Preventing Another Mortgage/Financial Crisis

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I suppose I won’t get away with saying it’s probably already too late to prevent another financial crisis because the seeds were already planted during the last one. Recessions are necessary for a healthy economy, major crises are not. A mortgage crisis is just one flavor of financial crisis, but according to Kindleberger-Minsky they all play out in a similar fashion. The next crisis will probably come out of some other asset based market, however economic crises typically share the same characteristics. At this point, it is probably time to discuss how the next crisis is going to be dealt with rather than how to prevent it. Nevertheless, anything is possible and with a just a few simple steps, major years-long financial crises like the ones that have become the norm in the last century can be prevented.

1. Privatize the Fed. The Fed is a banking cartel, owned by its member banks, for the benefit of banks. As with all cartels, the purpose is price fixing, and in this case the price is the interest rate – which also happens to be the most important price in the economy. The Fed is an independent agency and contrary to what many seem to believe it is not subject to Congressional oversight. Although the board is selected by the President, the selections are made from a short list provided by the Fed. The Fed's primary stated goal from the start has been to stabilize the economy. Considering we've had a Great Depression, runaway inflation, numerous recessions, and a Great Recession/Depression II in the last hundred years, this is a mission in which it has spectacularly failed. There are many other reasons, enough to fill numerous books on the matter, but this one should be convincing enough that the Fed is either not capable of performing its primary stated mission, or it's doing something else entirely. Privatize the Fed and give it no favored legal status, express or implied. Do not allow it to set official monetary policy or interest rates, and revoke legal tender status for it's bank notes. Revoke its Congressional charter and allow it to incorporate like any other business. Let it act as a private industry regulator for its member banks. If the Fed necessary and beneficial to society, it will figure out how to serve the market and survive. So will its member banks once they are no longer indirectly backed by the Federal Government.

2. Privatize the FDIC. The FDIC was formed during Roosevelt's 1933 bank holiday to protect depositors from loss and restore confidence in the banking system. Sounds like a great idea, until considering that it also protects banks from losses, whether due to runs or malinvestment of deposits. This moral hazard market failure required another law, the Glass-Steagal Act, to separate investment banks from commercial deposit banks. This law was retroactively repealed in 1998 and replaced by an even more complicated law, but the barrier between investment banks and commercial deposits had been breached. Now there are even more laws piled on, creating as of yet unseen unintended consequences. Deposit insurance has market value for both banks and their customers. The FDIC needs to drop the F and be privatized. There is demand for its product and competition will both improve the product and lower the price. Deposit insurance should be the choice of the depositor, banks and customers can work out details on premium payments and claims, but the insurance must be visibly paid by the customer. The FDIC is backed by the federal gov't so it's not subject to the same requirements as other insurers, like collecting enough in premiums to cover potential losses. Subjecting it to market discipline and competition will ensure that it serves the depositors who pay the premiums rather than saving banks from reckless decisions and bad investments.

3. No publicly funded bailouts for anybody. Ever. There should never be any question about whether taxpayers will save failing businesses and/or their investors. Bailouts probably create less moral hazard than they get credit for, no company or CEO wants to risk nationalization and no investor wants to sink money into a company at risk of nationalization. The biggest problem is that bailouts don't really save businesses and jobs, they save bad business practices. Banks and US automakers are back to pre-crisis business as usual, a few band-aids have been slapped on the gushing wounds, but little has changed in regards to underlying market fundamentals. Fiat fractional reserve banking and mortgage securities are still being propped up by the Fed, subprime mortgages are back at pre-crisis level, and GM is still building cars nobody wants that aren't worth half what they cost to build. Chrysler continued building some of the worst cars ever produced after they were bailed out in 1977, leading to their latest bailout. Amtrak still loses billions of taxpayer dollars every year offering a service that has long ceased to be of any economic value, it costs less in both money and time for travelers to fly or take a bus. Saving bad business practices may provide temporary relief and put off the crash for another day, but doesn't force businesses and consumers to change bad habits, and ends up exacerbating the inefficiencies that led to the crisis. Failure is simply a market signal that inefficiencies exist within the economic system. Reaching the point of failure suggests that previous signals were likely ignored or not properly prepared for. Businesses that are otherwise sound, yet not insulated enough from market disruptions to survive a crisis are still engaging in bad business. Allowing companies, even entire industries, to fail makes way for more resilient market restructuring to prevent another such calamity. Profitable businesses, or components of, that get caught up in the failure will be purchased by more able investors who protected themselves by making better decisions. Large failures are indeed very disruptive to the economy, but we have a choice. Do we want more frequent, short-lived, and less severe recessions, or do we want to save them all up for a big crash with a long drawn out psuedorecovery that leads us right into the next big crash? 4. Fully privatize Fannie and Freddie. The implied backing of these agencies by the Treasury contributed to reckless mortgage lending. The market needs to know these agencies are on their own and will not be supported by taxpayers. Like the Fed and FDIC, if the market deems these agencies necessary, they will survive.

5. Phase out limited liability companies. I know this one will not be popular and will require major overhauls in the legal system to accomplish. There are good reasons for limited liability, however they are negated by unintended consequences. Limiting liability creates a great deal of moral hazard. Boards, managers, and investors must be held personally accountable for the actions of their businesses. If CEO's run businesses into the ground, they need to feel the losses rather than shifting them to somebody else and riding out on a golden parachute. No need to put them in jail, let them lose all their money without much prospect of making it back since they will likely have a tough time finding a job, or at least a job at the same level in the same industry. If stockholders elect ineffective boards that in turn hire ineffective managers, they should have to pay the price for making a bad investment. Investors will be forced to actually pay attention to what corporations are doing and who they are hiring. If there is demand for a product, someone will provide it. If there is money to be made, investment will still take place even with elevated risk, although businesses will have to pay a premium to investors for the extra risk. Companies will be forced to take great care in providing safe, beneficial products and serving their customers. Businesses that have grown past the point of being able to keep most of their customers happy most of the time can not continue to exist. This also could be the subject of a book, but those are a few main points.

6. End housing subsidies.Primarily the mortgage interest deduction. Most homeowners never get to take advantage of the deduction, so it is not beneficial to most of society as it's sold. Within the current tax code, this deduction should be changed into a credit and shifted to encourage more liquid savings. Assets do provide a store of wealth but can be volatile and difficult to sell when the cash is needed. Liquid savings are extremely important to the overall stability of the economy by allowing consumption to continue after a loss of income. Tax-free savings plans can be developed and implemented similar to 401(k)'s, that remain tax free when used in the case of an emergency, such as making mortgage payments after unexpected job loss, but incur heavy penalties if used for anything else. Employees can be automatically opted-in unless they specifically object. There are many ways to induce savings, but first savings have to be recognized as beneficial rather than harmful to the economy.

7. Install firewalls. This is already being done, but financial firewalls and circuit breakers need to be constructed to prevent contagion, so one highly interconnected and poorly managed business can not take down an entire industry or segment all by itself. Internet firewalls help to protect individual users from general threats, and also protect the rest of internet users by helping keep malware contained locally, while still letting all the desirable websites through. In May 2010, the Flash Crash was caused by an investor mistake that was transmitted throughout the financial system by high-frequency trading algorithms that set off a feedback spiral. This relatively minor event was prevented from becoming a major disaster by momentarily halting securities trading. This was an example of a successful financial circuit breaker that kept a small problem from becoming an unmanageable one.

8. End State Professional Licensing. Licensing is touted by (already licensed) industry professionals as a consumer protection. It is not. Licensing serves only to restrict market entry and protect current licensees from competition. It also allows markets to be controlled by industry professionals, rather than consumers. In the case of housing, licensed real estate agents can keep other licensed agents in line by threatening to revoke the license. Competition is restricted to only the agents who conform to industry standards and don't upset the system by undercutting other agents. Workarounds have arisen, such as DIY realty and realty assistance by licensed real estate agents at reduced commission, however selling a property is a lot of work and many people have neither the skills nor time that is necessary.

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