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Wall Street Wrecked The Economy, Not Government

Over at bloggingheads, my CAF colleague Bill Scher discusses the new international banking standards with Conn Carroll, a conservative blogger for The Heritage Foundation. Carroll actually agrees with a lot of what I have to say about Basel III, but I he draws conclusions from my post that overemphasize the role of regulation and ignore the insane lobbying and outright fraud that Wall Street deployed to create a crisis. The fact that Carroll and I can agree on this stuff (to an extent) shouldn't come as a terrible shock—Wall Street reform is about the basic functioning of the economy—it's not an issue that needs to ignite ideological conflict. Here are his key comments: "I like the acknowledgement that the problem of this last financial crisis had to do with a problem of regulation." Nothing wrong there. You'd have to be insane to believe that financial regulations—or the regulators who implemented them—were up to snuff. But here's where I part ways with Carroll: "When this economy started melting down and the financial crisis happened . . . the reason is regulation. It wasn't because of the free market, it was because of Basel II with their regulations saying that AAA-securities were an asset that qualified created a huge demand for all of these mortgage-backed securities." Basel II was indeed terrible, and the credit rating agencies were totally corrupt (quite possibly fraudulent) operations. But you can't blame Basel II and the rating agencies for all of the Wall Street excess that created the crisis. Basel II didn't forcebanks to buy up lousy mortgage-backed securities that rating agencies had evaluated improperly. Nobody required banks to rely on bad ratings alone. Bankers and traders were paid very well to find assets that would enrich their firms. They got it completely wrong, destroyed their companies and nearly destroyed the global economy. The fact that rating agencies alsogot it completely wrong doesn't excuse this behavior, nor does the fact that regulators also relied on rating agencies. Bankers found loopholes, exploited them and wrecked the economy. In other words, the financial crisis is a story about regulation allowing reckless behavior, not a story about regulation encouragingreckless behavior. Bad regulations let the free market to run amok—they did not tie the market's hands and require market actors to do reckless things they really didn't want to do. Plenty of people at major Wall Street banks knew that they were courting disaster, but went ahead in the quest for bigger bonuses. Everybody on Wall Street who packaged mortgage-backed securities and collateralized debt obligations knew the rating agencies were meaningless, because they had to work with those same rating agencies in concocting their own toxic securities. What's more, plenty of people on Wall Street knowingly bought the toxic securities that they themselves created. ProPublica has documented the most damning case of this practice, a situation in which banks sold crappy CDOs to investors, but actually purchased risky parts of the CDO themselves in order to establish fake demand for the entire product. Merrill Lynch was the most frequent offender in this respect, but Citigroup and Goldman Sachs adopted the same scheme. Rating agencies and Basel II didn't force Goldman to concoct a "shitty deals" and brag about them over email, and they didn't force Lehman Brothers or Bank of America to adopt Enron-style schemes to conceal debt from investors. The lousy financial regulations that lead up to the crisis were not written by wild-eyed consumer advocates unaware of the potential consequences. They were written by policymakers who were extremely sympathetic to the global financial elite, and in many cases, by policymakers who were members of the global financial elite. They knew these rules wouldn't do much to affect banker behavior, which is why they pursued them. That point applies to just about every faulty regulatory maneuver preceding the crisis. In the U.S. alone, policymakers lifted leverage caps on Wall Street investment banks, deregulated the derivatives market, repealed Glass-Steagall and refused to regulate the mortgage market. That was because regulators had been corrupted by the financial establishment, not because it's just impossible for regulators to figure out how to write decent financial rules. None of this, of course, implies that international regulators should continue to rely on rating agencies or exclusively rely on any risk-weighted capital requirements. On this, Carroll and I agree. Whatever the criteria for risk-weighting, Wall Street will come up with some way to game those rules. When they do, we'll all wish Basel III had imposed a meaningful, hard leverage cap as a back-up.