Financial Reform: Bigger Government, for the Benefit of Special Interests

In 1971 George Stigler published his “Theory of Economic Regulation” in which he hypothesized that regulatory agencies tend to be “captured” by the organizations they are regulating, so that the regulated organizations benefit at the expense of the general public.

Stigler’s capture theory of regulation is playing itself out again in the financial market regulation that is currently being considered by Congress.

Peter Wallison gives a good accounting of that reform effort here, drawing heavily on Robert Higgs’s “crisis and leviathan” framework.  Wallison argues that this proposed financial reform is ideologically driven; a push for big government that is at best peripherally related to the causes of the recent financial crisis.

Wallison pins the blame for the financial meltdown squarely on the federal government, saying that two-thirds of mortgages were either guaranteed by the federal government or owned by government-controlled institutions like Fannie Mae and Freddie Mac.  This generated mortgages issued to people who could not pay them, which led to the mortgage market meltdown and financial crisis.

The proposed reform does nothing to address the problems that caused the crisis.  Instead, it proposes more regulations on an industry that is already one of the most heavily-regulated industries in the economy.

Wallison says the motivation behind those proposed regulations is an ideological one: to give government more control over the economy.

Wallison notes that Fannie Mae and Freddie Mac had advantages over other mortgage lenders because investors correctly perceived that the government would treat them as too big to fail.  They essentially were risk-free institutions, because any losses would be covered by the taxpayers.  He argues that the proposed financial reforms would create a whole new set of “too big to fail” institutions, with the same competitive advantages.  Big firms are favored by the proposed regulations; small firms will be at a competitive disadvantage.

These big firms, supported by the government, will in turn have to toe the government line.  Wallison says, “They will no longer be independent and innovative competitors, but government-controlled institutions. Each will have to pay more attention to what Washington wants them to do than to what competition would demand.”

Wallison argues, “Among other adverse effects, large companies would be favored over smaller ones, the U.S. financial-services industry would morph from a competitive and innovative system—with many large and small competitors—into a system dominated by large institutions that are virtual wards of the government, and successful financial firms would prosper through effective representation in the power corridors of Washington rather than competition in the marketplace.”

Here is an example of special interests already at work: Proposed regulations on derivatives would impose costs on Warren Buffett’s Berkshire Hathaway, and Buffett is lobbying Congress for a deal to keep his derivatives free of regulation.  Some firms would benefit; others would be held back by the regulatory noose.

We are seeing Stigler’s capture theory of regulation in action.  Even as new financial regulations are being written, they are being designed to benefit a few powerful interests at the expense of smaller competitors, and of the general public.  Meanwhile, they ignore the underlying causes of the problem that allegedly prompted the call for regulation.

Ultimately, the ideology of government economic planning is driving this reform, which completely ignores the sources of the recent problems suffered by financial markets.