the American tradition of federalism. Federal functions should be “few and defined” in James Madison’s words, with most government activities left to the states. The explosion in federal aid to the states since the 1960s has strangled diversity and innovation in state governments because aid has been accompanied by a mass of one-size-fits-all regulations.

For more, see DownsizingGovernment.org.

Six Reasons to Downsize the Federal Government is a post from Cato @ Liberty - Cato Institute Blog

Despite still defending the Fed’s bailouts, Fed Governor Kevin Warsh gave a speech this morning offering a few insights about reforming our financial system that seem to be lost on both Obama and Bernanke.

A few highlights:

The mortgage finance system is owed far stricter scrutiny to gather a fuller appreciation of the causes of the crisis. The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, for example, were given license and direction to take excessive risks.

One has to hope that both Bernanke and Obama are listening.  The silence of the Obama administration on fixing Fannie and Freddie is nothing short of shocking and irresponsible.  Any commitment to real reform has to include the GSEs.

Granting new powers to resolve failing firms in the discretionary hands of regulators is unlikely, in the near-term, to drive the market discipline required to avoid the recurrence of financial crises.

…Some newly-empowered and untested regulatory structure is not likely — in and of itself — to be sufficient to tackle institutions that are too-big-to-fail, particularly as memories of the crisis fade. Regulation is too important to be left to regulators alone.

I believe these two points cannot be stated more strongly:  what we need is more market discipline, rather than less.  Putting the entire weight of our financial system on the backs of our financial regulators is a crisis just waiting to happen.  Sadly the direction of both President Obama and Congress seems to be in undermining market monitoring of firms and relying solely on regulators to “get it right” – the very same regulators who were asleep at the wheel prior to the last crisis.

Fed Governor Starting to Make Sense is a post from Cato @ Liberty - Cato Institute Blog

There seems to be near universal agreement that the excessive use of debt among both corporations, particularly banks, and households contributed to the severity of the financial crisis.  However, other than the occasional refrain that banks should hold more capital, there has been little discussion over why corporations choose to be so highly leveraged in the first place.  But then such a discussion might lead us to the all too obvious answer — the federal government, via the tax code, encourages, even heavily subsidizes corporate leverage.

Cato scholar and banking analyst Bert Ely has estimated that the subsides for debt have historically resulted in an after tax cost of debt of 3 to 5 percent, compared to an after tax cost of equity of 12 to 15 percent.  With differences of this magnitude, it should not be surprising that financial companies and corporations in general become highly leveraged.

For corporations, this massive difference in cost between debt and equity financing results primary from the ability to deduct interest expenses on debt, while punishing equity due to the double-taxation of dividends along with taxing capital gains. 

If we are going to use the tax code to subsidize debt and tax equity, we shouldn’t act surprised when firms load up on the debt and reduce their use of equity — making financial crises all too frequent and severe.

For Financial Stability, Fix the Tax Code is a post from Cato @ Liberty - Cato Institute Blog

The Obama Administration is presenting a misguided, ill-informed remake of our financial regulatory system that will likely increase the frequency and severity of future financial crises. While our financial system, particularly our mortgage finance system, is broken, the Obama plan ignores the real flaws in our current structure, instead focusing on convenient targets.

Shockingly, the Obama plan makes no mention of those institutions at the very heart of the mortgage market meltdown – Fannie Mae and Freddie Mac. These two entities were the single largest source of liquidity for the subprime market during its height. In all likelihood, their ultimate cost to the taxpayer will exceed that of TARP, once TARP repayments have begun. Any reform plan that leaves out Fannie and Freddie does not merit being taken seriously.

Instead of addressing our destructive federal policies aimed at extending homeownership to households that cannot sustain it, the Obama plan calls for increased “consumer protections” in the mortgage industry. Sadly, the Administration misses the basic fact that the most important mortgage characteristic that is determinate of mortgage default is the borrower’s equity. However, such recognition would also require admitting that the government’s own programs, such as the Federal Housing Administration, have been at the forefront of pushing unsustainable mortgage lending.

While the Administration plan recognizes the failure of the credit rating agencies, it appears to misunderstand the source of that failure: the rating agencies’ government-created monopoly. Additional disclosure will not solve that problem. What is needed is an end to the exclusive government privileges that have been granted to the rating agencies. In addition, financial regulators should end the outsourcing of their own due diligence to the rating agencies.

The Administration’s inability to admit the failures of government regulation will only guarantee that the next failures will be even bigger than the current ones.

Administration Reform Plan Misses the Mark is a post from Cato @ Liberty - Cato Institute Blog