What NOT to do right now about the economy

In the wake of the subprime lending frenzy and subsequent market turmoil (some of the causes of which we discussed here), many in Congress are now gearing up for increased regulation of the financial markets.

The fact that government regulation often has unintended consequences, and has been partly responsible for the recent problems in the financial system, does not deter those whose answer for every crisis is knee-jerk regulation. Yesterday the Wall Street Journal led with a front-page story entitled "Political Pendulum Swings Towards Stricter Regulation." It started out with the provocative assertion that: "The idea that less regulation is better for the economy has held sway in Washington since the Reagan administration. Now that consensus is crumbling [. . .]."

There were two other related stories in the same Journal, one called "Washington Sees Several Fronts for Attacking Mortgage Crisis" and one called "Mortgage Rescue Options." (Access to articles in the Wall Street Journal may require a subscription).

The Fed's most recent actions have probably ensured that the financial system will "unfreeze" and continue to operate. Such actions are appropriate in light of the fact that the Fed was created to prevent such failures in the banking system. Some of those who now want even greater government intrusion into the mortgage market are calling the Fed's action a "bailout" of Bear Stearns, saying that if the government "bails out" Wall Street it then has an obligation to "bail out" Main Street.

But the government did not "bail out" Bear Stearns; Bear Stearns shareholders got hammered (Bear may have survived intact if some of the Fed's new lending policies had been enacted a couple weeks earlier). The recent actions to thaw the banking system are akin to stepping in to keep the freeway system operating in the event of a severe storm.

However, a widespread rejection of "the idea that less regulation is better for the economy" that has "held sway" since the Reagan administration would be the wrong response. As Art Laffer wrote over the weekend, "[From 1981 up to 2002] The U.S. led the world with tax cuts, free trade, sound money and controlled spending." This environment led to tremendous prosperity and growth for twenty-five years.

Now, however, those who prefer to see a weak dollar because of concern over the meaningless "trade deficit" (otherwise known as a "capital surplus") as well as those who favor higher tax rates and greater government regulation are gaining influence.

Misguided government regulation was part of the cause of the most recent crisis. Creating additional legislation and regulation now is not a wise course of action especially since that is exactly what has caused much of the recent problem.

For later posts dealing with this same subject, see also:


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